China: Becoming World’s Biggest Economy?

9 February 2021

China was the only major country to record economic growth in 2020, with GDP expanding 2.3%. Indeed, following three consecutive quarters of expansion, national output is already 6.5% above pre-Covid levels. As we approach Chinese New Year, the IMF optimistically projects 8.1% GDP growth during the year of the Ox. Likewise, I believe China’s ouput gain may even exceed 10% in 2021.

These upbeat appraisals are leading many to project the size of Chinese GDP may surpass that of the USA by 2028 or earlier (Chart above). Inevitably, China’s economy will become the world’s largest (of course, the USA will remain much larger on a per capita basis). However, the Covid crisis has diverted attention from the vital structural challenges China confronts. Importantly, efforts to reduce the nation’s debt burden (deleveraging) and to shift economic activity towards consumption/services and away from exports/investment (rebalancing) appears to have lost momentum in recent years. Moreover, China will continue to confront formidable external risks. To be sure, while US President Biden may use new tactics, America will continue to press for greater access to the Chinese market.

As a result of these headwinds, China’s long-term GDP growth potential will slow towards 4%-5% during the next few years. Consequently, the size of China’s economy may not surpass the USA’s until 2035, or even 2040.

Covid Containment and Uneven Recovery

The Chart above illustrates China’s impressive 6.5% GDP growth in Q4 2020 was the world’s strongest. Moreover, the graph highest the strong link between the containment of the Coronavirus and economic revival. Successful pandemic control paves the way for recovery in the Asia-Pacific (and Scandinavia, except Sweden) compared to most of Europe. US economic resilence has relied upon its massive fiscal stimulus, despite its poor Covid track record.

Detailed analysis, however, reveals China’s recovery has been uneven, and highly reliant upon expansive fiscal policy. The budgetary stimulus, which amounted to 4% of GDP (impressive compared to other EM countries, but much smaller than G-3 nations), focused on boosting infrastructure spending. As a result, public sector fixed asset investment expanded 5.5%; on the other hand, private sector capital outlays rose a mere 1%.

Meanwhile, the Chart above illustrates the Chinese consumer has hard-hit by the Covid crisis. For instance, despite recent improvements, retail sales slumped 4% in 2020. With government efforts focused on boosting public investment, income support for households has been limited. Moreover, reflecting the economic uncertainty and China’s notoriously weak safety net, households also significantly boosted savings during crisis (next Chart).

As in many other countries, recent PMI surveys suggest China’s initially sharp recovery may be losing some momentum, although exports and industrial production posted healthy 18% and 7% gains respectively in December. Sustaining recovery in 2021, therefore, will require additional budgetary stimulus — with greater priority given to support household incomes and spending.

However, China has considerably less fiscal space than in the past. The IMF already projects a 2021 government budget deficit of 11% of GDP (including local governments the red ink could total 17% of GDP!). And, while Chinese authourities suggest goverment debt stands at a very manageable 45% of GDP, the IMF’s broader definition of “augmented” total public sector liabilities is twice that amount (includes off balance sheet public borrowing) .

Rebalancing and Deleveraging Lose Momentum

The Chart above illustrates China’s high level of debt (public and private sector combined): standing at 258% of GDP in 2019 compared to 195% in other Emerging Market countries. In the private sector, liabilities amounted to 205% of GDP compared to 128% and 153% (which are viewed as very high) in the EM and developed market countries respectively. In China, there is widespread consensus that this debt load is unsustainbly high, and must be reduced. Unfortunately, the burden has been rising, not consistently falling.

The sectoral breakdown is revealing. The recent sharp rise in household liabilities is not especially worrisome, as levels are lower than in comparable countries, and the government wants to encourage consumer spending. Likewise, even though government liabilities are rising sharply, the level is still favourable compared to other countries (however, recall the IMF’s public sector debt estimates are much higher than those of the Chinese authourities).

However, the high level of corporate debt — 150% of GDP compared to 99% in the rest of the world — is the most concerning. And, after declining modestly between 2016-2018, these liabilities again rose sharply during the Covid crisis. During 2020, for example, bank lending expanded 13%, with inefficient State-Owned-Enterprises seemingly the largest recipient.

Clearly, increased borrowing across all sectors added fuel to China’s post-Covid recovery. Eventually, deleveraging will resume. And, large-scale corporate sector deleveraging campaigns in other countries typically resulted in slower long-term GDP growth prospects, and often severe recessions.

What is the progress of economic rebalancing towards domestic consumption and the service sector? Fortunately, the Chart above illustrates the share of the tertiary area (e.g. services) expanded sharply between 2011 and 2017. To be sure, service industries world-wide have been devastated during the Covid pandemic. However, the Graph indicates the transition from manufacturing to services had lost momentum as early as 2017. Eventually, rebalancing will resume, which is likely to contribute to slower long-term GDP growth (as service sector productivity is lower than in manufacturing).

The government’s medium-term economic strategy aims to boost consumption and lower the reliance on exports and investment. The Chart above illustrates the relative shares of exports and consumption did perform as planned for several years. The Graph, however, again indicates that progress on these favourable patterns has slowed markedly in recent years, and indeed was reversed during the Covid crisis. Contrary to government expectations, for example, China’s external sector has contributed positively to GDP growth in three of the past 4 years, largely as a result of weak import growth. Likewise, the proportion of capex (much of it occuring in inefficient SOEs) remains undesirably high.

Biden: New Tactics, Same Message

In contrast to his predecessor, President Biden may adopt a more multi-lateral approach to addressing Sino-US trade issues. Nevertheless, the USA will continue to pressure China to liberalise its trade and investment regime. In the United States, there exists a broad consensus that China engages in unfair trade practices. It is widely believed China’s restrictions limit American exporters’ penetration of China’s lucrative domestic market, while China enjoys relatively unfettered access to US consumers. This is not surprising. The Chart above illustrates US involvement in China’s domestic market is amongst the most limited of all America’s trading partners.

President Trump’s confrontational, bilateral approach to Sino-US trade relations did lead to a sharp reduction in the trade imbalance between the two partners. Nevertheless, the Chart above illustrates America’s world-wide trade deficit continued to grow. Thereore, trade was not expanded, it was diverted. Americans simply satisfied their insatiable appetite for imported products by purchasing from new partners.

A successful Sino-US trade policy will include: a) Stronger Chinese domestic spending to fuel imports; b) Greater access of American exporters to China’s domestic market; c) US efforts to boost its savings rate to reduce import demand. Establishing explicit targets can enhance accountability and build confidence in the process. However, even though US sales to China increased 25% in 2020, China failed to meet the target established in the Phase 1 Trade Agreement (Chart above provided by PIIE’s Chad Brown). Meanwhile, although I appreciate the political motivation behind President Biden’s “Buy America” and “Trade Agreements for the Middle Class” campaigns, they will not enhance US prosperity nor sustainably reduce America’s trade deficit with China or globally.

Biden’s Multilateralism: No Quick Fix

President Trump’s trade tactics had important unintended consequences. Following US abandonment of the TransPacific Partnership (which excluded China), Asian nations forged an additional regional trade deal with China (RCEP) without America involvement. Likewise, unpredictable American leadership contributed to Europe’s decision to sign a bilateral Comprehensive Agreement on Investment with China (CAI).

A multi-lateral approach should be more productive, and quite feasible. To be sure, the Chart above suggests America’s penetration of China’s markets is amongst the most limited of all China’s partners. However, many European nations, Mexico, and key Asia countries also encounter similar problems. These nations would welcome the opportunity to increase the small share of their exports currently destined for the Chinese market (next Chart).

The Chart above provides additional insights into the role of international trade in its overall economic strategy. For instance, China runs large trade deficits with countries providing capital goods, e.g. Korea, Taiwan, Japan, Switzerland, and Germany. In addition, China has shortfalls with nations providing necessary natural resources, e.g. oil producers, Australia, Brazil, and Malaysia. These inputs have fueled China’s manufacturing sector which supplied goods consumed in North American and Europe where China enjoys large trade surpluses.

In China’s next stage of development, consumer- and service-led growth should lead to new opportunities for American (and European) producers, which should help reduce bilateral trade imbalances.

On the other hand, Asian countries would welcome a renewed American “pivot” towards Asia, especially to counterbalance more aggressive Chinese regional policies, e.g. in the South China Sea. However, Asian countries would not want to upset the deep trading ties already established with China. The Chart above illustrates Asia’s increasing reliance on the Chinese market in recent years. Likewise, the Belt and Road Initiative (BRI) now represents the majority of China’s annual FDI outflows — totaling $800 billion since 2014 (next Chart). And, as Asian countries account for over 50% of the loans granted, they do not want to upset their powerful regional partner. To be sure, President Biden’s multilateral approach to China trade will pay off, but it’s no quick fix!

Strategic Considerations

  • China’s economy is undergoing profound structural changes. However, progress on economic rebalancing and deleveraging has lost momentum in recent years — a trend exacerbated by the Covid crisis.
  • China’s GDP may expand 10% in 2021. However, foreign trade pressures and domestic adjustments will be medium-term growth headwinds. China’s long-term economic growth trend will slow to below 5% in the years ahead.
  • As a result, China may have to wait until nearly 2040 before overtaking the USA as the world’s largest economy. Of course, this will depend on America’s ability to cope successfully with the long-term consequences of the Covid crisis.
  • American (and global) exporters will enjoy vast new opportunity, if China succeeds in producing consumer-led growth. This should contribute to smaller bilateral trade imbalances eventually.
  • US President Biden’s multilateralism will pay dividends over the medium term. However, existing US tariffs will remain in place for now. As part of the trade adustment, the Chinese Yuan will appreciate towards CNY 5.75 in coming years.
  • Reflecting China’s strong 2021 economic recovery, Asian equities will be top performers this year.
  • As China transitions from manufacturing to services, regional supply chains will shift towards low cost producers, e.g. Vietnam. Moreover, in Covid’s aftermath, American and European countries are likely to relocate production of some essential products (e.g. health-related) back home.