6 February 2022

During the past two Covid-strickened years, China’s economic growth has outperformed global activity. Indeed, while output in developed nations contracted nearly 5% in 2020, the Chinese economy actually gained 2%. Likewise, China’s 8% recovery in 2021 outpaced the 5% rebound in the world’s richer countries.

Behind the headlines, however, the news has not been as good. For example, the meagre 4% GDP gain in Q4 2021 indicates China’s rebound has lost momentum. On the one hand, the economic deceleration reflects China’s seemingly premature decision to remove much of the fiscal support that cushioned the economy during the pandemic.

More importantly, China continues to confront numerous structural challenges as the Year of the Tiger commences (I began discussing these issues four years ago in my blog “China: Growth Slowdown Just Beginning”). For example, recent problems in the property sector are just beginning to reveal the need for extensive deleveraging in China’s heavily-indebted corporate sector. In addition, progress in reducing the economy’s reliance on investment and exports, and rebalancing towards consumer spending, appears to have lost momentum. Similarly, climate change, demographic trends, and weakening productivity growth could all dampen China’s long-term growth potential during the next 5-10 years: the so-called “middle-income trap”.

During China’s Lunar New Year’s celebrations, family members exchange red packets full of money to encourage good luck and prosperity. Similarly, despite large government budget deficits, I expect Chinese policymakers will provide their own red packets to support economic activity this year, e.g. additional monetary and fiscal stimulus. Until then, Chinese and Emerging Market equities are likely to continue to underperform. Beyond these cyclical considerations, however, China’s long-term growth prospects will continue to slow towards 4% in coming years, and 2022 GDP growth may dip below this rate. Investors take note: the era of 7-10% Chinese GDP growth is unlikely to return.

Rebalancing: Pandemic Has Slowed Progress

A key Chinese economic objective has been to expand the service sector (consumer), and to reduce the reliance on industry (investment and exports). This strategy has been largely successful for many years, as the tertiary sector’s share of the economy has grown (Chart above). During the pandemic, however, the Figure also illustrates progress has shifted into reverse. Indeed, the government’s Covid support has focused on boosting public sector investment. Meanwhile, assistance for households has been far less generous.

As a result, the recovery of retail sales (and consumer spending more broadly) has not been sustained, as households have boosted discretionary savings in this uncertain period. Recently, retail sales grew only 3% during Q4 2021– half the long-term trend (Chart above).

The second rebalancing objective has been to reduce the reliance on the external sector. However, the Chart above indicates the foreign sector has contributed positively to GDP growth during each of the past three years. After surging 30% last year, Chinese exports will slow sharply in 2022. Likewise, public investment (along with the property sector) has also lost momentum, and the consumer remains weak. Overall, therefore, slower rebalancing will take its toll on GDP growth in 2022, unless additional stimulus is provided.

Corporate Deleveraging: Just Beginning

The Chart above illustrates the rapid increase in China’s borrowing in all sectors. To be sure, higher household debt plays a welcome role in rebalancing. On the other hand, however, large-scale corporate sector leverage has been recognised as a widespread problem, and not just in the headline-grabbing property sector. In response, China successfully lowered business sector debt between 2016-2019. However, the renewed corporate binge during the pandemic has reversed these previous achievements. Of course, businesses world-wide have taken advantage of low interest rates. But, corporate debt (as a percent of GDP) is comparatively lower in the USA (84%), Europe (112%), and Japan (115%). In other countries, previous deleveraging programs have been a drag on economic growth for many years.

Has China Slipped Into the Middle Income Growth Trap?

After growing rapidly for many years, economic growth in many Asian nations (Korea, Japan, and others) slowed markedly once attaining middle-income status. Is this happening in China? Long-term growth trends are the result of labour force growth, productivity gains, and capital spending. But, the Chart above indicates China’s labour force has already peaked, and will decline sharply in coming decades, as occurred earlier in Japan. Recent shifts in the “one child” policy will take time to have any impact.

Or course, higher productivity could offset the inevitable decline in workers. However, the trend in Chinese efficiency has slowed sharply during the past decade. Reform in China’s bloated State-Owned enterprises (SOEs) could help reverse this pattern. The following Chart illustrates SOE productivity is 20% lower than in private firms: and, the gap is much larger in many key sectors. However, the Chinese government’s recent heavy-handed interventions in key fintech and technology sectors could worsen the business environment and stifle private sector investment and innovation.

The following Chart illustrates the diminishing contribution of labour force and productivity growth in the past decade. Likewise, the role of capex is set to decline as well, as part of the rebalancing plan. It seems inevitable, therefore, that China’s will fall into the “middle-income trap”, and long-term growth potential will slip towards 4-5% in coming years.

Climate Change: Scale of the Challenge is Immense

A full discussion of China’s climate challenge, of course, is well beyond the scope of this blog (for insights see my essay “Asia: Urgent Climate Action to Prevent Inequality”). For now, it is worth outlining the scale of the challenge and the key ingredients in reducing emissions. On the positive side, at the time of the COP-26 summit, China finally pledged to cap emissions by 2030, and to reach carbon neutrality by 2060. Given the urgency of the situation, however, many view these goals as unambitious (many countries have committed to deep emissions reductions by 2030 and neutrality by 2050). Furthermore, as the world’s largest emitter of methane, China’s decision not to join the pledge to reduce these particularly toxic emissions by 2030 was disappointing.

Of course, Chinese participation (if not leadership) on this most critical issue is vital. Not only is China the largest source of carbon dioxide, but emissions grew 22% durng the past decade: compared to 25% and 20% declines in the European Union and the USA respectively. In China, as elsewhere, emissions reductions will come from a combination of improved energy efficiency (lower C02 per unit of GDP), lower carbon intensity (reduced C02 per unit of energy consumed), or slower GDP growth (less desirable).

To be sure, China has recorded some impressive achievements. The Chart above, for example, illustrates that China’s energy efficiency has improved dramatically in the past two decades: far more than in other countries. Nevertheless, China still creates twice as much C02 per unit of GDP compared to the USA and four times more than France. Therefore, China is capable of further improvement, and technological advancement will play a huge role.

Meanwhile, progress in reducing the amount of C02 produced per unit of energy consumed has been less impressive. The Chart above illustrate China’s carbon intensity is still 33% higher than the USA and more than double in France. This largely reflects China’s continued extensive use of coal. Nearly two-thirds of China’s electricity is generated by the black rock, compared to 12% and 20% in the EU and USA respectively. To stand any chance of approaching their climate goals, China will need to dramatically shift towards renewable sources (or at least natural gas).

China’s future energy demands are immense. Indeed, during the past decade, electricity usage rose 85%, even before the expected electrification of the economy in the future. In order simultaneously to meet its climate goals and satisfy this appetite for power, China’s energy mix and energy efficiency must continue to shift dramatically. Potentially, this transition will produce huge economic opportunities and benefits. Without these changes, however, climate change could prove to be a material drag on future economic growth.

Global Environment: Could Again Turn More Negative

As mentioned, the global environment proved benign in 2021, as China’s external sector contributed strongly to GDP growth on the back of a 30% surge in exports. However, this favourable climate may not last forever. While China’s world-wide current account surplus is not large (1.5% of GDP), its imbalance with the USA remains bloated. Phase 1 of the US-China trade deal established targets for American exports to China for 2021/22. The Chart above (provided by the Institute for International Economics) indicates US sales remain 40% below the agreed goals. Despite my misgivings regarding the effectiveness of this deal, American politicians and policymakers are likely to draw attention to China’s failure live up to its commitments eventually.

Policy & Market Implications: Waiting for the Red Packet

• With many countries fighting inflation and preparing to raise interest rates in 2022, China’s priority will be to support the slowing economy, as inflation remains low. Indeed, President Xi questioned the global tightening of monetary conditions at the recent WEF summit in Davos. Following January’s easing in monetary policy, I expect additional interest rate reductions in H1 2022.
• The premature removal of much of the Covid support has contributed to China’s recent economic deceleration. In 2022, however, I expect an additional fiscal boost, perhaps in H1 2022 — a much needed red packet. However, China’s large budget deficits will limits scope for additional stimulus compared to past slowdowns. Indeed, the IMF estimates the red ink may amount to 15-20% of GDP if all levels of the public sector are considered (Chart above). Therefore, the government will need to redirect its spending priorities. Ideally, the measures should involve reduced relief for SOEs in order to provide additional support for households and consumers. China’s comparatively low level of support for households has resulted in high levels of discretionary savings during uncertain times.

• The Chinese RMB may weaken somewhat this year, as China prioritises economic growth and the US fights inflation.
• Emerging Market equities confront formidable headwinds: rising US interest rates, a strong US dollar, and slowing Chinese growth. Therefore, additional Chinese stimulus is the first precondition required to prevent the further underperformance of EM markets.