China’s Chickens Are Coming Home to Roost

07.24.2023 Hope that China would reemerge from its zero-tolerance lockdown policy as a global economic engine has been met with disappointment as data depicts a country struggling to find its footing. China’s gross domestic product (GDP) expanded at a less-than-expected 6.3 per cent in Q2 compared with a year earlier, when the country was in lockdown. It also grew less than one per cent quarter on quarter, a figure more consistent with an aging developed market country, not an emerging powerhouse. Retail sales, meanwhile, rose 3.1 per cent year on year in June, a far cry from expectations. For a country hoping its next phase of growth would be driven by domestic demand, these results are dour. In a world in which most central banks are battling inflation, the People’s Bank of China is facing a serious deflation threat. We suspect China’s troubles aren’t simply cyclical – the slowdown facing the world’s second-largest economy is quite likely secular. What does this mean for the rest of us?

China Real GDP Growth History

China, the biggest beneficiary of globalization, enjoyed stratospheric growth for most of the 1990s and early 2000s as rich countries outsourced their manufacturing work to a labor force willing to work for dimes on the dollar. For Chinese households, most of whom in dwelled in poverty on family farms, moving to a city for a manufacturing job ensured a higher living standard. For Communist leaders, facing an aging population without a social safety net, globalization hit the right notes, even if it meant pretending to be capitalists in the interim. At the peak of this internal migration, roughly one million rural Chinese migrated to urban areas every month, as the desire for a better life outstripped even the growth prospects that globalization brought. Beijing’s solution to a massive labor supply/demand imbalance was to hand a shovel to everyone looking for a job and send them to a construction site. Real estate and infrastructure building mushroomed, fueled by massive debt growth. China’s economy expanded by 648 per cent, or about 12 per cent annually, between 2004 and 2022. That growth was powered by a nearly 1600 per cent expansion in debt, which translates to 17 per cent per year.

China Total Debt vs Nominal Debt GOP Chart

Residential real estate development mushroomed as newly minted middle-class households accumulated property and now, according to Reuters, a whopping 70 per cent of household wealth is tied up in real estate. By 2020, China’s residential investments had surpassed 10 per cent of GDP. The country is grappling with a real estate bubble. Remember ours? America’s housing bubble burst in 2007, thanks to a combination of a public policy of home ownership combined with negligent underwriting standards. Residential housing expenditures as a share of GDP peaked at just over six per cent at that time. Our housing bubble led to a financial crisis as borrowers defaulted and the system’s dominoes fell. China’s housing bubble is on a gargantuan scale compared to ours.

Residential Housing Expenditures as % GDP

We don’t expect a financial crisis in China, given that the country’s ultimate lender is the People’s Bank of China. But the country will nonetheless face substantial headwinds for many years to come as it attempts to right-size its capital structure. Near term, the economy is struggling. Enormous debts are crippling households and local governments. Consumers, worried about their futures, are hoarding cash. More than one-fifth of Chinese youths aged 16-24 were unemployed this spring, according to The Wall Street Journal.

US-China relations are fraught, as the two countries exchange tariff volleys and restrictions on intellectual property rights. Western leaders are attempting to “de-risk” from President Xi’s autocratic regime, because “de-coupling” is not an option. Western businesses hope to sell into one of the world’s largest consumer markets, while Western government policymakers are restricting the export of sophisticated semiconductors and other critical technology. At the same time, China controls enormous reserves of rare earth materials, which are critical to battery technology and the green energy transition. The EU imports 97% of its lithium from China, according to the Financial Times. Firms like Apple produce most of their products in China and Volkswagen derives half its revenue from China.

China Exports to US chart

China’s falling population is a demographic impediment to economic growth. The country’s population is already aging and its workforce shrinking, thanks to a multi-decade one-child policy, placing tremendous pressure on the younger generation. With a birth rate of 1.1 babies per woman, China’s population is expected to fall to 1.317 billion by 2050. This rapid and compressed demographic transformation is unique to China, with no other country expected to be undergoing such an immense population transformation. China’s changing demographics pose major, prolonged challenges for sustaining a workforce to fuel China’s emergence as a global industrial powerhouse. Now, the number of Chinese retirees will soon skyrocket, reducing the size of China’s workforce and putting pressure on China’s social safety net and healthcare system.

China's Population Problem

Investment conclusions:  China over the next 20 years will be just a shadow of the economic engine it has been over the last 20 years. The world’s second-largest economy might, in fact, never surpass the US in economic strength, thanks to a difficult blend of over-leveraging and demographics. De-coupling from China is not an option for Western governments because of the geopolitical risks that could emerge if China’s economic fortunes head south too precipitously. Nonetheless, China will have wins. It is an innovator of green energy, electric vehicles, batteries, trains, ships and biogenetics, according to Barron’s. McDonalds and Starbucks are opening hundreds of new outlets there, according to The Wall Street Journal. Between 2003 and 2021, MSCI China drove emerging market equities. That leadership abruptly reversed post-pandemic, and we believe China will continue to weigh on EM performance for several years to come.

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