Uncommon truths: China in the balance

Uncommon truths China in the balance
The thorny question of whether China’s economy is out of balance.

China continues to invest more than other nations. That may depress capital efficiency. However, saving is even higher, which makes China self-financing and more balanced than many countries. 

The title of this article could refer to the recent increase in Covid-19 cases and deaths in China but it doesn’t. Equally, it could refer to China’s increasing isolation on the world’s geopolitical stage. Again, it doesn’t. What is referenced is the thorny question of whether China’s economy is out of balance. 

It is received wisdom among many commentators that the Chinese economy is fundamentally imbalanced, the only questions being to what extent and with what eventual consequences. Over recent years we have published extensive picture books about China and its financial system to test that hypothesis and have generally concluded that, though there are some issues, the problems have been greatly exaggerated.   

This is the first in a series of mini updates to those tomes and focuses on the overall balance of the economy. Subsequent editions will focus on investment spending, the banking sector and the broader financial system (including shadow banking). 

As background, it is well known that China faces a demographic challenge. UN estimates suggest the working age population (20-64-year olds) has already started to shrink. Having grown by 43% in the 30 years to 2020, the UN expects a 17% decline in the next 30 years, with a further 22% decline in the 30 years thereafter. We think that suggests less economic growth in the future (unless GDP per capita accelerates). Though the world faces demographic issues, the problem is far worse in China than in the rest of the world. Looking to 2100, the UN expects annualised working age population growth of -0.7% in China versus +0.5% in the rest of the world (growth rates since 1950 were +1.7% and +1.8%, respectively). 

We suspect that demographic drag was one of the factors behind the gradual decline in China’s GDP growth rate over recent years (ignoring the peak growth years of 2007-11, World Bank data suggests a steady decline from 7.9% in 2012 to 6.1% in 2019). 2020 has been an altogether different story as a result of Covid-19, with GDP growth of -9.8% QOQ in Q1 followed by +11.5% in Q2 (according to China’s National Bureau of Statistics). The net result was that first-half GDP was 1.6% below the year ago level, which is quite a deficit versus the circa 6% growth that might otherwise have been expected. Hope may come from the improving trend but reported daily Covid-19 infections have gone above 200 in recent days. This is well below the rate seen elsewhere but is the highest reported in China since February. If that continues, further lockdowns may be imminent.  

Returning to the long term, one solution to the demographic deficit could be to boost productivity via more investment spending. However, excessive investment is one of the charges frequently levelled at China. Figure 1 shows that investment accounted for 40%-50% of GDP for most of this century (dotted line). That is indeed high, especially when compared to the 20%-25% typically seen in the EU, Japan and the US. 

Even Japan and South Korea didn’t reach such levels during their development phases, when their investment/GDP ratios peaked at around 39%. We can think of two reasons why high levels of investment could be problematic: first, because it drives down the marginal efficiency of capital, thus acting as a drag on future growth and, second, because it is not affordable, thus requiring financing from overseas. 

Our original documents pointed to a decline in capital productivity (GDP/capital) and marginal efficiency of capital (GDP gain per unit of investment) and we will return to this topic in a future edition. For now, we will focus on the affordability of China’s investment, which is why Figure 1 is focused on saving. As can be seen, though China has been investing a lot, it has been saving even more since the mid-1990s (often said to be due to the lack of a social safety net).   

One implication of saving exceeding investment is consistent current account surpluses (the size of which can be judged by the gap between saving and investment in Figure 1). It could perhaps have been argued in the 2007-09 period that China’s current account surplus was excessive (saving was way too high relative to investment). However, that imbalance has since diminished, initially due to a rise in investment but more recently because saving has fallen more than investment (as percentages of GDP). 

A second implication of consistent current account surpluses is that China has been able to finance its own investment spending while also providing finance to the rest of the world. China may have a lot of debt but it is owed to itself, which makes it hard for a debt crisis to be imposed from outside. 

China’s status as an international creditor can be seen in Figure 2, which shows net international investment positions (NIIP) as a percent of GDP. NIIPs are the result of accumulated current account surpluses and deficits. For example, Germany’s NIIP/GDP ratio has been increasing because current account surpluses have exceeded 6% of GDP in most years since 2006. Japan has a similar creditor status, as does Switzerland (NIIP of 117% of GDP in 2019 but not shown). China is not in that league and its NIIP/GDP ratio has been trending down in recent years because GDP has grown faster than NIIP. It is on the right side of zero but does not appear imbalanced. 

On the other hand, a range of countries are net debtors and are heading in the wrong direction, with worsening imbalances, including France and the UK (Italy has seen improvement). The US appears to be in a league of its own among debtors, though Turkey (not shown) is nearly as bad (47% of GDP in 2019). It is not as though the US invests too much (around 20% of GDP in recent years) but rather that it saves too little (less than 19% of GDP in 2019). Luckily, the US owns the world’s reserve currency, otherwise we doubt it would get away with such an imbalance. 

In conclusion, China may invest a lot and this may depress returns on investment. However, it is self-financing and from this perspective has fewer imbalances than the US, the UK and France. That is relatively comforting from a financial stability perspective. Among surplus countries, it appears better balanced than Germany and Japan, which could ease growing geopolitical pressures on China. 

Unless stated otherwise, all data as of 31 July 2020.

Paul Jackson is Global Head of Asset Allocation Research with the Global Market Strategy Office. András Vig is Multi-Asset Strategist with the Global Market Strategy Office.