china macroeconomics
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Figure 1: Growth in China is noticeably
higher than in the G7
Source: Datastream
Figure 2: Investment component drives the
extremely powerful growth rate
Source : Datastream
ContactDr. Alessandro Bee
Economist
+41 58 317 9283
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China GDP growth y oyG7 GDP growth y oyKorea GDP growth y oy
Japan GDP growth y oy
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China consumption contribution of GDP growthChina investm ents contribution of GDP growthChina net exports contribution of GDP growth
1 | Macro Focus Economic & Strategy Research
Challenges facing the MiddleKingdom 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 pro-
cess
The need for reform in China
The Chinese economy has been chiefly as-
sociated with unbridled growth in recent
years. But nowadays, the Middle Kingdom is
mostly associated with the reform concept.
Given the marked cooling in Chinas eco-
nomic momentum recently (see Figure 1),
the need to reform its economy has become
progressively more important. Chinas eco-
nomic 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 out-
stripped economic growth in the G7 coun-
tries.
Investments drive growth
Chinas breakneck economic growth was
mainly fuelled by a massive increase in in-
vestment 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, to-
gether with the lack of a social safety net.
On the other hand, Chinas underdeveloped
capital markets offer savers few alterna-
tives. The high savings rate also means that
the investment ratio is above 40%. 2) Regu-
lations are used to keep interest rates arti-
ficially 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 invest-
ments profited from this regime of financial
repression. 3) Despite Chinas one-child pol-
icy, its working age population has in-
creased from 59% to 73% of the total popu-
lation over the last 30 years. 4) But Chinas
progressive urbanisation is far more im-
portant. Whereas in 1980, more than 80%
of the population were employed in the (not
very productive) agricultural sector, this per-
centage has since declined to 50%.
5) Cheap and abundant resources meantthat China was able to expand its manufac-
turing industry and boost its exports. China
benefited from the fact that the last 20
years were characterised by the rapid global-
isation of product markets and that a boom
in US consumption until Lehman Brothers
collapsed created strong demand for Chi-
nas products.
Unsustainable growth model
Chinas growth model has proved very suc-
cessful to date, but it has also created ex-
ternal and internal imbalances, which pose
a threat to its economic stability in the long
term. 1) In terms of foreign trade, the future
Macro FocusEconomic & Strategy Research21 November 2013
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Figure 3: Financial repression in China
negative real interest rates
Source: Datastream
Figure 4: Investments as % of GDP in Chi-
na, Korea and Japan
Source: Datastream
Figure 5: Urbanisation in China, Korea and
Japan
Source: Datastream
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013-5
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China deposit rate 1 year nominalChina deposit rate 1 year real
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China investment/GDP ratioKorea investment/GDP ratioJapan investment/GDP ratio
1960 1965 1970 1975 1980 1985 1990 1995 2000 200510
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China urban population in % of totalKorea urban population in % of tot alJapan urban population in % of t otal
2 | Macro Focus Economic & Strategy Research
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 in-
vestments, there are increasing signs that
the artificial stimulation of investments hasresulted in a misallocation of resources. The
corporate debt bubble and real estate bub-
ble 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 wide-
ranging reforms at the third plenary session
of the 18thCentral Committee of the Com-
munist 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 ex-
port-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 organi-sations, whereas the services sector is
dominated by privately owned companies,
this also entails the privatisation of the
economy. Also of central importance is fi-
nancial 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 re-
form plans recently outlined by the Chineseauthorities 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 Chi-
nas impending rebalancing. In the optimis-
tic 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 coun-
try makes a smooth transition to the new
economic model. In the pessimistic scenar-
io, the current economic model very quickly
loses traction and momentum rapidly sub-
sides. But as it will almost certainly take a
decade for the reforms to kick in, China will
face a very difficult rebalancing process andrun the risk of a hard landing, i.e. a very se-
vere 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 de-
liver 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 peri-
od (Figure 4). The urbanisation picture looks
similar. Chinas urban population is current-
ly at a similar level with that of Korea in the1970s (shown in Figure 5). Koreas urbani-
sation increased to 80% in 2000, which
suggests China still has potential. The un-
tapped 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 fric-
tions or a hard landing.
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