People seem to be settling into the view that China is slowing down. How much, how fast, and whether it is cyclical or something more secular like the lower-middle income trap or a Lewis turning point is still very much the subject of debate.
I find it at odds with this growing impression, therefore, that so many investors and analysts seem to be clinging to high growth forecasts. The Chinese government only tweaked its forecast lower to 7.5% for this year, while I would cuff the mean private sector forecast at slightly higher.
But the underlying argument of the panda huggers seems to be drifting. Until recently, many were essentially citing the power of the conditional convergence growth hypothesis as the reason China’s slowdown would be shallow and ephemeral. Lately, however, the defense of Chinese growth has been shifting toward the argument that any slowdown could and would be countered aggressively by monetary and fiscal stimuli, as was the case in 2009, thereby keeping growth robust and any slowdown firmly under control.
While I am by no means a panda mugger, I do think that there is significant room for further disappointment for two reasons: (1) the secular slowdown in China’s growth rate looks to be greater than most analysts are currently factoring in and (2) China has far fewer financial and political degrees of freedom with which to combat the cyclical elements of the current deceleration.
The secular case—China’s growth rate will be much lower and much more volatile:
1. Base Effects. China’s growth has been nothing short of parabolic. When you have over a billion people and a USD$1 trillion economy, it doesn’t take much to generate huge productivity gains, and you can grow at 15% while still being a price taker in global markets. However, when your economy is USD$6 trillion and your dollar growth is 15% (Chinese GDP + inflation + FX appreciation) you have become a price maker and the supply function with which your burgeoning demand is met is no longer so elastic. This curtails growth. (For a fun related interactive graphic, go here.)
2. Demography. The Prime worker ratio (working age population, 20-59, divided by those 60 and older) is currently at 5, but projected to be at 2 by 2035. (Japan went from 5 to 2 from 1980-2006 as its growth went from 8% to sub 2%. The US is at 3.2 today, and is projected to be at 2 by 2027). The graph below should give you an idea of the dynamics in China:
3. The Lewis Turning Point. It is impossible to say with precision whether we are at that point, but we do know dollar-based unit labor costs (international competitive benchmark) in China have gone up sharply over the last few years—despite significant productivity gains. This suggests, inter alia, that the supply of labor is becoming less price elastic, which is consistent with what one would see near a Lewis turning point. Experts in China say the 2nd derivative of labor force turns negative in either 2013 or 2014. This means what has been a huge tailwind for China becomes a headwind.
4. Changing the growth model. Everyone knows that China is trying to switch from and investment/export growth model to a consumption-led model. The implication is that consumption-led model does not accelerate or decelerate on command the way investment does. Trying to manage this new economic paradigm in the way the old one was will lead to greater fits, starts and policy missteps: hence, more volatility.
The Policy Backdrop—why China can’t and won’t respond as forcefully to the coming slowdown:
1. China is still digesting all the leverage it put into the system in 2009-10. Non-financial debt in China went from 160% of GDP to 200% in two years. Non-financial corporate debt breached 100% of GDP, more than in the US and Germany, about the same as in Korea and the UK, and less than in Japan. To put the 40 percentage point increase in perspective, it is roughly the same percentage point increase the US experienced over 2003-07. It is true that the “denominator” in China grows much faster and this lessens the danger from the growth in the “numerator”, but the point here is that China is not in a position to repeat anywhere near the credit stimulus it unleashed in 2009.
2. The economy’s ability to absorb new investments has also diminished. A sponge can only hold so much water, and there seems to be very little in the way of low hanging fruit on the productivity side in the wake of the wave of credit that was unleashed in 2009. So, even if the authorities were to attempt a 2009 repeat, it is highly likely they would be getting far less bang for their RMB. Moreover, the tradeoff with inflation today would be far more pernicious.
3. Now the Chinese have to deal with managing growth AND inflation. Until this last cycle, Chinese policy makers had to worry only about growth. Yes, there were transitory spikes from exogenous shocks like the blue-eared pig disease of 2007-8, but the underlying wage dynamic and expectations were well anchored and stimulus ran very little risk of inflationary side effects. As noted above, this is no longer the case. And those in power in China remember the experience of the early 90s where inflation was on the verge of destabilizing politics. These new structural elements to Chinese inflation will also keep any urge to relive the stimulus of 2009 in check.
4. 2012 is a political transition year. Chinese policy makers are notoriously conservative and incrementalist. Their revealed preference is that they fear the law of unintended consequences above all. Innovative? Yes. Bold? No. One can expect this tendency to be all the more true in a political transition year. And the unusual degree of turbulence so far in the transition process—notably the demise of Bo Xilai, the ongoing backroom maneuvering with respect to Standing Committee memebership, and even the postponement of the Party Congress—suggests that until the transition is secured, there is a greater risk of errors of omission than commission.
From my standpoint, the bottom line is clear: the headwinds to Chinese growth are underappreciated and growing, and if you are counting on policy stimulus to bail you out, think again. Our tendency to recall the last stimulus and overstate the parallel (availability heuristic), could end up being a costly mistake for all of the investors still hiding out in Asia as the last bastion of growth in their emerging market allocation.