China’s economic outlook: the end of certainty?
30 Jul 2015|

China’s economic outlook: the end of boom times?

As everybody now knows, the Chinese economy has a big impact on Australia. Chinese demand for Australian commodities influences our rate of economic growth, the value of our currency and—critically for the government—our tax revenues. Over the past decade, we’ve ridden the roller coaster from the good times to the bad. At the same time, cheap manufactured goods from China have benefited consumers while simultaneously putting pressure on local manufacturers.

Treasury and the Reserve Bank, not to mention the resource sector, are surely keeping a close eye on current developments. There’s a lot at stake; unemployment levels, tax revenues, corporate profits and Australia’s overall prosperity all depend upon the Chinese economy.

China’s long-term economic prospects remain favourable. The latest forecast (paywall) from the Economist Intelligence Unit is for the Chinese economy to overtake the US economy in 2026 and to be 50% larger by 2050. The strategic consequences of this long-term shift in economic weight have been explored many times; my most recent contribution is here. In comparison, far less attention has been paid to the near-turn strategic consequences of China’s economic performance. I think that’s a mistake.

As best I understand from discussions with Chinese counterparts and China experts, the Communist Party’s hold on power rests on two things; nationalism and growth. Whatever remnants of Communist ideology remain have been rendered irrelevant by China’s embrace of capitalism. Of greater contemporary relevance, though of much earlier origin, is the notion of the Mandate of Heaven, which links the historical rise and fall of Chinese dynasties with their ability to deliver competent government. Whereas democratic countries punish incompetent governments at the ballot box, more drastic measures are required in a one-party system—no different from when China was ruled by hereditary dynasties.

Although the current Chinese system seems stable, the Chinese Communist Party (CCP) doesn’t take its position for granted. A regime confident of popular support doesn’t control information and suppress dissent to the extraordinary extent the CCP does. We should have no more confidence in the stability of present arrangements in China than its architects.

What happens if the Chinese economy suffers a serious setback in the next several years and how would the Chinese people respond to a recession that saw the economy contract and unemployment rise to double digits? Perhaps the party would explain the need to tighten belts and people would do what was necessary to get things back in order—think Iceland and Ireland following the 2008 financial crisis. However, even under this favourable scenario, it could take years to put things right; economic output can decline quickly but is painfully slow to re-establish.

A less benign scenario is also possible. The Party could fall back on the remaining pillar of its domestic legitimacy—nationalism. Chinese nationalism is remarkably heartfelt, and in many ways understandable given the country’s diverse achievements. But a strong theme of historical grievance also runs through Chinese nationalism. The ‘century of humiliation’ has been kept alive in Chinese popular culture, resulting in widespread anti-Japanese sentiment and a strong resolve to never again be put upon by external powers.

It’s impossible to foresee how nationalism might manifest in an economically weakened China. But it surely wouldn’t make China easier to deal with over issues such as the South China Sea. More assertive behaviour than what we’ve already experienced is possible, and the prospects for compromise are likely to diminish. Don’t mention Taiwan. Even setting aside strategic matters, an economic downturn could see tensions rise over exchange rates and trade—especially with competing US-led and China-endorsed trade pacts under development.

So what do the economists say? Back in 2011, the IMF forecast future Chinese growth of around 9.5% a year. By April this year the medium-term forecast had been revised down to around 6.3%. That’s hardly the end of the world—most countries would be satisfied with 6% growth—but it’s still a substantial drop. More importantly, it shows that things are happening that the IMF didn’t (or couldn’t) anticipate. That’s not a swipe at the IMF; global macroeconomics in the post-financial crisis era has defied prediction and is even difficult to explain ex-post. Nonetheless, within the broader context of uncertainty, there are reasons to be concerned about what comes next for China.

There’s a risk that, like many that came before, China will fall into the middle-income-trap and see its growth stagnate. The trick will be to capture higher value-add export markets while expanding domestic demand. At the same time, China has to unwind the mountain of debt that’s accumulated in its economy over the past decade. With total debts amounting to 282% of GDP, China is a middle-income economy with an advanced economy’s level of debt. Moreover, because Chinese authorities manipulated bank interest rates to provide artificially cheap lending (at the expense of household savers), borrowers showed little discipline in their investments over the past decade. In a haunting echo of the 2008 financial crisis, almost half of China’s debt (US$9 trillion) is related to real estate.

In theory, it’s possible for China to switch from credit driven growth to more sustainable domestic demand—but it’s hardly assured. As always in economics, there’ll be winners and losers. Reforms are needed to put more money in the hands of Chinese households at the expense of those who currently benefit from cheap credit. Taking from the rich to give to the poor isn’t easy, even in a one-party state like China.