Macro Series

Focus – A longer term perspective on China’s economy

John Llewellyn, Saul Eslake

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( 12 mins)
  • China has racked up extraordinary economic achievements over the past 40 years
  • In so doing it is returning to its historical position in the global ‘pecking order’
  • In the process China has become surprisingly unequal for a ‘socialist’ country
  • It is becoming more assertive, particularly in the ‘Indo-Pacific’ region
  • Though not an immediate threat, its financial system presents medium-term risks


Four decades of extraordinary economic progress

China has made extraordinary economic progress …

China’s economic achievements over the past four decades have been extraordinary. Notwithstanding its share of the world’s population declining from 22¼% to 18¼%, its share of world GDP has increased from 2¼% to 18½% (in purchasing power parity (PPP) terms). Other shares have also increased commensurately: merchandise trade from less than 1% to over 13%; energy use from 6¼% to over 24%; and stock and annual flow of outward foreign direct investment from virtually nothing to over 6% and over 10% respectively. And per capita GDP (again, at PPPs) has increased from 3% of the ‘advanced’ economy average to 33%.

… but it has not become ‘freer’ as it has become ‘richer’

However, contrary to what had been widely expected after the fall of the Soviet Union in 1989, and when China entered the World Trade Organization in 2000, China has not become ‘more like the West’. China has not become more ‘economically free’, relative to other countries and, by most measures, less ‘politically free’, especially since the ascension of Xi Jinping in 2012. Rather, it has become a more formidable competitor and rival – to the United States, in particular – than the former Soviet Union ever was.

A longer-term historical perspective

Xi Jinping summarises China’s economic trajectory – both over recent decades and between this year (which marks the 100 th anniversary of the foundation of the Chinese Communist Party) and 2049 (the 100 th anniversary of the foundation of the People’s Republic of China (PRC) as the fulfilment of “the Chinese dream” of the “great rejuvenation of the Chinese nation”.

For most of recorded human history China was …

Throughout most of recorded human history, China was not only one of the (if not always the) largest economies, but also one of its richest – reflecting in part the inventiveness of its people and the comparative efficiency of its system of government (Figures 1 and 2).

… one of the world’s largest and richest economies

China’s decline as a global ‘great power’ began long before the incursions of European powers, followed by Japan and the United States, into its ‘sphere of influence’ and then into its own territory – what China nowadays refers to as its “century of humiliation” (between the First Opium War, during which Britain grabbed Hong Kong, and the establishment of the PRC in 1949). And it continued for another quarter-century after the establishment of the PRC, under the chaotic rule of Mao Zedong.

Focus - A longer term perspective on China's economy 1

To at least some extent, therefore, China’s return to the front rank of nations was more or less inevitable once a semblance of order returned to China’s governance, as it did from 1979 onwards. But of course China’s progress since then has been much more rapid than that.

Not quite as extraordinary in every dimension, though

One of China’s proudest boasts is that it has almost completely eliminated ‘extreme’ poverty: less than 1% of China’s population now subsists on less than the World Bank’s US$1.90 a day (in 2011 PPPs) threshold of ‘extreme poverty’, compared with almost 90% at the beginning of the reform era. This achievement has been widely recognised. That said, US$1.90 a day is a dire level of poverty, being equivalent to about £1.25, or €1.40, per day in 2020 values).

Much of China’s population is still very poor …

Less widely recognised is that, while hardly anyone in China today is extremely poor, by this benchmark large proportions of China’s population remain very poor by ‘advanced’ economy standards: in 2016, according to World Bank data, 57% were living on less than US$10 per day, and 88% on less than US$20 per day (in 2011 values) (see Figure 3). Those figures are about on par with Vietnam, and higher than (for example) Mexico or Brazil.

… and China is a highly unequal Society

The other side of this coin is that China has become a highly unequal society during the reform era. Its Gini coefficient rose from 18% in 1981 to a peak of 44% in 2010, before edging down to 38% as of the most recent reading in 2016. That puts China in between Indonesia and the Philippines on this measure of inequality (Figure 4) – scarcely a “moderately prosperous socialist society in all respects”, Xi’s ‘Centenary Goal’ for 2021.

More work to do – which calls for new sets of goals and acronyms

Xi’s second ‘Centenary Goal’ is for China to become “a great modern socialist country” by 2049, by which is meant “a global leader in total national strength and international influence”, having reached “new heights in every dimension of material, political, cultural, ethical, social and ecological advancement”.

Demand for precautionary balances has risen

To that end, at Xi’s instigation, the Chinese Communist Party last year formally adopted a new economic strategy formally entitled ‘Dual Circulation’ (DCS). Officially, this has two strands: first, China will continue to ‘open up’ to trade with other countries and to foreign investment (‘international circulation’); and second, it will “unleash the full potential of its domestic demand … to propel stronger and sustainable development”.

In practical terms, DCS appears to be about ‘de-coupling’ China from ‘the West’ in high-tech products, energy, and food; reducing China’s reliance on exports and on foreign investment (including backing away, to some extent, from the hitherto much-touted ‘Belt and Road Initiative’ (BRI); and re-directing the flow of investment from property development towards (in particular) ‘advanced manufacturing’.

Focus - A longer term perspective on China's economy 2

More assertive in dealings with the rest of the world

It is becoming increasingly clear that one dimension of China’s image of itself, under Xi Jinping, as a ‘great nation’ is a much more assertive posture in its dealings with the rest of the world.

China has increasingly ignored ‘Western’ opinion

China has become more belligerent in its dealings with its neighbours, in particular those who have overlapping claims to areas of the South China Sea, and with India. It has ignored Western opinion in its treatment of its Uighur population in Xinjiang, and in its imposition of ‘national security’ laws in Hong Kong. It has continued to acquire (sometimes through apparently ‘private’ enterprises) various islands in the Indo-Pacific region, which have the potential to serve military or strategic purposes. It has positioned cadres in senior roles in international organisations (easier to do when the US had turned its back on those institutions). And it appears keen to ‘test’ the new US Administration’s resolve to defend Taiwan from forceful ‘re-unification’ with the mainland.

Its newfound assertiveness is apparent…

China sees all of this as appropriate behaviour for a country with its economic heft – and nothing less than the US has done, in the ‘western hemisphere’ since at least the proclamation of the Monroe Doctrine in 1824, and in the western Pacific since 1945. Like the US before it, China considers that it has the right to change the rules to suit it, rather than meekly accepting those drawn up by others, without its involvement.

China’s increased assertiveness is also apparent in its ‘trade war’ against Australia, launched in response to what it sees as a series of slights by the Australian Government over the past four years, including the banning of Huawei from Australia’s ‘5G’ rollout, a measure since emulated by others, and Australia’s calls for an international inquiry into the origins of Covid-19.

… especially in its ‘trade war’ against Australia

China can inflict economic ‘pain’ on Australia because Australia is one of very few ‘Western’ countries with which it runs a bilateral trade deficit: notwithstanding that it has no ready alternative to Australia’s iron ore (which accounts for more than half its total imports from Australia), it seems willing to, in the words of a well-known Chinese proverb, “strangle the chicken in order to warn the monkey” – that is, to signal to other countries, in East Asia in particular, the potential consequences should they offend Beijing in any way.

In the meantime still some key risks, especially in the financial system

China’s economy still confronts some important risks, particularly in its financial system. Although not representing any material threat to its near-term growth prospects, these could loom larger over the medium term.

The 2015-16 mini crisis casts some doubt on stability …

China’s large corporate sector debt (equivalent to over 160% of GDP as at last June, according to the BIS) are well-known. Most is owed by state-owned enterprises to state-owned banks: and the assumption has long been that, in the event of widespread defaults on those debts, the state-owned banks would be re-capitalized using the reserves held by the PBoC (as has happened twice in the past 25 years).

… of its financial system and/or exchange rate regime

However, that assumption has seemed less plausible since China’s ‘mini-financial crisis’ of 201516, when China’s stock market dropped 43% in ten weeks, triggering a surge of capital outflows that resulted in the renminbi depreciating by 11% over the following 18 months, and the PBoC losing almost US$1 trn (or 25%) of its FX reserves in preventing it from falling even further.

This episode underscored that, large as China’s reserves still are, each US $1 of them can be used only once: either to recapitalise banks or to defend the exchange rate.

Since that episode China has maintained strict exchange controls on capital outflows, which have helped to keep the Rmb ‘basically stable’, in line with the PBoC’s stated objective, notwithstanding much smaller current account surpluses than China had been running prior to the 2008 crisis.

… which depends crucially on a current account surplus …

The crucial importance of those exchange controls in this context is evident from the fact that China’s domestic credit has continued to expand while the PBoC’s FX reserves have flat-lined.

In the absence of strict controls on capital outflows, this conjuncture would be a recipe for significant currency depreciation, as has been the fate of other fixed or tightly-managed exchange rate regimes where domestic credit or money supply growth has vastly exceeded the growth of central banks’ FX reserves.

… and maintenance of strict capital controls

Were China to start incurring persistent current account deficits at any stage, or the controls on capital outflows to become substantially more porous, a sudden and large depreciation of the currency could well result.

The banking system has developed an ‘Achilles heel’ …

The other significant latent risk in China’s financial system is what also was the Achilles heel of the US and European banking systems in the lead up to the global financial crisis of 2007-09: increasing banking system reliance on ‘wholesale funding’, rather than retail deposits.

Since the crisis of 2015-16, China’s monetary authorities have kept a fairly tight rein on traditional bank lending, and on lending through the ‘shadow banking’ system which sprang up after the global financial crisis. But China’s banks have continued to increase lending to the public sector, in particular to local governments, at a rapid rate: and a large proportion of this has been funded through the issuance by banks of bonds and other ‘wholesale’ products.

… an increased dependence on ‘wholesale funding’

As a result, the deposits-to-loans ratio of the Chinese banking system as a whole, which had been over 100% since at least the late 1990s, and consistently over 120% between the last major recapitalisation in 2006 and mid-2013, dropped below 100% in mid-2016, and has continued declining ever since, to below 90% as at the end of 2020.

While this does not pose any immediate threat to the stability of China’s financial system, given the apparently low level of bad debts on the other side of banks’ balance sheets, should a meaningful deterioration in the credit quality of banks’ assets arise in the future, the chance of a ‘wholesale run’ on the liability side of the banking system could increase significantly – and it could then be difficult for China’s authorities to prevent that from spilling over into the exchange rate.

Watch fors

Our economic judgements stand most likely to be challenged by consequences (e.g. rising unemployment, or inventory stockpiles) of the continuing divergence between strong growth in supply and weaker growth in demand as the economy recovers from Covid-19. So watch for:

  • Deterioration in banking-system asset quality (unlikely to be seen first in official reporting).
  • Signs of capital ‘leaking out’ through exchange controls.
  • Any abrupt deterioration in China’s current account balance.

On the political front, watch for:

  • Escalation of tension between China and the US over HK or Taiwan; or conversely.
  • Dialogue over climate change serving to reduce US – China tensions.◼