What To Expect From China

When analysing China, I think there are currently three main themes to explore: 

1. Can China sustain its remarkable growth rate of the past 30 years? 
2. What are the implications of the structural breakdown of US-China relations? 
3. How quickly will China integrate into global financial markets? 

1. Can China sustain its growth rate? 

China has delivered remarkable growth since the 1980s, and although its pace of growth has slowed since the global financial crisis, the country’s overall contribution to global GDP has continued to increase. There is, moreover, room for it to grow further: while China’s population accounts for roughly 20% of the world’s population, its GDP amounts to around 17-18% of global GDP, and its exports account for 15% of global exports – so there is still room for further expansion. 

There are three main challenges to China’s future growth: 1) Debt and ageing; 2) Economic rebalancing; and 3) Statism vs innovation. Let’s look at each of these in turn.  

1) Debt and ageing 

China has accumulated an enormous amount of debt over the past decade. In response to the global financial crisis, the country launched a massive stimulus programme and it has continued to add further stimuli whenever the economy has threatened to slow in subsequent years, further adding to the stock of debt. In China’s favour, however, is the fact that it runs a savings surplus and is able to utilise lots of levers to prevent a liquidity crisis from morphing into a solvency crisis. That said, while China can probably absorb more debt, any increase in the debt stock will need to be much slower in the future, and that will be a constraint on growth. 

Demographics are also important. China has benefited from a remarkable demographic tailwind over the past 30 years, for two reasons: first, because there has been a surge in the population; and second,  because there has been urbanisation as people have moved from the countryside to the towns. Both of those tailwinds are now largely exhausted, which will be a headwind to growth. However, this will be partially offset by the fact that China’s working age population is increasingly skilled – over the past decade, the number of university graduates entering the workforce every year has risen from a couple of million to around nine million. 

2) Rebalancing the economy 

Prior to the global financial crisis, around 35% of China’s GDP came from exports; since then, this has fallen to around 20%. A ‘normal’ proportion for a developed economy would be 15-20%, so it is reasonable to assume that the rebalancing of the Chinese economy with regard to exports has now largely occurred.  

There is still considerable rebalancing to occur from investment to consumption, however. As noted above, around 40-45% of China’s GDP comes from investment, which is very high. This will need to come down over time because if that much GDP is invested, it results in falling returns to capital – and indeed, that has been happening in China. On the plus side, there has been more rebalancing from industrial production to services, and that has been a positive for the economy. 

3) Statism vs innovation 

China is a notionally communist country with a very strong capitalist overlay – it has used the market heavily in order to develop. However, the authorities retain a strong ideological commitment to retaining a large state sector, and indeed over the past five-to-eight years there has been a slow but steady reinforcement of the state sector. Can China continue to grow quickly while it is reinforcing the state sector? Returns on capital in the state sector are lower than those in the private sector, so continued heavy reliance on the state is likely to drive down down medium-term growth. 

In the short term, that kind of commitment to the state sector probably helps when getting through issues such as Covid-19, etc. After a very sharp drop in Chinese growth in Q1, the economy bounced back remarkably – close to the pre-coronavirus high – in Q2. This was largely due to state efforts to contain the virus, then to stimulate the economy through various tools, such as infrastructure investment and the use of the SOEs. China remains the factory of the world and is exporting a lot of medical equipment and IT goods. Its current account surplus is rising. 

2. What are the implications of the structural breakdown in US-China relations? 

The relationship between the US and China is now more of a full-blown geopolitical rivalry than a mere trade war. I think the phrase ‘cold war’ is inaccurate, though – there are many differences between the US-China situation and that of the US and USSR during the last century. The current rivalry between the US and China largely a fight over technological leadership of the world, although there are also potential flashpoints on the geopolitical side over issues such as Taiwan, the Indian border and North Korea.  

China’s response to increasing tensions on the tech side has been to double down on self-reliance by developing its own technologies to plug the gaps in areas that it has been targeted for sanctions. It is trying to rebalance towards more reliance on domestic consumption. 

3. How quickly will China integrate into global financial markets? 

Because of its capital controls, China has been difficult to invest in for global investors. But that is changing. China is a lot more interested in attracting global capital and has initiated reforms to open up access to its markets. It is becoming much easier for global investors to invest in China, and as a result, the leading bond indices are beginning to include China in a much more meaningful way. Over time, I expect China to assume a much bigger proportion of global bond and currency indices. Global central bank reserve managers are starting to add the Chinese renminbi to their reserve mix, albeit modestly for now.

Conclusion

My expectation is that China will continue to grow. Growth will continue in the single-digit range and will probably fall to around 4% in the end of the next decade. However, there are several challenges to overcome along the way, chief among them China’s integration into the global financial system, which remains well behind its integration into the global economy. I expect China’s integration into the global financial system to increase meaningfully in coming years, which will have a major impact on investors’ asset allocation decisions. Geopolitical concerns, in particular the US-China rivalry, will continue to add noise around investment decisions, but should not derail China’s continued rise as an economic and financial power.