Until the late nineteenth century, China was the world’s largest economy. It lost that status roughly 150 years after the industrial revolution began in the West. After the Chinese economic revolution of recent decades, it is taken as axiomatic that the crown and mantle of the world’s largest economy will return to Beijing – as measured by GDP at market prices. Or will it? Is the severe market correction (OK crash) in Chinese equities over recent weeks telling us something about long-term economic prospects in China? Will China’s spectacular rise be followed by a similarly spectacular fall?
Let’s have a quick diversion into the three relevant GDP statistics: GDP at purchasing power parity (PPP), GDP at market prices, and per capita GDP. Measured by GDP at PPP China is already the world’s largest economy. But this measure of performance isn’t the gold standard, which resides with GDP at market prices. Measured at market prices, China’s economy was 60 per cent of the size of the US in 2014. The uphill struggle for China appears even steeper when looking at per capita GDP, where the latest figures show China at $7,500 compared with almost $55,000 in the US. In other words, per capita income in China is a mere 14 per cent of that in the US.
Received wisdom is that China will overtake the US at some point in the 2020s, as the world’s largest economy measured at market prices. It’s not difficult to see where this view comes from. Even if you lower the long-term Chinese growth rate to 7 per cent, its economy will double in size 10 years from now. In comparison, even the most optimistic view of the US sees an expansion of around 30 per cent over the same period. Seven per cent annual growth doesn’t quite take China over the top, but throw in some exchange rate appreciation against the dollar, and hey presto China is number one by the mid 2020s. Unassailable logic, job done, slam-dunk? Not so quick.
The tribulations of recent weeks reflect China’s growing pains as it matures and evolves. There was always going to be a day of reckoning. You can’t transition from communism to capitalism (in this case crony capitalism) without pain at some point. The remarkable fact is that China hasn’t hit the buffers before now, given the scale of bad debt in the financial system, excess investment and extreme capital-output ratios.
Growth can hide a multitude of sins, but not forever. China also faces immense environmental and resource challenges, and some are pretty basic e.g. hundreds of Chinese cities face severe water shortages. When I last checked, depletion of underground water had caused cities like Shanghai to sink by more than six feet over recent decades!
There is also a more fundamental constraint on long-term growth, namely people. It sounds bizarre to say that the country with the world’s largest population faces demographic disaster, but it does. The legacy of the one child policy and an ageing population means that the working age population is set to decline by a third, with falling participation rates likely to compound the problem. So number one status may not be reached in the 2020s.
All this reinforces the message that the Chinese economy is transitioning from one based on perspiration (labour and capital inputs) to inspiration (productivity growth), from comparative advantage in labour intensive activities to higher value added. Market movements are merely reflecting the uncertainty which goes with such a dramatic shift.