Macro Focus

Economic & Strategy Research

21 November 2013 Figure 1: Growth in China is noticeably higher than in the G7
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Challenges facing the Middle Kingdom

Chinas economic model proved successful in the past, but it is now reaching its limits China announces the right reforms, but implementation poses the biggest risk The untapped potential of urbanisation and capital stock will help to advance this process The need for reform in China The Chinese economy has been chiefly associated with unbridled growth in recent years. But nowadays, the Middle Kingdom is mostly associated with the reform concept. Given the marked cooling in Chinas economic momentum recently (see Figure 1), the need to reform its economy has become progressively more important. Chinas economic policies over the last 30 years have scored big successes in this respect. The economy has expanded by about 10% p.a. since 1980. Growth in China has far outstripped economic growth in the G7 countries. Investments drive growth Chinas breakneck economic growth was mainly fuelled by a massive increase in investment activity (shown in Figure 2). Whereas investments in the USA currently contribute less than 20% to growth, in China the figure is close to 50%. There are good reasons for this: 1) China has an extremely high savings rate. On the one hand, this is explained by its rapidly aging population, together with the lack of a social safety net. On the other hand, Chinas underdeveloped capital markets offer savers few alternatives. The high savings rate also means that the investment ratio is above 40%. 2) Regulations are used to keep interest rates artificially low. Figure 3 shows that in recent years, real interest rates were on average negative. By keeping capital costs artificially low, both the banking system and investments profited from this regime of financial repression. 3) Despite Chinas one-child policy, its working age population has increased from 59% to 73% of the total population over the last 30 years. 4) But Chinas progressive urbanisation is far more important. Whereas in 1980, more than 80% of the population were employed in the (not very productive) agricultural sector, this percentage has since declined to 50%. 5) Cheap and abundant resources meant that China was able to expand its manufacturing industry and boost its exports. China benefited from the fact that the last 20 years were characterised by the rapid globalisation of product markets and that a boom in US consumption until Lehman Brothers collapsed created strong demand for Chinas products. Unsustainable growth model Chinas growth model has proved very successful to date, but it has also created external and internal imbalances, which pose a threat to its economic stability in the long term. 1) In terms of foreign trade, the future

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80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 China GDP growth y oy Japan GDP growth y oy G7 GDP growth y oy Korea GDP growth y oy

Source: Datastream

Figure 2: Investment component drives the extremely powerful growth rate

16 14 12 10 8 6 4 2 0 -2 -4

2004 2005 2006 2007 2008 2009 2010 2011 2012 China consumption contribution of GDP growth China inv estments contribution of GDP growth China net exports contribution of GDP growth

Source : Datastream

Contact
Dr. Alessandro Bee Economist +41 58 317 9283 alessandro.bee@jsafrasarasin.com

1 | Macro Focus Economic & Strategy Research

Figure 3: Financial repression in China negative real interest rates

5 4 3 2 1 0 -1 -2 -3 -4 -5

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 China deposit rate 1 y ear nominal China deposit rate 1 y ear real

potential of Chinas export markets in the West has greatly diminished because the industrialised world continues to suffer the consequences of the Great Recession. 2) Regarding the domestic economy, China faces a decline in its working age population in the coming years, which could potentially accelerate wage growth. 3) In terms of investments, there are increasing signs that the artificial stimulation of investments has resulted in a misallocation of resources. The corporate debt bubble and real estate bubble are evidence of this. There is a risk that investments in future will no longer be able to boost production to the desired extent. Chinas reform plans Chinas leadership recently announced wideranging reforms at the third plenary session of the 18th Central Committee of the Communist Party of China. They are designed to reduce the economys external and internal imbalances (rebalancing). The central focus of this rebalancing process is to strengthen consumption. Setting up a social safety net is an important aspect of this endeavour. Strengthening consumption goes hand in hand with changing the structure of the economy from the current model of an export-based manufacturing industry to that of a domestic-oriented services sector. Since a large part of Chinas manufacturing industry is in the hands of quasi-government organisations, whereas the services sector is dominated by privately owned companies, this also entails the privatisation of the economy. Also of central importance is financial liberalisation, which should spell the end of financial repression in China. On the one hand, consumers will have access to new resources, while on the other hand, the introduction of market-based capital costs reduces the risk of bad investments. The reform plans recently outlined by the Chinese authorities address all these key issues; however, it is the implementation phase that usually determines whether reforms are successful. Nonetheless, it must be said that Chinas leadership has successfully executed its reform policies over the last 30 years, which gives rise to the hope that this time will be no different. Two transition scenarios There are two potential scenarios for Chinas impending rebalancing. In the optimistic scenario, China manages to maintain the current economic model for several years and, as a result, generates high growth

rates. Supported by strong growth rates, the Chinese government manages to gradually introduce the pending reforms and the country makes a smooth transition to the new economic model. In the pessimistic scenario, the current economic model very quickly loses traction and momentum rapidly subsides. But as it will almost certainly take a decade for the reforms to kick in, China will face a very difficult rebalancing process and run the risk of a hard landing, i.e. a very severe downturn resulting in a stagnation or even in a recession. Intact growth driver It is therefore of paramount importance whether the current economic model can deliver high growth rates in the coming years as well. The deteriorating demographics and dwindling demand from the West are bound to slow growth. However, one should not overlook the fact that the level of Chinas economic development even after the powerful growth rates recorded in recent years is still relatively low. Chinas per capita capital stock is now at the same level with that of Japan in the early 1970s and Koreas capital stock in the 1980s. Yet both countries still managed to record very high rates of investment in the subsequent period (Figure 4). The urbanisation picture looks similar. Chinas urban population is currently at a similar level with that of Korea in the 1970s (shown in Figure 5). Koreas urbanisation increased to 80% in 2000, which suggests China still has potential. The untapped potential of urbanisation and capital stock gives rise to the hope that Chinas old economic model is still in a position to generate high growth rates. This suggests China should manage to rebalance its economy without encountering serious frictions or a hard landing.

Source: Datastream

Figure 4: Investments as % of GDP in China, Korea and Japan

50 45 40

35 30 25

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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 China inv estment/GDP ratio Korea inv estment/GDP ratio Japan inv estment/GDP ratio

Source: Datastream

Figure 5: Urbanisation in China, Korea and Japan

100 90 80 70 60 50 40 30 20 10

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 China urban population in % of total Korea urban population in % of total Japan urban population in % of total

Source: Datastream

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