In recent years, many savers have diverted part of their investments to the Chinese stock market, trusting in the growth potential of the Asian giant and in the enormous progress made by it in the technological field: the “Chinese decade” was a slogan coined by market operators
However, after a very difficult 2022 and a problematic 2023 (so far at least) more than someone is wondering if the game is worth the candle.
To understand the complex situation of the Chinese economy, it is necessary to broaden the horizon of analysis beyond the events of recent years, and consider the main drivers that have guided its development over time.
This leads to note how, apart from Covid 19, the current difficulties of the Dragon (including the real estate crisis) are attributable to inefficiencies in the allocation of resources dating back at least to the post-Great Financial Crisis period.
This observation, if on the one hand highlights the enormous margins of development of the first Asian economy, on the other hand highlights the need for a change in the economic policy implemented by the Communist Party, so that this potential can find expression.
To what factors is the economic development of a country attributable?
Following the macroeconomic literature, the total amount of output produced by a country depends on the amount of labour available there, the capital stock within it (plant, machinery, roads, ports, railways, etc.) and the total productivity expressed by the country in question.
The latter depends in turn on factors such as the quality of the workforce (high levels of education make it more productive), the technology available, the pace of innovation, etc.
In other words, the concept of productivity gives us a measure of the efficiency with which the factors of production (capital and labor) are put together and organized to obtain the overall product. In studies of economic growth, this magnitude is referred to as Total Factor Productivity (TFP).
So let’s see in detail how these three factors have evolved in China over time.
Demography
China currently has a rapidly ageing population, which has a significant impact on the available workforce. While this trend is shared with many advanced countries, and a decrease in the birth rate is generally consistent with income growth within a country, in China it has been accelerated by the one-child policy introduced since 1980.
China’s investment in physical capital
As shown in the chart below, the accumulation of physical capital has historically been a strong development driver for China. Since 2008, however, the weight of this component has increased substantially to even 80% of output per worker.
If we think in comparative terms, this value is much higher than what has been experienced in the past, at the same stage of economic development, by countries such as Japan and South Korea.
Source: World bank Group
Now, if we think about one of the main ways of accumulating physical capital in China, namely investment in infrastructure, it is evident that it is necessary to sustain the growth path of a country, especially when this growth is at its initial state.
However, as a country develops, any additional investment in infrastructure will bring less and less benefit to overall productivity (no nation need to build highways and bridges indefinitely…) resulting in redundant limits: in other terms, it will support demand and production in the short term, but will probably divert resources from more productive uses in the long future.
This is what has happened in China since 2008: the substantial fiscal stimulus plan promoted by the Government, first in response to the Great Financial Crisis and then to the slowdown of 2015-2016, has favored investment in physical capital, primarily infrastructure and real estate.
In addition to a decreasing contribution to overall productivity provided by this type of investment (degenerated, for the real estate part, into a real bubble), this trend has subtracted resources from investment at company level, whose dynamism is the main engine of productivity of a country.
The graph below highlights this dynamic:
Accumulation of physical capital by sector. Source: World Bank
The productivity of Chinese companies
Returning to the first graph proposed, we note how Total Factor Productivity has been a strong growth lever for the Chinese economy since the 80s (contributing between 2% and 4% per year) or since Mao’s successor, Deng Xiaoping (in office from 1978 to 1989) introduced a series of reforms aimed at making the economy more market-oriented. Further impetus came from China’s accession to the World Trade Organization (WTO) in December 2001.
However, since the Great Financial Crisis, the contribution of productivity to economic growth has declined significantly. In part, this can be attributed to the normal development path of an emerging economy which, in its first phase, is characterized by the reallocation of the workforce from the agricultural sector to the more productive industrial sector (a phenomenon that occurred in China in a very substantial way but destined to run out over time).
While it should be noted that productivity also came to a halt globally in the post-2008 period, the intensity of this phenomenon in China deserves further study.
In this regard, a paper by the International Monetary Fund dating back to February 2022 entitled China’s Declining Business Dynamism highlights some very interesting aspects.
- Lower contribution of younger companies to overall productivity: the percentage weight in terms of turnover of the so-called young firms (under 10 years of age), generally characterized by innovation and higher productivity, fell from 70% in 2004/5 to 30% in 2017/18. (see graph below)
Source: International Monetary Fund
- Young firms are growing more slowly than in the past, and it is more difficult for them to reach an optimal size: this is linked to a lower capacity for investment and innovation and could be partly due to a lower ability to access capital.
- The reactivity in the circulation of capital from less productive to more productive realities (important driver of productivity in advanced economies) has greatly decreased over the years. In other words, capital does not move according to efficiency but there are frictions, probably connected to the difficulty of access to it by younger and smaller companies, which determine their static nature to the detriment of overall efficiency.
- There are still large differences in productivity between public and private companies.
In the short term more fiscal policy, in the long term more market
It is clear, from the evidence reported, that the Chinese problem has more immediate implications and issues related to a longer-term horizon.
In the short term, the Chinese authorities are looking for a new impetus capable of breathing space for an economy in deflation, weighed down by consumers in crisis of confidence and overly cautious investors. The effects of the closures related to Covid and the heavy measures taken against the real estate and technology sector are in fact more difficult than expected to dispose of.
The measures implemented so far, including ample liquidity provided to the banking system, cutting interest rates, reducing the tax on financial transactions, as well as tightening IPOs to prevent the dispersion of funds on the stock market, have not yet had the desired effect.
Is it time for another round of fiscal policy? The impression of the writer is that President Xi, tightened on several fronts, by the internal situation to the geopolitical conflict, can go in that direction: this, in the short term, could have very positive effects on the Chinese stock market (considering the current depressed prices), and increase confidence within the economy so as to encourage the transformation of the huge savings accumulated in the various lockdown periods into greater consumption.
In the long term, however, the logic changes and the path is almost obligatory if China really wants to impose itself on the rank of advanced economy.
A lower focus on the accumulation of physical capital and an improvement in productivity are needed, which can be achieved by leaving more room for the action of market dynamics within the economy. Dynamics that seem to have been scarified by realpolitik at least since the Great Financial Crisis.
This is also necessary in light of an international context in which geopolitical confrontation makes it more difficult to transfer technology from outside (a strong driver for productivity) through Foreign Direct Investment (FDI).
Looking beyond the near future, another fundamental element is the weight of domestic consumption on GDP, which today is just 37%, and which represents a key factor in the evolution of a country from an emerging economy to an advanced economy.
To be clear, the weight of this component in the US is about 68%. From this point of view, policies must be implemented to increase internal demand, such as the strengthening of the welfare system: just think that today the possibility of access is largely linked to the concept of residence, thus depriving workers who, coming from rural areas, work in the city.
So will the next decade be the Chinese Decade?
Much depends on the direction that President Xi’s government decides to take: in the presence of the right policies, the decade could even lengthen.
Reference Shelf
–China’s Productivity Slowdown and Future Growth Potential
https://elibrary.worldbank.org/doi/abs/10.1596/1813-9450-9298
– China’s Declining Business Dynamism
https://www.imf.org/en/Publications/WP/Issues/2022/02/18/China-s-Declining-Business-Dynamism-513157
-China,s economic choices: Where to from here?
https://www.lowyinstitute.org/publications/china-s-economic-choices
