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China’s structural growth - From opportunities to challenges with risks

After more than 40 years of economic reforms, China is arguably moving from an era of growth opportunities to one of growth challenges, characterised by reform fatigue, resistance to change and diminishing returns on investment. Looking ahead, what will drive China’s long-term growth?

In our view, the factors most likely to affect China’s growth trajectory in the longer term are: 

  • The repercussions of past economic excesses
  • A different ideological approach to development
  • An economic, structural transformation to address these two problems. 

These factors will likely create economic and geopolitical risks in the coming years. Some have drawn parallels between the future of the world’s second largest economy and the economic woes of Japan and the former Soviet Union in the 1980s and 1990s. Some even foresee an end to the China growth story.

Annual growth in China averaged more than 10% from 1980 to 2010. The rate has slowed under President Xi Jinping, with 6.6% average growth between 2013 (when he took office) and 2021.

Payback for economic excesses

A key reason for the slowdown is the payback for the excesses of the hyper-growth era. A government insider flagged this in a high-profile 2016 interview. As reported by international media,[1] he warned of the potential risk of an increasingly debt-fuelled, bubble-prone economy.

An overly indebted property sector and the expansion of state-owned enterprises through debt issuance since the 2008-09 Global Financial Crisis (GFC) fit this script.

Aware of this financial ‘time bomb’, President Xi launched a debt reduction campaign in 2017 to avoid a Japan-like stagnation. The result: A growth slowdown.

Ideological and structural change

An appetite for economic liberalisation brought decades of robust growth and financial development. It  created expectations that China would become politically more open and democratic. Research shows that long-run economic development tends to rely on strong state institutions and open political systems.[2]

These expectations prompted Western policies to facilitate China’s economic ascent by opening up international trade and investment. Many Western – notably US – firms decided to move some manufacturing capacity to China.

Mr. Xi has instead centralised power. China’s direction has shifted back from private-sector-driven growth to state capitalism.[3] His assertive foreign policy has fuelled trade and tech wars with the US, brought China closer to Russia, and increased nervousness over Taiwan. The resultant rise in geopolitical tensions has led to yet more de-globalisation. These tensions stand to unwind some of the growth benefits for China.

With these challenges intensifying, Mr. Xi has kick-started reforms to pull the economy out of the ‘Four Uns’ – unstable, unbalanced, uncoordinated and unsustainable. However, powerful vested interests have vigorously resisted any further changes that could hurt their interests.

This resistance diminishes marginal returns on investment in the economy (Exhibit 1). It also reflects reform fatigue in a political system that mixes commerce and politics, cultivating rent-seeking and moral hazard.

Challenges and risks

Diminishing economic returns present a crucial macroeconomic challenge that requires immediate policy attention. However, the leadership shakeup at the 20th Communist Party Congress in October 2022 has raised concerns that greater state control could mire China in the middle-income trap, where a country has lost its initial competitive advantage and is unable to keep with more developed economies.

President Xi may not be curtailing the private sector, but he is strengthening the state sector. Will China now suffer another aspect of ‘Japanification’? Is it headed for the kind of stagnation that can result from a dominant group of conglomerates working with a centralised authority that thinks it can create growth by subsidising and protecting these companies?

An industrial policy designed to dominate every significant sector might result in some – expensive – successes, but also failures in terms of a sub-optimal allocation of resources.

Furthermore, as China adopts industrial (and hi-tech) standards that differ from Western ones, it needs to gain global system dominance quickly. If not, it could isolate itself, just as Japan did with its mobile phone business early in the evolution of an industry that is now dominated by Samsung and Apple.

Mr. Xi’s approach has reduced debt and corruption.[4] However, it creates ‘key man risk’ as only he is really in charge.[5] The installation of Party committees in every public and private firm as the arbiters of strategic decisions is another risk. For some sectors or regions, this may mean just a little sand in the gearbox; for others, it could clog up the gears more significantly. Either way, it’s a potential threat to long-term growth.

‘Dual circulation’ is key

On housing, China’s development policy de-prioritises it as a source of growth. Greater emphasis is given to domestic demand under the ‘dual circulation’ policy.[6]

This emphasis on domestic demand should dispel worries that China needs the global market to continue growing. The economy shifted from export-led to domestic-driven growth after the Global Financial Crisis; indeed, net exports have contributed little since then, except in 2021 (Exhibit 2).

Beijing has announced further plans to expand domestic demand over the next 15 years[7] to reinforce its commitment to boosting growth from within.

The ultimate concern

President Xi’s pivot from collective term-limited leadership to autocracy could stifle productivity growth and private-sector incentive.

To be fair,[8] in the two decades before Mr. Xi, Beijing’s decentralisation efforts created serious moral hazard and corruption problems. Powerful local governors defied central government reforms.[9]

From Mr. Xi’s perspective, pulling power back to the centre is the only way to break the inertia. Western democracies see this is as a power grab and a significant setback in China’s governance.

History will judge who is right. For investors, China’s growth story may not be over. Stay tuned here for further analysis.

References

1 For example, see “China debt-fueled stimulus may lead to recession – People’s Daily”. Reuters, 9 May 2016 (here)  

2Institutions As The Fundamental Cause of Long-Run Growth”, Daron Acemoglu, Simon Johnson and James Robinson, Working Paper 10481, National Bureau of Economic Research, Massachusetts, Cambridge, May 2002; “The Role of Institutions in Growth and Development”, Daron Acemoglu and James Robinson, Review of Economics and Institutions, Vol. 1 – No. 2, Fall 2010  

3The State Strikes Back: The End of Economic Reform in China?” by Nicholas Lardy, Peterson Institute for International Economics, January 2019  

4Chi Flash: China’s New Government, What’s New?” 24 October 2022 (here).  

5 “Chi on China: Mega Trends of China (6): Evolution of China’s Growth Model”, 6 April 2018 (here).  

6Chi on China: China’s ‘Dual Circulation’ Strategic Pivot to Counter External Exigencies and Global Demand Shift”, 16 September 2020 (here)  

7China Plans to Expand Domestic Demand to Spur Economy – State Media”, Reuters, December 14, 2022 (here)  

8 See reference in footnote 6  

9China’s Impossible Trinity: The Structural Challenges to the ‘Chinese Dream’”, Chi Lo, Palgrave Macmillan 2015, pp. 76 – 80 

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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