The Chinese government has finally recognized the 30-year period of explosive growth the country has enjoyed might be coming to an end. For years China’s National Bureau of Statistics (NBS) published counterintuitively sanguine figures about economic growth, but at the beginning of 2019 the government-controlled agency released a collection of economic data that confirms what recent alternative estimates have consistently concluded: China’s GDP growth has indeed decelerated. We wanted to get an idea of how far the real path of economic growth diverges from the one the Chinese government tracked—as well as a sense of the pitfalls ahead on that path—so we collated and analyzed a number of data points to give us an idea of the bigger picture. Bottom line: Recession seems inevitable, and that might trigger major problems globally.
In January of this year, the NBS announced Chinese GDP grew by 6.6 percent in 2018, the lowest growth rate since 1990. Specifically in the fourth quarter of 2018, GDP growth decelerated 6.4 percent compared to the same quarter the year before. Why? We assess that the Chinese economy faces a number of hurdles, most specifically problems with domestic debt and high external debt, a cooling real estate market, an unproductive use of capital, and—a factor peripheral to our piece here—a dwindling working-age population. Growth indicators suggest deceleration in industry, construction, and financial intermediation sectors reflect the biggest challenges for the Chinese economy. These include debt overhang, a housing bubble, decreasing foreign demand, and excessive production capacities. Beyond this, modern non-macro indicators—such as falling car and iPhone sales—suggest an even steeper decline than the recent official figures indicate.
Certainly, the slowdown comes as no surprise. Growth usually tapers as an economy gets richer, because every new dollar of investment generates a smaller return on average. It’s irrational, then, to assume China would experience 10% growth forever. Even the reported 6.6% growth is actually quite high: among the 40 largest developed and emerging economies only India grew faster in 2018.
Today, experts track Chinese economic statistics closer than ever. China has a greater influence over a broader global downturn than any point in modern history, and a heavy reliance on debt financing—especially in light of lessons learned from 2008—could lead to a hard crash for them which in turn could kick off a global recession. The weaker economy will also likely factor into China’s ongoing trade conflict with the United States.
“When the downturn arrives, the world is likely to discover that China’s economy matters even more than most people thought.”
– Kenneth Rogoff
Under the influence
In 2014 China became the world’s largest economy (based on PPP estimates of GDP), and it currently generates about 19% of global output. This means the Chinese economy is a powerful engine for global growth. Each additional percentage point of growth there contributes approximately 0.19 percentage points to global growth. In 2018 China alone was responsible for 32% of the global 3.7% GDP growth.
Since 2009 China has been the second largest commodity importer globally. According to preliminary estimates, Beijing bought 12% of goods sold globally in 2018. China is now the largest market for critical materials, minerals, and energy commodities.
Probably the most economically significant statistic here is that China is now the world’s largest importer of crude oil. As the national economy slows, energy demand will decrease, which can put a lot of pressure on all other global commodity markets.
Additionally, over the last decade China (together with Hong-Kong) has attracted about 16% of global foreign direct investment (FDI) and was itself a source of 10% of global FDI.
All these facts demonstrate the influence of the size and global integration of the Chinese economy. Domestic growth creates jobs, exports, returns on investment, and funding flows worldwide that affect international economies and commodity markets, which in turn increase foreign dependencies on the health of the Chinese economy. In the words of Kenneth Rogoff, “When the downturn arrives, the world is likely to discover that China’s economy matters even more than most people thought.”
First, economists often cite agriculture and manufacturing revolutions as vivid examples of automation’s impact on employment in the past6. And indeed, if we look at these on an isolated industry-by-industry basis, the shifts seem radical: In the British census of 1841, 22 percent of citizens registered as agricultural workers; today that number is below one percent7. In the United States over roughly the same period, the agriculture share of employment declined from 58 percent of total employment to 2.5 percent8.
China in the World Economy
The Debt Problem
Researchers often cite China’s debt problem as the main threat to its economic growth.
This stemmed from the global financial crisis of 2008, when China sought turned to debt to boost domestic demand and spur economic growth. In 2008 Beijing pushed out a massive $600 billion stimulus package, nearly 13% of its GDP that year. The package was considerably larger than those offered by the world’s largest and third-largest economies—the U.S. and Japan—which pumped a comparatively meager $152 billion and $100 billion, respectively, into their own (much larger) domestic markets.2
Since then China has required more and more credit resources to sustain growth. According to the Bank of International Settlements, in mid-2018 China’s total non-financial sector debt relative to GDP exceeded a whopping 250%—compared to only 140% in 2008. The rise of domestic credit continues to beat output growth, and a growing choir of economists now openly questions how far China is from outright financial crisis.
If we want to estimate whether debt dependence is a true threat, however, we have to look beyond the size of the debt and consider duration of credit and interest rates. For example, in 2017 the total non-financial sector debt-to-GDP ratio in the U.S. and Japan exceeded 300 percent and 400 percent, respectively. But those countries have a relatively long average duration of credit and low interest rates, so the debt burden (i.e., debt-to-income ratio) on their non-financial private sectors is lower than in China. In other words, corporations and households in the U.S. and Japan spend less on debt than their Chinese counterparts.
Not only did China’s debt burden since 2008 increase by more than 100 percent—the fastest debt expansion among G20 countries—the country’s debt-service ratio grew by seven percentage points. No emerging economy since the 1990s has experienced nearly the same increase and escaped some sort of financial calamity.3 We therefore expect China will undertake debt-cutting measures that will further burden economic growth.
Some may argue that because China’s debt is mostly domestic—issued by state-owned banks to state-owned enterprises—Beijing can manage it. At first glance, this argument has merit. In the third quarter of 2018, the official value of China’s external debt increased to $1.9 trillion (15% of GDP), whereas it maintained $3.1 trillion in foreign exchange reserves, according to China’s State Administration of Foreign Exchange.
Official figures, however, don’t account for the value of dollar-denominated debt raised by China in financial centers such as Hong Kong, New York, and the Caribbean, which obscures China’s growing U.S. dollar debt. Kevin Lai of Daiwa Capital Markets pegs Chinese debt in mid-2018 somewhere between $3 trillion and $3.5 trillion, which makes China especially vulnerable to global exchange fluctuations, in particular a tightening U.S. dollar liquidity, a weakening yuan, and the ongoing U.S.-China trade war.4 Devaluation below seven yuan per U.S. dollar could trigger a major yuan selloff, which would further devaluate the yuan and ultimately trigger a dollar-denominated debt crisis.
For this reason Beijing can’t rely on a yuan devaluation to support domestic price competitiveness in trade with the U.S. If the U.S. Federal Reserve tightens monetary policy, China’s central bank—the People’s Bank of China (PBOC)—will also feel pressure to prevent capital outflow, and they’d do this by increasing interest rates. Those rising interest rates will in turn muffle China’s credit boom and, of course, further slow the economy.
China’s reliance on credit expansion has another limitation: returns on investment. Though new fixed capital generates enough income for a positive return on investment, credit expansion stimulates growth at the risk of a lower rate of return. The increased investment of cheap money—whether in yuans or dollars—will yield lower and lower returns, and inflation will come knocking.
And indeed, by 2012 China’s credit expansion resulted in a lower return on fixed capital investment. By 2017 the capital output ratio was already 1.7 times higher than in the 30-year period from 1981 to 2011, implying the economy needed more and more credit to balance out a slowdown. At this point a policy decision to deleverage will, yet again, lead to deceleration.
To stabilize economic growth and make a “soft landing,” the Chinese government continues to rely mainly on building up new debt. In January 2019 the PBOC lowered the amount of cash it requires banks to hold as reserves by one percentage point. This move freed up about $117 billion. In addition, this year Beijing plans to make a record-high railway investment of around $125 billion. Together, this represents approximately 1.7% of GDP.
“The enduring construction boom combined with these vacancy rates and soaring housing prices have sparked fears of an inevitable housing bubble in China”
When you combine new debt with unproductive capital investment, you can expect to see slow growth, but you’ll also see an increase in spare capacity. In the housing market, this manifests as an increase in vacancies.
According to the China Household Survey and Research Center, the proportion of vacant dwellings in tier-two and tier-three cities* was close to 22% in 2017.5 The total stock of vacant urban dwellings that year was 65 million units, an increase of nearly 20 million compared to 2011. This raises a paradox: Rapid urbanization in the world’s most populated country accompanied by a growing number of newly-constructed vacant housing.
The enduring construction boom combined with these vacancy rates and soaring housing prices have sparked fears of an inevitable housing bubble in China. Since the real estate market is closely connected to the health of the real sector and the financial system, we have to tally this crisis as one more threat to the Chinese economy.
On the other hand, Chang Liu and Wei Xiong, economists at Princeton University, show that housing price growth in China has been accompanied by equal or even faster growth in personal income. This suggests the construction boom has fundamental support.6
However, the simultaneous expansion of mortgages caused sales of residential buildings from 2000 to 2017 to grow almost two times faster than real per-capita income. Many Chinese households over that time considered real estate investment to be a lucrative alternative to banking deposits with low returns, a shift that increased construction.
We also note that China’s real estate market is oversupplied, which makes it vulnerable to shifts in broader economic winds. Consider that housing demand is only 40% of projected annual supply.5 Any reduction in household income or increase in mortgage rates will therefore put downward pressure on housing prices and eventually lead to a devaluation of all assets and revenues tied to real estate. These include local government land sale revenues, developer earnings, about 20% of household wealth,5 and 25% of banking assets (represented by mortgage loans to households, loans to real estate developers, and local governments).7 A drop in housing prices will also dent employment in the construction industry and the production of associated materials.
In fact, the latest data on housing sales and prices show that the increasing debt burden and excess housing supply have already hit the real estate market.8 Major Chinese developers just reported a year-over-year decline in January sales, while housing prices in the country’s three largest cities—Beijing, Shanghai, and Shenzhen—has stagnated since the end of 2016. Whether this will in turn lead to a nationwide real estate crash will depend now on how successful the government’s stimulus program is in sustaining a target growth rate above six percent for the next several years.
“The trade war initiated by the United States might be the straw that breaks the spine of economic policies Chinese authorities have erected to prop up their economy.”
The Trade War
We have a slowing economy, a looming debt crisis, and a cooling real estate market. But we now also have to factor in the U.S.-China trade war. At this point there’s an abundance of research on the consequences the trade war has for both countries, as well as for the world economy. Considering our scope, we’ll focus on the implications for the Chinese economy.
Economists estimate increasing trade tensions with the U.S. will cost China more than one percentage point of GDP growth per year at least in mid-term. This poses a direct threat in terms of hard lending and makes clear why Beijing is eager to bring the trade war to an end in early 2019.
The Trade War and the Chinese Economy
|Organization||Annual reduction in China’s GDP growth rate
|Citigroup||-1.04||Current US-China tariffs|
|CPB Netherlands bureau of economic policy analysis||-1.2||Current US-China tariffs + 25% tariff hike in 2019 on $200 bn from China + tariffs extended to all US-China trade|
|Institute of World Economics and Policies, Chinese Academy of Social Sciences||-1.2||Mutual trade war with unchanged tariff rate (30%)|
|IMF||-0.6||Current US-China tariffs + 25% tariff hike in 2019 on $200 bn from China + tariffs extended to all US-China trade + global risk premium+25% US tariffs on Chinese car parts|
|OECD||-1.4||Current US-China tariffs + 25% tariff hike in 2019 + tariffs extended to all US-China trade + global risk premium|
|The National Institute of Economic and Social Research (NIESR)||-0.8||Current US-China tariffs + 10% tariff hike in 2019 on $200 bn from China + 10% tariffs extended to all US-China trade|
The Chinese economy faces a number of hurdles, most specifically problems with domestic debt and high external debt, a cooling real estate market, an unproductive use of capital, and—peripheral to our piece here—a dwindling working-age population. These combined constraints have made China highly dependent on external conditions of development, and they’ve limited the scope of policy measures available to counteract adverse external changes.
In the end we believe further economic deceleration is nearly inevitable, though several factors unique to China—such as a high savings rate, a current account surplus, and various policy buffers—can help balance near-term risk.9 However, the trade war initiated by the United States might be the straw that breaks the spine of economic policies Chinese authorities have erected to prop up their economy. This complex management challenge leads us to anticipate Beijing will accept the new conditions proposed by the United States. True, such an agreement might exacerbate long-term political friction between the U.S. and China, but, as we’ve pointed out again and again here, China has far more to worry about in the near term.
*Cities in different tiers reflect differences in consumer behavior, income level, population size, consumer sophistication, infrastructure, talent pool, and business opportunity. The tier system is not an officially recognized system. Different sources can use different tier systems including different criteria and cities.
- Kenneth Rogoff, November 2018 “A Chinese Recession Is Inevitable – Don’t Think It Won’t Affect You” The Guardian. Link
- “Does China Face a Looming Debt Crisis” China Power, 2017. Link
- Michael Schuman, January 2019 “Forget The Trade War. China Is Already In Crisis”. Bloomberg. Link
- “China Is Underestimating Its US$3 Trillion Dollar Debt” South China Morning Post. November 2018. Link
- “Trend In The Housing Market And Housing Vacancy Rate In Urban China” China Household Survey and Research Center. October 2016. Link
- Chang Liu, Wei Xiong, 2018. “The Handbook of China’s Financial System”. Chapter 8 “China’s Real Estate Market”. Limk
- Deutsche Bank. (2016). Analyzing The Property Exposure, Market Research Report.
- “Chinese Developers Battered By Housing Slowdown” NIKKEI Asian Review, February 2019. Link
- Sally Chen and Joong Shik Kang, January 2018. “Credit Boom – Is China Different?” IMF Working Paper. WP/18/2. Link