China's economic miracle is reaching its limits and is in danger of doing more harm than good, writes Geoffrey Yu
Plastic dolls at a toy factory in Xietang, Zhejiang Province, China
China’s economic ascent over the past 40 years is considered one the defining achievements in human history. In less than two generations, an autarky closed to the outside world has managed to insert itself into every facet of modern life. From the simplest manufactured goods to sophisticated hardware, from asphalt roads to nuclear power stations, Chinese companies, predominantly state-owned, have disrupted the global production and investment chain.
The history of economic development, from the invention of the wheel to the fourth industrial revolution, is a story of disruption pushing the boundaries of productivity growth and China’s economic rise since its opening up in 1978 is no different. Such change has been welcome over the past few decades. China created jobs and wealth, while the rest of the world enjoyed a wider choice of products and services at lower prices.
Yet, all good things must come to an end. As the People’s Republic reaches its 70th birthday, it is no longer seen as a benign force. Challenges to China’s economic model are increasing, as witnessed by the trade and technology disputes between the Beijing and Washington.
What receives less coverage in the western press is how powerful forces unleashed by China’s economic growth are disrupting its domestic economy. To present and future Chinese leaders, managing economic change while maintaining social stability is much more important than figuring out how to respond to the social media rumblings of a sitting US president. For an economy as much as an individual, too much of a good thing can be detrimental. In the run-up to the global financial crisis, China’s economy, and more importantly, Chinese jobs, depended on exports.
Facing a collapse in international demand and a sluggish domestic labour market, China decided to switch gears in early 2009 and launched an unprecedented debt-fuelled investment spree.
The fabled ‘four trillion yuan stimulus’, which amounted to a liquidity injection worth more than 12 per cent of China’s 2008 gross domestic product, was credited with stabilizing the global economy. In comparison, the ‘Obama stimulus’ of 2009 in the United States, at just under $800 billion, amounted to only about 5.5 per cent of US GDP for 2008.
So began China’s addiction to debt, a situation the country’s financial regulators are finally starting to get to grips with, but only after realizing that going cold turkey during the latter stages of a global economic cycle is not a healthy condition either.
It is undeniable that ending its debt addiction has been painfully disruptive to the Chinese economy. While the trade dispute with the US dominated headlines over the past 18 months, growth strains were already showing in the first half of 2018.
UBS Investment Bank economists noted that ‘regulatory and fiscal tightening’ were the main reasons for decline in the growth rate. Firstly, there was a tightening of local government debt control which resulted in weaker infrastructure investment. Secondly, rules on shadow banking – one of the biggest sources of growth in the use of borrowed money – were tightened, leading to higher borrowing costs, a decline in shadow credit, weaker bond issuance and higher defaults. As a result, towards the end of 2018 the overall share of credit in GDP had stabilized to between 20-25 per cent, half the levels seen a decade before.
Financial markets were torn between commending the attempt to contain unsustainable investment growth and worrying about the slowdown in the economy, especially in the housing market.
A slowdown in housing wealth is expected to hit consumption growth, and this has been corroborated by high-level data – consumption growth fell to 7.4 per cent year-on-year in 2018, from 7.5 per cent in 2017, and is expected to fall below 7.0 per cent in 2019. Nowhere was this felt more than in the car industry: monthly sales fell from near 30 per cent year-on-year growth in mid-2016 to outright contraction starting in July 2018, and we have not seen a positive number since.
The days of credit-fuelled investment growth are over, but before we ring alarm bells it is important to stress that much of this is by design.
Consumption is still growing faster than the overall growth rate of the economy, while the opposite is true for investment growth. As long as there is material divergence between the two, the Chinese economy is rebalancing in the right way.
However, as household consumption begins to power the economy, thereby creating jobs in the services rather than manufacturing sector, then government and companies, both state and private, need to adapt to changing patterns of behaviour. In this respect, as China opens up, one of the biggest disruptive forces is when households don’t find the level of goods and services up to scratch and vote with their feet by looking abroad for answers.
Again, examining the car market, while total sales shrank by 6 per cent in China in 2018, buried in the fine print is the fact that domestic brands bore the brunt of the fall in demand. Without differentiating too much between imported cars versus domestically produced foreign-branded cars, lower prices for local names have not boosted demand. Even during a time of constrained household finances, it appears that Chinese consumers are willing to put a premium on quality, either perceived or real. This is a lesson that domestic firms badly need to learn, especially in industries that are less protected or where there is a weaker domestic footprint.
The race is now on for market dominance in electric or other fuel-efficient vehicles, where arguably there is no dominant global player. China is investing heavily in this industry and companies such as BYD and CATL have been categorized as disruptors in the field. Yet, with Tesla close to completing its first factory in China and foreign competitors’ efforts coming to fruition, there is every chance that Chinese consumers will again turn away from Chinese brands, even if their prices are more competitive. Capital ultimately flows overseas, which hurts the country’s balance of payments and affects the currency, and that is before we even start talking about perpetual worries of capital flight.
Like in many European countries, government subsidies and targeted regulation have incentivized investment in electric vehicles, but if Chinese brands fall behind in this race, questions will need to be asked whether a heavy state presence in this sector ultimately served as a hindrance. This brings us to the final, and perhaps, most significant disruptive risk, the rise of Chinese tech.
In the fourth quarter of 2006, one Chinese company made it on to the Financial Times’ list of the world’s most valuable publicly- traded companies – the Industrial and Commercial Bank of China. Within the top 10 were four energy companies, three banks and only one tech company. By the end of 2018, there was one bank left, while seven were tech companies, two being Chinese. Two decades ago, Tencent was only known for its chat engine while Jack Ma was starting Alibaba in his flat. At the beginning of 2018 the two companies were worth a combined $1 trillion and are the pride of China. State involvement in their rise was minimal. The way these two companies have disrupted the global tech scene, not to mention Chinese society, is well documented. Beijing can, with justification, point to the tech hubs of Shenzhen and Hangzhou as examples of how privately driven tech innovation and an authoritarian system can co-exist.
Companies can generally innovate independently as long as the state retains a legal right to intervene when technology poses a threat to the system. However, the disruption to an established economic system is becoming hard to ignore.
Take fintech, for example. The proliferation of online banking has led to a 21 per cent decline in bricks-and-mortar bank branches across Europe over the past decade. We can judge for ourselves the disruption to the labour market in what is generally considered a white-collar industry. The same is happening in China but on a much bigger scale, as even street beggars now accept mobile payments by having a large QR code available. If large sections of society bypass the formal banking system entirely, the risk of branch closures is clear. The difference with Europe is that China is still a developing country and the government’s legitimacy, especially in urban areas, relies on the creation of white-collar jobs.
If they are being destroyed faster than they can be replaced, through automation and artificial intelligence, and without a proper welfare system to support the population, the risk of social instability is clear. And that is before we start looking at conditions in rural areas where the labour force is largely unskilled and at even greater risk.
The bottom line is that while technology has done wonders for the Chinese people over the past decade, it may now have become too disruptive for its own good. Will Beijing ever ask the big tech companies to ‘slow down’? Or could the answer lie in further liberalization which lets the market create the requisite jobs? Would the country actively target lower productivity growth to limit the disruption, or opt for highly progressive taxation?
China’s economy has managed to defy expectations so consistently that whenever there is a wobble, the market retains confidence that, through monetary and fiscal stimulus coupled with administrative measures, it can find a way to muddle through.
There comes a point, however, when muddling through is no longer enough. Muddling through does not generate enough growth to create new jobs to offset domestically generated disruption, it does not create the wealth effect to encourage households to spend, it does not entice China’s ambitious citizens to keep their capital or even themselves in the country.
After decades of creating the most disruptive economic growth model the world has ever seen, Beijing is finding the model self-disruptive, though not yet self-destructive. There will be much on Xi Jinping’s mind as he greets the crowds in Tiananmen Square on October 1. Hopefully, at the forefront will be the question: Do we have jobs for all the people, and if not, how do we create them?
AUTHOR: Geoffrey Yu is Head of UK Investment Office at UBS Wealth Management