In my past articles on China, I discussed why I remained bullish on China’s growth prospects, despite the country’s inevitable economic slowdown as it transitions from an investments- and exports-driven model to one led by consumer spending (e.g. see my August 24, 2016 article “Three Ways To Profit From China’s Rising Global Economic Influence”). To recap, post-1978, China has relied on the following three main pillars of growth, all of which are becoming obsolete: 1) a demographic tailwind as exemplified by a young, growing, and increasingly-educated workforce, 2) technological catch-up and an unprecedented/exponential increase in infrastructure investments, and 3) through a combination of record-breaking CAPEX investments, technological catch-up, and a highly cost-effectively labor force, the creation of an export-led growth model following the footsteps of Japan, Taiwan, and South Korea (known as the “East Asian Model of Capitalism”).
Indeed, the Chinese labor force participation rate is already shrinking—from over 77% in 2010 to 72.4% in 2015. Similarly, China’s working-age population of between 15 and 59 years old had already peaked in 2011, and has dropped by nearly 20 million over the last five years. This sharp drop in China’s working-age population will accelerate in the coming years, pressuring wages higher and stressing the country’s retirement and healthcare systems. Similarly, growth tailwinds from technological catch-up and infrastructure investments are also dissipating. From 2000-2010, Chinese productivity growth was responsible for about 40% of the country’s economic growth; in this decade, it has dropped to just 30%. As Chinese wage pressures continue to grow—and as U.S. businesses are pressured to “re-shore” its manufacturing centers or relocate to cheaper locations (e.g. Vietnam or Bangladesh)—China’s export-driven model for economic growth will come under pressure as well.
Fortunately, Chinese policymakers recognize the limitations of the traditional “East Asian Growth Model” and are executing plans to create a more sustainable model for the country to transition from a developing to a developed economy. E.g. As I pointed out in my August 24, 2016 and earlier articles, China is leveraging its vast amount of domestic savings ($5 trillion of savings annually) to jump start infrastructure projects in the Eurasia and Africa regions as part of its “One Belt, One Road” (OBOR) initiative. While first suggested by Chinese President Xi Jinping in 2013 as a long-term development and trade integration policy for the Eurasia and Africa regions, the OBOR is no longer a unilateral policy, but one with the backing of 52 member states and 18 prospective members of the $100 billion Asian Infrastructure Investment Bank (AIIB), including countries such as Australia, Brazil, France, Germany, India, Italy and the UK. Policymakers who are part of the OBOR and the AIIB are already working together with professionals at the World Bank and he Asian Development Bank to fund infrastructure projects. This will ultimately serve to integrate China with various economic regions in Eurasia and Africa, resulting in better growth prospects and expanding the export market for Chinese-made industrial and consumer goods for years to come.
Another important policy to more sustainable economic growth is home-grown innovation, which Chinese policymakers enunciated as part of their “Made in 2025” initiative announced in 2015. The overriding goal of this initiative is to upgrade the quality of Chinese -made products in ten strategic industries: next-generation IT, robotics, aviation, maritime equipment, modern rail transport equipment, clean-energy vehicles, power equipment, agricultural equipment, new materials, and biopharma and other medical products—while utilizing data analytics to control every step of the manufacturing process. E.g. as recent as 2012, Chinese industries only utilized foreign-made robots; last year, 31% of robots purchased by Chinese industries were domestically-made. Chinese policymakers want to increase the share of domestically-made robots to 50% by 2020. More robots adoption and other advances in manufacturing automation will allow Chinese manufacturers to better compete globally as domestic wages rise, ensuring a more sustainable growth model for China in the years ahead.
While both the OBOR and the “Made in China 2025” initiatives are slowly but surely making progress, recent trends of 6%+ economic growth is not assured, as years of nearly-unrestricted economic growth has made the country vulnerable and highly dependent on the fluctuations in global geopolitics. Unless President Xi and Chinese policymakers can make substantial breakthroughs in innovation and to increase energy security, Chinese economic growth could turn negative under various, highly plausible scenarios. Following are three “known risks” (or “gray swan” risks) that have a plausible chance of derailing the Chinese economic growth juggernaut.
- China’s dependency on Middle Eastern Oil
Various Chinese leaders have at times stated that Chinese economic growth and overall development could only have occurred in a peaceful world, i.e. a world characterized by U.S. hegemony of all the world’s important sea lanes and because of that, open trade borders and robust global consumer spending that was conducive to China’s export-led growth model. Similarly—because China has been a net oil importer since 1993 (mostly from the Middle East)—historic U.S. protection of the world’s sea lanes has effectively secured Beijing’s economic and energy security for the last 25 years. Should the U.S. military adopt a more isolationist stance with respect to the Persian Gulf (which gets increasingly likely as U.S. domestic shale oil production continues to gain market share and as higher entitlement spending overwhelms the U.S. federal budget), a major Middle Eastern conflict—which has been the historical norm in the region—could easily break out, effectively removing millions of barrels a day off the market. China—being the world’s largest oil importer (at 8.5 million barrels a day, or over 60% of her consumption needs), along with being the furthest country from the Middle East by sea (around 7,000 miles)—will be the most affected, as the current capability of its navy isn’t sufficient to exercise sea lane control to secure its oil supplies from the Middle East. In fact, such modernization of the Chinese navy’s capabilities isn’t expected to occur before 2049 at the soonest. An alternative would be for the Chinese to develop her own immense shale oil resources; however, because of geological reasons and water limitations, Chinese shale oil production has so far disappointed. With the country expected to import nearly 75% of its oil needs by 2030, any interruption in global oil supply would hit the Chinese economy the hardest.
- Stubbornly high pollution levels have led to major health issues
According to the World Health Organization, outdoor air pollution is a direct cause of cancer. Next to smoking cigarettes, air pollution is the most important risk factor for lung cancer. In 2015, there were over 700,000 new cases of lung cancer in the country; moreover, it is estimated that outdoor air pollution contributed to 1.2 million premature deaths in China each year; it is now the fourth-highest cause of deaths each year, after dietary issues, high blood pressure, and smoking. Chinese policymakers recognize the severity of the country’s pollution problem but its actions so far have had minimal impact. E.g. through its “Action Plan on Prevention & Control of Air Pollution” in 2013, China pledged to reduce coal consumption from 67% of the total energy use in 2012 to 65% by this year. Thousands of highly polluting factories were subsequently shut down. The 74 cities that were tracked to gauge the effectiveness of the action plan showed a 14.1% reduction in PM2.5 concentration in 2015 from 2014; Beijing itself recorded 42 days of the highest polluting days, down from 45 in 2014.
Despite such actions, air pollution in China remains at dangerously high levels. According to the Chinese Ministry of Environmental Protection, air quality in 265 out of 338 major cities was above that of the national health standard last year. Indeed, China’s air quality has noticeably deteriorated as the country’s economic growth rebounded during Q1 of this year, prompting serious concerns on whether Beijing’s long-term efforts to curb air and other types of pollutions are feasible. With social unrest over China’s stubbornly high pollution levels reaching an inflection point, and with the country’s cost of lung cancer treatment rapidly rising, China must now seek more effective solutions to combat pollution without sacrificing economic growth. This is a tall order.
- China’s shadow finance system is too opaque for policymakers to police
As part of its policy to rein in rising property prices and prop up its currency, the RMB, Chinese policymakers began to tighten monetary policy late last year, as exemplified by the sustained rise in the 7-day repo rate over the last six months (see Figure 1 below).
A separate tightening policy was instituted through tighter controls of wealth management products. This was designed to limit credit creation as well as to control risks that have been brewing in banks’ off-balance sheet vehicles and the Chinese shadow financing system. As events surrounding the Panic of 1907 and the 2008-09 global financial crisis have shown, however, policymakers and regulators cannot effectively control or “paper over” risks if they do not have a firm grasp of the size of the issue or where individual risks lie. The speed of today’s “contagion effects”—where every-day, retail investors respond to global events instantaneously also provides policymakers a much smaller time frame to react should another financial crisis develop. E.g. Last week, the China Banking Regulatory Commission started regulating so-called “entrusted investments,” where banks funnel their clients’ money into hedge funds and mutual funds after promising them relatively high, fixed investment returns. Cumulative inflows into these products are estimated to be US$1.7 trillion after the banks’ own money is included. As a response to this crackdown, banks’ withdrawals from this product accelerated, resulting in the Shanghai Composite declining by more than 4% in the last 10 days, equivalent to a US$300 billion loss in market capitalization.
To sustain real GDP growth of 6% or over, Chinese and global policymakers will need to continue to develop new consumer markets, especially within the relatively low-income areas of central Asia, which encompasses around 3 billion people, if the Chinese population is included. Chinese policymakers and businesses especially will need to focus on homegrown innovation as the next stage of the country's development—innovation that will continue to build a list of Chinese multi-national companies that could compete globally. In addition, long-term security of Chinese oil supply is paramount; Chinese reliance on Middle Eastern oil has gotten increasingly alarming as the country is now the world’s largest oil importer, and as its navy still does not yet possess the capability to secure the 7,000-mile sea lane stretching from China to the Persian Gulf. To alleviate the probability of an oil shortage, China will need to develop its own shale oil resources or increase the size of its EV fleet—both of which are not yet progressing quickly enough.
Disclosure: Neither I nor does my firm, CB Capital Partners hold any shares or economic interests in any Chinese or Chinese-related equities or ETFs.
