China then, now and tomorrow

China is one of the world’s most important economies (equal in some sense to the US and Europe) because it is so large and dynamic. It is even more important for countries that export to it like Australia and Germany.  In the next 5 to 10 years, China will probably become the world’s largest economy (the IMF World Economic Outlook forecasts that this happens in 2017 once purchasing power differences are accounted for). But the China of tomorrow is likely to be much different from that of today or yesterday.

China then

After the social uprising in 1989, China had a few years of reflection before China’s fatherly leader, Deng Xiaoping travelled to the South of China and declared that it was glorious to be rich. China was poor (per capita GDP of less than $2000 compared with advanced economy average of $28,000). And, Deng’s words re-ignited the desire for economic reforms – as the word’s left his mouth, China set out to further liberalise markets, exploit the profit motive, and grow (economically). These reforms really started to gain momentum around the turn of the millennium, so we’ll call the whole package of reforms “the millennium reforms”.

Under the millennium reforms, private property was allowed (even for members of the communist party), and state-owned enterprises were restructured, broken up and, in many, cases privatised. The right to make money and keep it was a dramatic shock to the Chinese economy – it effectively legalised capitalism.  It came at a time when China joined the WTO, giving it greater access to markets, FDI was encouraged, giving foreign firms access to Chinese labour and China access to foreign know-how, and at a time when China was experiencing strong growth in its labour supply, which could not be prosperously absorbed by the rural sectors. In short, it sowed the seeds for a growth miracle – per-capita GDP in China is has doubled *twice* since 1990.

The combination of the sudden emergence of a capitalist class combined with abundant and cheap labour, had a dramatic effect on productivity and growth. But the 1997/1998 Asian balance of payments crises and China’s own (near) banking crisis put some serious constraints on the liberalisation path.  The authorities deemed that the financial sector would not develop like that of loosely regulated Singapore’s or Hong Kong’s, but would remain heavily regulated and controlled in order to contain and eliminate China’s problematic non-performing loans. They also pegged the exchange rate along and tightened capital controls to ensure that it would avoid a capital account crisis like that experienced in Thailand, Indonesia and Korea.

Lastly, the government gave the central bank a strong mandate to maintain price stability in order to avoid inflation that had been one of the factors contributing to the social unrest in 1989.

All this meant that China would experience a surge in growth fueled by cheap wages, an expanding labour supply, strong investment and big improvements in productivity (more efficient use of resources).  It also meant that there was no real mechanism to encourage local residents to buy the rising supply of manufactured goods produced by these more efficient and profitable firms. Normally a productivity surge like that experienced by China would result in a stronger exchange rate, but the exchange rate was fixed. So the local price of manufactures stayed relatively high, which discouraged consumption of, but encouraged production of, manufactured goods. In short, China produced more manufactures than it wanted to buy at the officially set exchange rate and it created a large trade surplus.

The nation’s excess savings were not accumulating with the nation’s relatively low paid workers, but with its new capitalist class.  The banks were being regulated and controlled to reduce risky lending, which meant less money for the entrepreneurs and more for the large state owned enterprises.  The entrepreneurs though saw great opportunity for future investment and growth, but they realised that they would have to save the money to finance that investment themselves. So they did. China ended up with stellar growth, high investment, high (especially corporate) savings and low levels of consumption (although consumption was also growing at a rate that was almost as stellar as the economy as a whole).

China Now

China now is much different from the China at the turn of the millennium. Today’s China has been dramatically shaped by the reforms.  It is much more well-off, its banks are (fairly) safe, and its capital controls protected it from the worst of the global financial crisis.  But China now has a very low level of consumption (around 35% of GDP) and very high levels of investment (50% of GDP). It is unlikely that, as a share of GDP, investment could rise, or consumption fall, much further. In fact, the latest figures show that so far this year, consumption growth in the economy has been faster than GDP growth.

Most importantly, as we’ve discussed before, the size of its labour force is peaking, meaning that the abundant supply of cheap labour is going to start to run out and wages will start to rise much more strongly than in the past.

China Tomorrow

In ten years time the average age of the Chinese population will be older. The changing labour force dynamics will make China somewhat less competitive and create some incentives to reduce the level of investment spending. In addition, aging will encourage people to run down their savings as workers retire. If things go as planned, the next decade will see the rise of the Chinese consumer. That said, the savings that China has accumulated are probably not very evenly distributed – they have generally accumulated with firms and the new entrepreneurial class, so retiring workers won’t be drawing on that portion of China’s wealth, so savings may not decline as much as people expect, and dependence on exports may therefore remain a feature of China’s aging economy.
Interestingly, estimates seem to show that labour force growth doesn’t account for much of China’s overall growth, so it is tempting to think that the slowdown in labour force growth won’t affect GDP growth much.  But it is fair to think that investment (mostly in machinery and equipment, which has accounted for around a quarter to a third of growth – productivity growth accounts for most of the rest), will probably slow. If you don’t need to equip as many workers, you don’t need as much machinery. And as the labour force ages, while it may become wiser, it might become more risk adverse, which could slow productivity growth.  Investment in human capital (learning) may slow too. It is also interesting to note that the combination of declining investment and savings will have an ambiguous effect on China’s trade surplus (which by definition is equal to  savings minus investment).

In addition, it is unlikely that China will be able to replicate the boost to productivity growth which came from the millennium reforms (more efficiently applying advanced and foreign technology to the abundant supply of rural labour and China’s vast pool of savings). Other reforms, such as improving social services might improve the quality of growth, but not the pace. Thus, productivity growth is likely to slow too.  China tomorrow will be one of continuing advancement, but at a slower pace than that which we have become accustomed.

 

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