China’s economic transformation in the last four decades is one of the great economic success stories of modern history. Through liberalisation and opening up to trade China was able to grow by 10% a year between 1980 and 2018. Its economy expanded by a factor of 30 and it easily dodged recession during the global financial crisis. There is no precedent in history for an economy of this size growing at such a rate for so long.
That long boom has come to an end. Growth has decelerated since 2015 and last year China’s economy grew by 6.6%, the slowest pace in almost three decades. Today China’s trend growth rate seems to be somewhere in the region of 5-6% a year.
China is experiencing a profound economic transition, one that is familiar to all developed economies. The initial stage of development, driven by manufacturing and exports, and fuelled by cheap labour and booming investment, is coming to an end. It is a transition to which the Chinese authorities have contributed.
They have sought to reduce excess capacity in basic industries, particularly steel-making, and to rein in credit growth and asset inflation. The aim is to tilt the economy towards a more Western model, where higher value production, consumption and services play a prominent role.
Rebalancing the Chinese economy will take time. Investment accounted for 42% of China's GDP in 2017, the highest share of any major economy, while household consumption accounted for about 38%. In comparison, investment accounts for 17% of UK GDP, consumption 66%.
More recently the long-term slowdown has been reinforced by protectionism, rising US interest rate and weakening global demand.
The US has imposed tariffs on roughly half of its Chinese imports and threatened to extend them. Unsurprisingly, Chinese exports to the US have plunged. Rising US interest rates have contributed to outflows of capital from China, with investors taking their money elsewhere in search of higher returns. Chinese corporates, especially technology firms such as Huawei, have been hit by greater scrutiny of their operations in Europe and America and their links with the Chinese state.
The Chinese manufacturing sector is now contracting for the first time since the financial crisis and imports are falling. Last year car sales in the world’s biggest vehicle market fell for the first time in two decades. Apple has reported that iPhone sales, which defied the global financial crisis, have slowed due to weakening demand in China.
The slowdown has raised concerns that the Chinese economy could see a “hard landing”. A long period of credit-driven rapid growth has resulted in bad loans and inflated asset prices, especially in the housing market. Last October saw a wave of protests by homeowners in major cities demanding refunds on their homes after property developers were forced to cut prices on new builds to stimulate sales.
Just as in the West during the financial crisis, lower asset prices and slower growth are creating problems for Chinese banks. Last week, China’s two largest state-controlled banks warned about rising levels of bad debts and sharply increased their provisions for future bad debt.
Chinese policymakers are seeking to manage the pace of the slowdown by easing policy. China’s central bank has cut banks’ reserve ratio requirement four times since last April and injected cash into the system, driving interest rates lower. The government has announced tax cuts supporting both consumers and corporates, in an attempt to boost flagging domestic consumption. It will also undertake targeted infrastructure spending.
External developments have offered some encouragement too. The dovish tone struck by the US Fed and the European Central Bank have lowered interest rate expectations in the West, which should slow the movement of capital out of China. Trade talks between the Chinese and US governments could yet create a route to defusing trade tensions.
The outlook has brightened somewhat. Credit availability for non-state-owned-enterprises, the most productive part of the economy, is improving. Alternative indicators of activity, such as electricity consumption, suggest growth is stabilising. Renewed optimism can be seen in the equity market too, with the Shanghai composite index, a national benchmark, trading 25% up from its late December low. It is quite possible that the pace of Chinese activity firms in the second half of this year.
Recent developments suggest that the risks to Chinese growth this year have eased. This does not change what is a decline in trend growth driven by a shrinking, ageing workforce and rising labour costs. The glory days of double-digit Chinese growth are past, with the IMF forecasting average Chinese growth of around 6.0% over the next five years.
For a maturing economy that is still a strong growth rate, one which would put China near the top of the global growth league. Slower growth holds open the prospect of a better-balanced economy, with less spare capacity and a more efficient, market-based allocation of capital.
This transition is not without risk. Any mistakes in the calibration of policy can cruelly expose underlying frailties. Chinese policymakers have shown skill in navigating the risks so far. They will need more skill, and luck, to ensure a soft landing for China’s vast economy.
PS: The veteran pollster Professor Sir John Curtice recently published new analysis on what might happen if a second Brexit referendum were to be held. His analysis suggests that 55% of UK voters would have backed Remain had a referendum been held last month. He finds that the proportion of voters who expect Brexit to be positive for the economy has fallen. Sir John cautions that the apparent increase in support for Remain is enough to raise doubts about support for Brexit, but insufficient to be conclusive. He concludes, “those on all sides of the argument might be best advised to show a degree of humility when claiming to know what voters really want”.
PPS: in a recent Monday Briefing we observed that asset bubbles are an unavoidable feature of the free market economy. Recent research from the International Monetary Fund shows how regulation can actually contribute to such bubbles. The research shows that time and again financial regulation is relaxed during the boom, thereby fuelling it. It is often after the bust, when the proverbial horse has bolted, that regulation is tightened.