Is China’s growth model sustainable?
On 15 May 2019, CFA Society Switzerland invited Iikka Korhonen, Head of Research at the Central Bank of Finland to hold a lunchtime presentation at Saxo Bank in Zürich on the topic of China’s current model for growth. Mr. Korhonen heads a research group of 10 economists that specializes in both China and Russia.
China’s post-2008 growth model
Since the last global financial crisis, China has embraced a growth model of ultra-high domestic investment. Currently almost 45% of GDP is plowed back into production facilities, infrastructure, and residences. This is a very high fraction by historical standards; even during the height of their growth phases, Japan and South Korea only reinvested between 30% and 35% of GDP. And currently Poland and Estonia invest around this fraction, and no other economy of size is anywhere near the Chinese level of investment.
This high level of investment is financed by domestic debt, both in the form of bank loans and shadow financing. Before 2008, China’s debt-to-GDP ratio was considered fairly low at around 120% but today it is nearly double that number. Since that time, the “Big Five” Chinese state-owned banks increased their balance sheets by almost a third, as the debt ratio has climbed in several spurts over the past decade. Most of this new debt is yuan-denominated.
The current economic situation
China is in a transition, as its government now emphasizes growth in private consumption over investment growth. In 2018, Chinese growth overall decelerated, but the official growth numbers out of Beijing did not. Dozens of authors attempt to estimate true levels of Chinese GDP growth, both real and nominal. Nominal GDP numbers seem to fluctuate “a lot” from period to period, but since China prints real GDP growth, that number can be smoothed by appropriate choice of a GDP deflator.
Currently, Q1 2019 official real GDP growth is 6.4% annualized, whereas the correct number is estimated at closer to 4.9%. (Mr. Korhonen stated that the official number is these days consistently about 1.5 percentage points above the true number.) In 2019, imports of raw materials like copper and iron ore are declining, as are overall imports from the EU, USA, and Japan. Based on these facts, there is little chance China can be growing as fast as the official numbers claim.
Looking deeper into the new trade war (that some are calling a new cold war) between America and China, imports from the USA into China were down by one third, and that was before the latest round (May 2019) of tariffs and threats. According to a Bank of Finland model, the USA could lose 1.0 percentage point of GDP growth due to this trade war, and China could lose 1.0 – 1.5 percentage points, but the rest of the world would see only a tiny effect.
Based on 2015 data and a global model of final demand (final sale point for goods and services), about 4% of the total Chinese GDP is dependent on the USA, whereas 1.2% of US GDP is dependent on China. So perhaps the US has an advantage in the current dispute.
Risks to China’s growth model
Rapid increases in debt (even from a relatively low level) have often ended badly, in historical scenarios elsewhere. China’s overall level of debt is not so bad when compared to the Euro area, the UK, or Japan. But the speed at which it has grown these past 10 years is a cause for concern, according to the presenter; there is abundant research to show that fast debt growth causes economic instability. On the plus side, this new Chinese debt is almost exclusively domestically held. Many banks and other lending firms are also state-owned. So is it perhaps a case of a state writing checks in its own currency that it can always cash?
What might the next 2-3 decades bring?
They seem to bring a lot of questions. Today China’s per capita GDP at purchasing power parity (PPP) stands at around 40% of that of the USA, and it is growing. Japan and South Korea experienced similar trends, and their GDP at PPP capped out at around 70% of the American level. Is China on a similar trajectory?
The working-age population of China is today declining, the same as it is in the EU. Even with incentives, it is “very difficult to get the birth rate up”. So in order to enable continued growth, China will need to increase its productivity. That means innovation, and innovation means research and development. China is currently allocating 2-3% of its GDP straight into R&D. Will this be enough to keep Chinese growth on target?