CHINAMacroReporter

China GDP: 'A very long period of Japan-style low growth.’

Here are some of the insights from ‘The Only Five Paths China’s Economy Can Follow’ by Peking University’s Michael Pettis. This excellent analysis of China’s economy is worth a careful reading.
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CHINADebate

May 14, 2022
China GDP: 'A  very long period of Japan-style low growth.’
Michael Pettis

With Xi Jinping’s ‘zero covid’ policy and the impact of resultant lockdowns, foreign companies in China may have reached a turning point in their participation in the Chinese economy.

  • If they lose confidence in China as a base for manufacturing and sourcing, the impact will be felt - good and bad - throughout the global economy.

As Joerg Wuttke, president of the EU Chamber of Commerce in China noted in the last CHINAMacroReporter, ' "Zero Covid" & the Shanghai lockdown: The impact on China’s economy, global supply chains, & foreign business in China’:

  • ‘China is losing its credibility as the best sourcing location in the world.’
  • ‘With the current situation in China comes a huge loss of confidence, which will eventually lead to changes in supply chains.’
  • ‘Foreign companies are not packing up and moving out of China, but they are considering moving parts of their investments to other countries.’
  • ‘And I am now hearing from more and more foreign companies that they are trying to move their supply chains to other countries.’
  • [Note: I am honored that Mr. Wuttke will be the special guest expert at our upcoming CHINARoundtable on May 20.]

Now a flash survey of members of the EU Chamber in China – ‘COVID-19 and the War in Ukraine: The impact on European business in China’ - confirms Mr. Wuttke’s remarks.

  • ‘China’s COVID-19 containment measures have had a negative impact on overall operations for 75% of respondents.’
  • ‘Businesses are struggling to carry out the most basic of tasks, and not knowing from one day to the next if they will have enough staff to maintain operations or if their premises will be suddenly shut down altogether.’
  • ‘As business operations in much of the rest of the world look set to return to pre-COVID levels of normality, confidence in the China market is clearly diminishing.’

Kicking off, though, is a terrific analysis of China’s economy - ‘The Only Five Paths China’s Economy Can Follow’ - by Peking University’s Michael Pettis.

  • There is ‘an aggressive debate about whether or not China would be able to meet the 5.5 percent GDP growth target it set for itself this year.'
  • ‘But it’s a mistake to view China’s growth in terms of whether it can or cannot achieve a particular GDP target.’

Why? China is juicing GDP by piling up debt on non-productive infrastructure and real estate projects - "inflated" not "genuine" growth - to meet growth targets 'decided by Beijing at the beginning of the year.’.

  • And this, as Chinese policymakers know, isn't sustainable.

China needs a new path for China’s economy.

  • And Mr. Pettis describes 'the only five paths China's economy can follow.

He implies, though, that China – like other countries that have followed a similar 'high savings, high investment' growth model - may well take the fifth path:

  • ‘Reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply.’

The result of that path: ‘In my opinion, China will face a very long, Japan-style, period of low growth.’

  • Have a look at how Mr. Pettis gets to this conclusion - well worth a thorough read.

In the meantime, here are some of his key points.

PART ONE | Why China's GDP Says Little About the Health of the Economy
Michael Pettis

Here are some of the insights from ‘The Only Five Paths China’s Economy Can Follow’ by Peking University’s Michael Pettis.

  • This excellent analysis of China’s economy is worth a careful reading.

1 | Not a Measure of Economic Performance

There is ‘an aggressive debate about whether or not China would be able to meet the 5.5 percent GDP growth target it set for itself this year.’

  • ‘But it’s a mistake to view China’s growth in terms of whether it can or cannot achieve a particular GDP target.’

‘China’s GDP growth is not a measure of the country’s economic output and performance in the same way the statistic is for other major economies.’

  • ‘China’s GDP growth target is an input decided by Beijing at the beginning of the year.’
  • ‘Its fulfillment depends on the extent to which the economic authorities are able and willing to use the country’s resources and debt capacity to achieve the required amount of economic activity.’

‘Higher GDP growth for China, in other words, doesn’t mean a better economic outcome than lower GDP growth, as it does for most other economies.’

  • ‘It just means that the authorities were more willing to employ resources – including debt - for creating economic activity, whether or not that activity is productive or sustainable.’

‘This GDP target says little about how healthy the economy is.’

  • ‘That being the case, what matters is not the level of GDP growth China manages to reach in 2022 but rather the way in which that growth, whatever its level, is achieved.’

2 | “Genuine” versus “Inflated” Growth

‘Beijing has already long distinguished between “high quality” growth and “other” growth, a distinction that seems to be reflected in an important essay last year by

President Xi Jinping in which he calls for more “genuine,” not “inflated,” growth:’

  • ‘ “Genuine” growth, broadly speaking, can be thought of as sustainable growth generated largely by consumption, exports, and business investment (with the last of these elements aimed mostly at serving the first two).’
  • ‘ “Inflated” growth consists mainly of nonproductive, or insufficiently productive, investment in infrastructure and real estate.’

‘The purpose of inflated growth is to bridge the gap between genuine growth and the GDP growth target deemed necessary to achieve the Chinese leadership’s political objectives.’

3 | Productive and Nonproductive Investment

‘Investment in property and infrastructure doesn’t inherently cause an economy’s debt burden to rise.’

  • ‘If the investment is broadly productive—that is to say, if the direct and indirect economic value it creates exceeds the cost of the investment—then any increase ‘in debt will be more than matched in the short term to medium term by an increase in GDP.’
  • ‘If the created value outweighs the cost of the investment, the country’s debt-to-GDP ratio will not rise.’

[And if the cost of investment outweighs the value it creates, the country’s debt-to-GDP ratio will rise.]

4 | With and Without Hard Budget Constraints

‘Investment in China can broadly be divided into two categories that mirror the distinction between “genuine” and “inflated” growth.’

  • ‘ “private business investment with hard budget constraints”: investment by entities that operate under hard budget constraints, activity that tends to be productive because nonproductive investment eventually lead to insolvency.’
  • ‘ “investment by entities without hard budget constraints”: investment by local governments, state-owned enterprises, and, until recently, the property sector—whereby loss-causing activities can be subsidized or ignored for long periods.’

‘It is mainly this latter category that accounts for the surge in China’s debt-to-GDP ratio.’

  • ‘To the extent that much of China’s investment in property and infrastructure in recent years cannot be justified economically, in other words, it explains the sharp rise in the country’s debt burden.’

5 | Not Sustainable

‘By 2006 to 2008 - like every other country that has followed a similar “high savings, high investment” growth model - China seemed to have closed the gap between its level of capital stock and the level that its workers and businesses could productively absorb.’

  • ‘Between these years there was an observable acceleration in debt and a deceleration, gradual at first, of GDP growth.’

‘Once it reaches that stage, such a country must shift to a new growth model.’

  • ‘Until the country begins its difficult adjustment, it can continue to grow rapidly only with the piling on of more nonproductive investment, creating more “inflated” growth.’

‘Because this fictitious growth isn’t sustainable, it must eventually be amortized, and in every previous case the period of adjustment reversed much of the previous growth.’

  • ‘Unfortunately, the more fictitious growth that is created, the more politically difficult and economically costly the amortization of this growth tends to be.’

‘The problem with this stage of the development model—and it is worth repeating that this also happened to every other country that followed a similar approach—is that the continued high levels of growth generated by systemic investment misallocation are not sustainable.’

6 | China’s Five Paths

‘Once it is recognized that China’s surging debt burden is a function of nonproductive investment, and that this investment must eventually be curtailed, it turns out that there are a limited number of ways the economy can continue growing.’

  • ‘Any economy broadly speaking has only three sources of demand that can drive growth: consumption, investment, and trade surpluses.’

‘For that reason, there are basically five paths that China’s economy could take going forward.’

  1. ‘China can stay on its current path and keep letting large amounts of nonproductive investment continue driving the country’s debt burden up indefinitely.’
  2. ‘China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with productive investment in forms like new technology.’
  3. ‘China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with rising consumption.’
  4. ‘China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with a growing trade surplus.’
  5. ‘China can reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply.’

‘These are the same five paths, by the way, faced by every other country that has followed the high savings, high investment model.’

  • ‘Each of these paths creates its own systemic difficulties and each, except for the first, implies substantial changes in economic institutions that, inevitably, must be associated with substantial changes in political institutions.’

‘This may be why in the end every previous country followed the last of the five paths:’

  • ‘Reduce the large amount of nonproductive investment on which it relies to drive growth and replace it with nothing, in which case growth would necessarily slow sharply.’

7 | ‘A Very Long, Japan-Style, Period of Low Growth’

‘Historically, there have been two ways (or some combination of ways) in which the adjustment to much slower growth occurs.’

  1. ‘One way is for this shift to happen rapidly, usually in the form of a financial crisis along with a sharp contraction in GDP.’
  2. ‘The other way is through lost decades of very low growth.’

‘In my opinion, domestic financial conditions are such that China is still unlikely to have a financial crisis or a sharp economic contraction.’

  • ‘It is much more likely, in my opinion, that the country will face a very long, Japan-style, period of low growth.’
PART TWO | The Impact Of China’s COVID-19 Containment Measures & the Ukraine War on European Business In China

The EU Chamber in China has recently published  a flash survey of members of the EU Chamber in China – ‘COVID-19 and the War in Ukraine: The impact on European business in China.’

Below are some of the insights and charts from the EU Chamber's flash survey.

1 | Impact of COVIC-19 Containment Measures

‘Overall, the most significant challenge to business posed by China’s current COVID-19 containment policy is the massive uncertainty that it creates.’

Losing Confidence. ‘China’s COVID-19 containment measures have had a negative impact on overall operations for 75% of respondents.’

  • ‘Businesses are struggling to carry out the most basic of tasks, and not knowing from one day to the next if they will have enough staff to maintain operations or if their premises will be suddenly shut down altogether.’

‘As business operations in much of the rest of the world look set to return to pre-COVID levels of normality, confidence in the China market is clearly diminishing.’

Impact on Revenue.

Impact on Revenue

‘Nearly six out of ten businesses have already downgraded their revenue projections for 2022 as a result of China’s stringent COVID-19 containment measures.’

Impact on Investment.

Impact on Investment

‘Nearly a quarter (23%) of respondents are considering moving planned or current investments from China to other markets due to the introduction of more stringent COVID-19 containment measures across the country, as investors seek more stable and predictable operating conditions.’

‘A significant 77% report that China’s attractiveness as a destination for investment has decreased because of the country’s stringent and erratic COVID-19 policy.’

Impact on Logistics and Supply Chains.

Impact on Logistics and Supply Chains

‘Companies are also being overwhelmed by logistical and supply chain challenges, something that has negatively impacted 94% and 92% of respondents respectively.’

  • ‘China’s COVID-19 restrictions have led to a substantial decrease in traffic at ports. For example, data shows that the volume of goods leaving Shanghai’s port dropped by a quarter between mid-March and early April,9 and China’s road-freight traffic fell by 40% over the same period.’
  • ‘This is impacting companies’ upstream and downstream operations, with companies struggling to both transport raw materials and components to their factories, and to ship finished goods to customers in China and overseas.’

‘Specifically:’

  • ‘85% are struggling to access raw materials or components needed for production;’
  • ‘89% are struggling to transport raw materials or components needed for production;’
  • ‘87% are struggling to deliver finished products within China, and
  • ‘83% are struggling to deliver them to the rest of the world.’

Still Not Leaving. ‘As detailed in the ‘European Chamber’s Position Paper 2021/2022,’ and the joint European Chamber / MERICS report “Decoupling: Severed Ties and Patchwork Globalisation,” while decoupling is leading to some European companies being forced out of China, this is not happening on the scale that some had predicted.’

  • ‘Instead, companies are re-evaluating how they can optimise their operations in China while minimising the impact of geopolitical disruptions.’

'Despite the challenges now being faced, European companies seemingly remain committed to China in the long-term and are prepared to weather the storm for now.'

  • 'The question is, for how long?'  

2 | Impact of the War in Ukraine

'While the war in Ukraine is not as immediate a concern for European businesses in China as COVID-19, it is impacting them nonetheless.'

Less Attractive.

Less Attractive

‘A third of respondents report that China has become a less attractive investment destination due to the war.’

‘The impact of geopolitical tensions is garnering more attention in boardrooms as the susceptibility of operations to future shocks must be weighed, in particular the prospect of a deterioration in European Union (EU)-China relations.’

  • ‘For a small proportion of businesses (7%), the risks have already led them to consider pulling the plug on current or planned investments in China.’

Impact on Logistics, Material Costs, & Energy Costs.

Impact on Logistics, Material Costs, & Energy Costs

‘In terms of the tangible effect the war has had on European businesses operating in China, the main impact has been the disruption of logistics to and from Europe, with 65% of respondents being negatively impacted.

  • ‘Companies are having to adapt to new conditions, with rail freight between China and Europe no longer an option and the need for aircraft to circumvent Russian and Ukrainian airspace increasing both the distance and cost of air routes.’
  • ‘Sea freight costs have also spiralled out of control due to several factors, and major ports such as Shanghai have suffered COVID-induced congestion on an unprecedented scale.’
  • ‘Other key impacts from the war include rising material and energy costs, which is having a negative impact on 63% and 58% of respondents respectively, as commodity prices are driven up, further impacting freight prices, with trucks and ships having to pay more for gas and oil.’

Impact of Russian Sanctions.

Impact of Russian Sanctions

‘The picture is similar in terms of the impact that the sanctions imposed on Russia have had:’

  • ‘Logistical challenges (negatively impacting 52%), rising material costs (57%) and energy costs (52%) ranking as the top-three challenges ’

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