China’s Development Path: Downside Risk From Debt Fueled Growth

China’s economic growth has been extremely strong for decades and is generally expected to remain robust going forward. The country is facing massive demographic headwinds though and as commentators have been pointing out for years, their economy has been overly reliant on investment and debt which creates downside risk. There is also credible evidence suggesting data on things like population and the economy is overstated, which could mean the situation is worse than it appears. Evergrande has highlighted some of these issues and created fears of contagion, but given the ability and will of the CCP to intervene a recession may be unlikely. The transition to a consumption led economy is not without risk though and even if successful will likely result in China’s economic growth approaching that of developed nations.

Drivers of Economic Growth

A number of factors have contributed to China’s rapid economic growth, but these are all one-time boosts that have largely played out. Urbanization has resulted in many people moving from subsistence farming (or similar) into the formal economy, dramatically increasing output per capita. In the past China had limited access to cutting edge technologies but this has changed dramatically in recent decades as China opened up to the global economy. Growth in China’s TFP is likely to be far more modest going forward, as they are now at or near the efficient productivity frontier. China’s integration into the global economy also provided a one-time boost to the economy through trade. With many countries, including China, adopting an increasingly inward-looking viewpoint trade could in fact be a headwind going forward.

China’s total debt increased eight-fold between 2008 and 2019 and was approximately 300% of GDP prior to COVID-19. While I do not believe this necessarily implies a risk of financial collapse, as many countries have shown an ability to support this type of debt burden for many years, it does raise questions about China’s ability to continue using debt to drive growth.

Urbanization, trade and productivity growth drove China’s growth up until the 2010s, but since then a rapid expansion of debt has been required to keep the ball rolling. With a relatively stable labor force, stagnating TFP growth and high debt levels, China’s days of sustainable high growth are likely behind them.

Demographics

The 21st century is often referred to as the Asian century, but this gives little consideration to the demographic headwinds that many countries are facing. While many Asian nations are likely to exhibit rapid economic growth in comparison to Western peers, stagnating populations that are rapidly aging will create problems similar to those faced by Japan and many European countries.

Many Asian countries will have demographics comparable to western nations (or worse) in coming decades and will face the same problems as Japan and Europe, and to a lesser extent the US.

This is problematic because aging populations tend to have relatively low consumption and investment and an excess of savings. This creates an environment with low economic growth, inflation and interest rates and elevated asset prices. With a sufficiently old population there is also the risk of weak economic growth, high wage inflation and inflation concentrated in areas like health care.

China enjoyed extremely favorable demographics up until the 2000s, with 10 working-age adults for every senior citizen, compared to an average of closer to 5 working-age adults for every senior citizen in most major economies. China’s working age population has been shrinking since around 2011 and according to UN projections from 2019, China’s total population could start to decline as soon as 2025-2031. China’s current demographic issues have been exacerbated by the one-child policy, which has ensured that a large elderly population will need to be supported by a relatively small working population in the future. From 2020 to 2050 China is expected to lose 200 million working-age adults and gain 200 million senior citizens. Current projections suggest China’s medical and social security spending will have to increase from 10% to 30% of GDP by 2050.

Demographic headwinds in western countries have been softened significantly by relatively high immigration rates. This is not currently the case for Asian countries though, which means that their issues could be more pronounced, like in Japan. Given China’s size and tenuous relationship with many countries, it is not clear that they could encourage sufficient immigration to have a meaningful impact, even if there was the political will to do so.

Investment and Debt

The Chinese economy as a whole has rapidly been building out infrastructure in recent decades (roads, rail, airports, etc.) and while this improves productivity, it is a one-time boost. China’s reliance on investment and debt to drive growth over the past decade has created vulnerabilities in a number of sectors.

Since 2005, China has contributed on average one-third of total global economic growth. China also accounts for 10% of global imports and is one of the world’s largest consumers of many commodities. This makes China’s transition to a consumption led economy important globally, although the downside risks are likely to be concentrated as many countries and companies have little to no direct exposure to China.

Investment’s share of GDP in China rose to around 45% after the global financial crisis. As a result the capital stock-to-output ratio has risen and been accompanied by a declining marginal return on capital. Falling productivity growth and diminishing returns on capital imply that China is reaching the limits of investment led growth. If they continue to push against these limits, imbalances will grow and threaten medium-term growth.

China is potentially at a crucial point in its economic development, a point where many developing economies have previously failed to maintain robust growth. The transition to an advanced economy led by consumption is not easy, but as shown by Taiwan, Japan and Korea is possible.

Data indicates that the following factors are supportive of a successful transition to consumption led growth:

• A stable macroeconomic environment
• Openness to trade and foreign direct investment
• High human capital levels
• An export or production structure which favors high-technology exports
• A more equal distribution of income

Conversely, countries with high old-age dependency, high and rising investment rates, undervalued real exchange rates and a deficient level of infrastructure are more likely to face a growth slowdown. This puts China in an interesting position, as they tick many of these boxes (both good and bad). The size of China’s population and demographic problem, their heavy reliance of debt fueled investment and the inward-looking nature of the country indicate they could face a slowdown though. Most countries that have experienced a large increase in debt relative to GDP have faced a subsequent slowdown in GDP growth and Japan is a clear example of how abrupt the slowdown in growth can be.

China has made major investments in key technologies and communications infrastructure and have a multi-continent Belt and Road Initiative to bring other countries into its orbit. While much of China’s investment in areas like infrastructure have been necessary and are likely to yield significant benefits, there should be concern about the size of investments relative to GDP. China’s level of investment exceeds similar countries on their development path, which may indicate over investment and poor returns on those investments.

Much of this investment has gone into residential property development, which has resulted in the excess capacity that is now creating problems for companies like Evergrande.

Evergrande

Evergrande is a Chinese property conglomerate that has operated on the principal that borrowing to build (primarily housing) is an attractive option. Evergrande is facing bankruptcy as China tries to shift from debt-driven construction towards consumption and services. It should be noted that this is occurring as a policy choice though as the CCP is trying to create an economic model with common prosperity. As a result, affordable housing is being prioritized over commercial developers. For example, China recently trialed the introduction of a property tax, which is an initiative aimed at reducing the attractiveness of property as an asset class.

Real estate in many Chinese cities is extremely expensive, although this does not appear to be the result of a supply shortage. The square feet of housing per capita in China is already relatively high, indicating that continued large scale property development is not sustainable. Home Price to Income ratios in a number of Chinese cities are the highest in the world and ensuring that the average Chinese citizen can afford a reasonable quality home will likely be a significant focus for the CCP going forward.

How much the CCP can do to reduce overinvestment in real estate and speculative property investments is questionable though. China’s real estate sector contributes 29% of GDP, meaning that a significant slowdown in the housing market could have a large impact on the economy as a whole. A real estate slowdown could be exacerbated by the fact that China stores 70% of its wealth in real estate, meaning that a drop in real estate prices could create a negative wealth effect that impacts consumption.

The Global Financial Crisis appears to have primed investors to believe that every debt default will result in contagion and threaten to collapse the global economy. It should be recognized that the GFC was the result of a unique confluence of events that bears little resemblance to Evergrande.

Statistical Issues

Assessing China’s situation is complicated by the fact that official statistics are questionable, whether they relate to the economy, population, COVID etc. Research indicates that official statistics overstate China’s economic growth rate and that this problem has become worse in recent years.

Local governments are incentivized to over-report economic activity, leading to the sum of local estimates generally exceeding the national value. China’s National Bureau of Statistics has recognized this issue and as a result adjusts these figures to create the official estimates for China’s GDP. Local estimates of GDP exceeded national GDP by an average of 5-6% between 2003 and 2016.

The corrections made by the NBS are believed to be accurate prior to 2008, but after this researchers believe the corrections have been too small. Even after adjustments it is thought that China’s GDP growth from 2010 to 2016 was overstated by about 1.8% annually. Given this, it would not be unreasonable to expect China’s actual GDP growth to approach 3% in coming years.

Conclusion

China’s government is focused on transitioning to a consumption-based economy with a strong position in advanced industries. As a result, there likely will be support for local companies and potentially restrictions on foreign competitors. China’s end goal is likely to import primarily commodities and basic manufactured goods and export services and advanced manufactured goods. Fiscal and monetary policy appear focused on stability and reducing systemic risk, while continuing to support economic growth.

As China shifts towards a consumption led economy, its demand for raw materials will moderate and its demand for consumer goods will likely increase. An economic slowdown in China will be negative for countries with large exposures to China, including Taiwan, Korea and Australia.

Normally I would expect a recession in China to have a relatively muted impact globally, but given the elevated share prices of many companies producing goods that could be impacted by weak Chinese demand, this has the potential to weaken sentiment and drive a significant pullback in markets. Apple (AAPL) and Tesla (TSLA) are two prominent examples of companies at risk, although a strengthening Yuan could result in increased consumer demand for imports, as could a more consumption driven economy.

Apple allegedly has an agreement in place with the Chinese government to help develop its economy, a deal that Tim Cook was personally involved in. The deal is reported to be worth approximately 275 billion USD over 5 years and involves Apple increasing the use of Chinese suppliers, working with Chinese software firms, investing in local tech companies, providing training and working with Chinese universities on new technologies. Apple continues to focus on creating demand in the Chinese market and its supply chain also continues to heavily rely on China, a risky situation given rising geopolitical tensions.

Treasury Wines is a clear example of how fortunes can rapidly change for companies that are overly reliant on access to the Chinese market for profits. China imposed anti-dumping and other measures that resulted in tariffs of up to 175.6% on Treasury Wines’ products. The Chinese market had accounted for about a third of the company’s profit, and as a result Treasury Wines’ stock is down 40% from its peak.

Investors with exposure to China, either through Chinese companies or foreign companies operating in China, should keep in mind the economic risks the country is facing. Investors in companies that rely on access to the Chinese market or have supply chains that are reliant on China should also be wary of rising geopolitical risks. Further deterioration in China’s real estate sector or in international relations may be reason to reduce exposure.