Download the Chinese economy`s uncertain future

November 2, 2015
The Chinese economy’s uncertain future
A development model that has reached its limits
The times in which the Chinese economy grew at a pace
greater than 10% a year seem to be over. The country’s
economic growth has declined in the last few years and
is now below 7% (graph 1). This Economic Viewpoint
examines the deep causes behind the slowdown, causes
that are essentially related to the fact that Chinese’s
development model is showing its age. Reforms seem
needed to repair the situation over the long term, but
would probably be at the cost of an adjustment period
that would temporarily penalize growth. All in all, we
do not anticipate any improvement in China’s economic
situation and uncertainty could remain palpable.
Graph 1 – China’s economic growth is slowing
Ann. var. in %
Ann. var. in %
Chinese real GDP
16
16
15
15
14
14
13
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
Sources: Datastream and Desjardins, Economic Studies
However, such investment requires substantial financial
resources and at the lowest cost possible. China is managing
to meet its needs without a net inflow of foreign capital.
Instead, it depends on households’ strong propensity to
save; given the lack of adequate social security measures,
households have to shield themselves from life’s vagaries
and provide income for retirement. Their savings mainly
go to the banks, with other investment opportunities quite
thin on the ground. China’s stock and bond markets remain
relatively small and the intense volatility, such as was seen
in the stock market last summer, encourages savers to opt
for the safety of bank deposits.
Overview of China’s development model
The Chinese economic boom of the last two decades was
based on a very particular recipe. Firstly, the economy is
very investment heavy. Investment accounts for about 45%
of China’s GDP, putting the country in top place among the
major economic powers (graph 2).
Graph 2 – The weight of investment is much higher in China
Total investment as a percentage of GDP
(G20 countries, 2010–2014 average)
China
India
Indonesia
Korea
Australia
Saudi Arabia
Canada
France
Russia
Mexico
Brazil
Turkey
Japan
South Africa
Germany
United States
Argentina
Italy
United Kingdom
0
5
10
15
20
25
30
35
40
45
Chinese authorities’ control over international capital
flows makes it easy to capture national savings cheaply.
Although the country frequently posted growth rates above
10% between 2002 and 2011, interest rates remained very
low during this period, often below inflation (graph 3 on
page 2). Control over capital flows limits savers’ ability to
invest in assets outside the country, where they could get
better returns.
50
In %
Sources: International Monetary Fund and Desjardins, Economic Studies
François Dupuis
Vice-President and Chief Economist
Hendrix Vachon
Senior Economist
514-281-2336 or 1 866 866-7000, ext. 2336
E-mail: [email protected]
Note to readers: The letters k, M and B are used in texts and tables to refer to thousands, millions and billions respectively.
I mportant: This document is based on public information and may under no circumstances be used or construed as a commitment by Desjardins Group. While the information provided has been determined on the basis of data obtained from sources that
are deemed to be reliable, Desjardins Group in no way warrants that the information is accurate or complete. The document is provided solely for information purposes and does not constitute an offer or solicitation for purchase or sale. Desjardins Group
takes no responsibility for the consequences of any decision whatsoever made on the basis of the data contained herein and does not hereby undertake to provide any advice, notably in the area of investment services. The data on prices or margins are
provided for information purposes and may be modified at any time, based on such factors as market conditions. The past performances and projections expressed herein are no guarantee of future performance. The opinions and forecasts contained herein
are, unless otherwise indicated, those of the document’s authors and do not represent the opinions of any other person or the official position of Desjardins Group. Copyright © 2015, Desjardins Group. All rights reserved.
November 2, 2015
Economic Viewpoint
Graph 3 – China is keeping interest rates very low
In %
In %
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
1997
1999
2001
2003
2005
2007
2009
Rates on 1-year deposits
2011
2013
2015
Inflation
Sources: Datastream and Desjardins, Economic Studies
High savings also means more moderate consumption,
creating an imbalance with the increase in production
capacity boosted by investment. To deal with the situation,
China must export some of its production; using a managed
exchange rate policy helps it maintain a positive trade
balance.
Beyond the mechanisms in place that define the Chinese
model, the existence of a large pool of labour has also
provided important support for economic growth. So
have migratory movements, as the movement of the large
rural population to industrialized urban areas improved
productivity through a more efficient use of workers.
Overinvestment is testing the model’s limits
The model made rapid development possible in China for
many years, but this does not mean it is infallible. The
signs of that it is running out of steam are proliferating.
Among them, the return on investment has declined sharply
over the last few years, as can be noted by the change in
the incremental capital-output ratio (graph 4). The ratio’s
increase means that investment is becoming less and less
www.desjardins.com/economics
efficient at generating economic growth. The phenomenon
may seem normal, to a point. Although, in the early stages of
a country’s development, the first roads, railroads and plants
generally pay off handsomely, at one point, the positive
impact of adding new infrastructure or production capacity
dwindles. The fact that China has very intensive investment
both speeds up and magnifies this result, however.
The problem is exacerbated by deficiencies in the funding
conduits. Chinese banks, which reap the bulk of the savings,
are often directly or indirectly controlled by the government.
Political interference makes it hard to ensure that the capital
goes to the most profitable projects. The underdevelopment
of the bond and stock markets is also an issue.
Another consequence of overinvestment is that it accelerates
debt growth. Compared with other major emerging
economies, Chinese businesses carry much heavier debt
loads (graph 5). This could become especially problematic
in a context of declining return on investment. A vicious
circle could materialize if, in response to weaker economic
growth, the authorities stimulate credit to give even more
support to investment; this would, in the end, further reduce
the return on investment while increasing debt loads.
Graph 5 – China’s businesses have an especially big debt load
In % of GDP
In % of GDP
Credit to non-financial corporations
175
175
150
150
125
125
100
100
75
75
50
50
25
25
0
0
2006
2007
Brazil
2008
2009
Russia
2010
India
2011
China
2012
2013
South Africa
2014
2015
Turkey
Sources: Bank for International Settlements and Desjardins, Economic Studies
Graph 4 – In China, investment has become much less efficient
in recent years
Ratio
Ratio
Ratio of capital growth to production growth
7
6
7
6
Capital is growing more and more
quickly in relation to economic growth
5
5
4
4
3
3
2
2
1993
1995
1997
1999
2001
2003
2005
Sources: International Monetary Fund and Desjardins, Economic Studies
2
2007
2009
2011
2013
2015
An exchange rate policy with perverse
results
The exchange rate policy that allows China to maintain a
trade surplus also has its limitations. The policy implies that
other countries must continuously spend more than they
produce; in other words, they have to go into debt. Sooner
or later, these countries will have to reduce demand to pay
off their loans or at least rein in their debt loads. This would
force the countries that are amassing surpluses to find other
outlets, particularly local outlets. Since 1997, China has
amassed current account surpluses in excess of US$2,600B;
November 2, 2015
Economic Viewpoint
this places it in the lead among G20 nations, after Germany
and Japan (graph 6). At the other end of the spectrum, the
United States has accumulated total deficits of more than
US$8,500B over the same period. If Americans decided
to take on less debt in the future, this would necessarily
limit the ability of countries like China to maintain trade
surpluses.
Graph 6 – China is contributing to global imbalances
by artificially maintaining a trade surplus
G20 nations’ accumulated
current account surpluses and deficits since 1997
China
Japan
Germany
Saudi Arabia
Russia
Korea
France
Indonesia
Argentina
South Africa
Canada
Italy
Mexico
India
Turkey
Brazil
Australia
United Kingdom
United States
-9,000
www.desjardins.com/economics
Graph 8 – The mandatory reserve ratio has been raised several
times to sterilize exchange interventions
In %
In %
Chinese banks’ mandatory reserve ratios
Ratio applied to small banks
21
21
Ratio applied to big banks
19
19
17
17
15
15
13
13
11
11
9
9
7
7
5
5
1999
2001
2003
2005
2007
2009
2011
2013
2015
Sources: Datastream and Desjardins, Economic Studies
-7,500
-6,000
-4,500
-3,000
-1,500
0
1,500
3,000
In US$B
Sources: International Monetary Fund and Desjardins, Economic Studies
Managing the exchange rate also comes at a price for China’s
economy. Until 2013, China amassed substantial foreign
exchange reserves to curb the yuan’s appreciation (graph 7).
This strategy has the drawback of increasing the monetary
base, which could generate inflation and an appreciation in
real terms of the exchange rate. To counter these effects,
monetary authorities must sterilize the accumulation of
foreign exchange reserves by taking liquidity out of the
financial system. The main tool used here is the mandatory
reserve ratio, which ratio hit a ceiling of 21.5% in 2011 for
the country’s major banks (graph 8). However, this strategy
affects the banks’ profitability and makes them less able to
cope with bad debt. Moreover, it encourages banks to cut
the interest rates offered to depositors or to increase rates
for borrowers. Although the monetary authorities regulate
retail rates heavily, the banks have some leeway.
Given that the Chinese exchange rate is essentially pegged
to the U.S. dollar, the greenback’s generalized rise since last
year has trimmed the yuan’s undervaluation considerably.
Among other things, this resulted in a reduction in foreign
exchange reserves. This does not mean the problem is
solved, however. China still has a substantial trade surplus,
and the mandatory reserve ratio applied to the banks
remains very punishing. Moreover, an eventual drop by the
U.S. dollar would probably be enough to make China amass
further foreign exchange reserves.
Less favourable demographics
The advanced nations are not the only ones undergoing
structural changes due to demographics. The one-child
policy enforced in China from the end of the 1970s has
curbed population growth and the population aged 15 to 64
has already begun to crest (graph 9). Stabilization by this
part of the population points to weak growth in the number
of workers and, in turn, a drop in China’s economic growth
potential. The recent end of the one-child policy will not
change the situation for the next 15 years.
Graph 9 – The 15-to-64 population group is stagnant in China
In millions
In millions
Chinese population
1,500
Graph 7 – China has large foreign currency reserves
1,500
In US$B
1,250
1,250
4,000
4,000
1,000
1,000
3,500
3,500
3,000
3,000
2,500
2,500
2,000
2,000
1,500
1,500
1,000
1,000
In US$B
Official foreign currency reserves
500
0
1999
750
750
500
500
250
250
1950
1975
2000
2025
Population aged 15 to 64
500
0
2001
2003
2005
2007
2009
2011
2013
Sources: United Nations and Desjardins, Economic Studies
2015
Sources: Datastream and Desjardins, Economic Studies
3
2050
2075
Total population
2100
November 2, 2015
Economic Viewpoint
Economic growth is still being buoyed by productivity
gains, including the gains that stem from population
migration to urban areas. Although the urban population
became larger than the rural population in 2010 (graph 10),
China is still nowhere near the urbanization rate of about
80% that characterizes advanced countries.
www.desjardins.com/economics
Graph 11 – Consumption’s share remains below investment’s
share, and is not growing much
Distribution
Breakdown of Chinese GDP
100%
90%
80%
70%
60%
50%
Graph 10 – Migration to urban areas continues
In millions
In millions
Chinese population
900
40%
900
800
800
700
700
600
600
500
500
30%
20%
10%
0%
1994
400
300
Rural population
200
1995
2000
2005
2010
2004
2006
2008
2010
Government expenditures
2012
2014
Net exports
In yuans*
60,000
Average wages in urban units
Average wages in the manufacturing sector
50,000
Given slowing economic growth,
reforms are needed
2002
Average annual wages
60,000
2015
Sources: Datastream and Desjardins, Economic Studies
2000
Investment*
Graph 12 – Wages have grown substantially
in the last two decades
300
In yuans*
200
1990
1998
* Including inventory change.
Sources: Datastream and Desjardins, Economic Studies
400
Urban population
1996
Consumption
50,000
40,000
40,000
30,000
30,000
20,000
20,000
10,000
10,000
China’s development model is showing clear signs of age. If
nothing is done, economic growth could keep eroding. The
monetary authorities are piling on the measures, such as
interest rate cuts, to stimulate credit, but such actions could
be harmful over the long term if all they do is maintain
an investment rate that is already too high. Devaluing
the exchange rate to increase exports does not seem like
a sustainable strategy, either. The solutions should instead
target the Chinese economy’s structural problems.
programs and introducing social security measures could
lessen consumers’ propensity to save and, in turn, would
stimulate consumption. Government spending would also
go up.
To start with, reforming the banking system to make it
more competitive and independent from public decision
makers would be welcome to improve capital allocation and
investment profitability. However, it would still be better
to make investment less intensive; this could be done by
fostering a greater contribution from consumption. The
weight of consumer spending in China’s GDP is currently
stable at around 40%, but has previously been around 50%
(graph 11). Growth that is more dependent on consumption
would also lessen the need to maintain a trade surplus, as
the increase in domestic demand could replace some of the
foreign demand.
It would likely take even deeper reforms to maximize the
chances for a successful shift to consumption. Developing
the bond and stock markets to make them less volatile and
more accessible to consumers would help to increase the
return on their savings. The resulting wealth effect would
stimulate consumption; what’s more, these financing
channels could improve the allocation of financial resources.
Greater liberalization of capital flows would also provide
other investment opportunities and contribute to the wealth
effect. Lastly, abandoning the managed exchange rate
regime would increase consumers’ buying power when the
yuan appreciates.
The potential provided by consumption is even greater as
Chinese consumers do not generally carry much debt and
have seen average wages go up substantially over the last
decade (graph 12). Reforms would be needed to capitalize
on this potential, however. In particular, developing social
There is another side to this coin, however. Many of these
reforms create substantial risks to the country’s short-term
economic and financial stability. In particularly, it would
no longer be possible to keep interest rates artificially low
for savers who have more investment opportunities. The
4
0
0
1990
1995
2000
2005
2010
2015
* 1,000 yuans equals about US$155.
Sources: Datastream and Desjardins, Economic Studies
Economic Viewpoint
November 2, 2015
www.desjardins.com/economics
banking system would have to adjust, becoming more
competitive and profitable. Also, higher interest rates and
tighter credit for risk loans could be hard for businesses to
handle when they are already carrying a lot of debt. Some
businesses would probably close, especially in sectors that
are being supported by investment, low interest rates, or
the managed exchange rate policy. Workers would have to
turn to more consumption-oriented industries, where the
growth outlook would be better. These adjustments would
take time and, in the near term, would result in a higher
unemployment rate and a heavier curb on the economy than
if few reforms were instituted.
No perfect scenario
Faced with these risks, the decision to reform China’s
economy is not an easy one, even though it is necessary,
in our view, given the long-term gains that would result
from it. Moreover, the fact that China has extensive foreign
exchange reserves could help it stabilize the capital flow and
limit interest rate movements for several quarters or even
years. On the other hand, it means that the rest of the world
economy would have to absorb a lot of government bonds,
which make up the bulk of China’s reserves. Successfully
transforming China’s economy could come hand in hand
with a successful effort by advanced nations to reduce their
debt loads, failing which the global balance between savings
and credit would tip in the direction of higher interest rates.
Given that there is no perfect scenario, Chinese authorities
will likely opt to tackle the issue very slowly, to try
to mitigate the risks. Banking system reforms and the
introduction of social security measures could be the
easiest to implement initially. However, dropping controls
over capital flows, particularly for Chinese households, and
liberalizing the exchange rate could be much harder to put
into effect. Clearly, going slowly or even taking only partial
action means that it would take longer for the benefits to
materialize and, therefore, China’s economic growth
could continue to decline and approach 6%. As a result, it
will be hard for China’s authorities to completely rein in
uncertainty.
Hendrix Vachon
Senior Economist
5