The Truth Behind China's Economic Miracle
The tyranny of distance makes it hard for most Australians to gauge the size and importance of China to our economic prosperity. The simple reality is that china is experiencing its own industrial revolution and the accompanying urbanization this triggers. This in turn is feeding demand for Australian commodities – but how resilient is this rapid economic change? Sino-sceptics tell us that there are multiple bubbles waiting to burst in China; and while it’s true that massive economic change is hard to manage, we show some key data to help clarify why (and for how long) China’s growth will continue to feed the Australian economy.
In a nutshell, the data is clear – China’s economic expansion is close to becoming self fulfilling; and China remains on track to become the world’s largest economy by 2020 (some 20 years sooner than predicted pre GFC).
Understood in that context, Sino-scepticism can largely be seen as a front for aggressive hedge fund speculation around currencies, commodities and stockmarkets.
To help prevent these “vampire squids” profit at your expense, consider the following:
- China (and India) are reclaiming the places they’ve occupied in the global economy for all but the last 200 years;
- The processes of urbanization and industrialization has several decades yet to run;
- China’s economy will continue to experience cyclical fluctuations, but there’s no reason to expect it to have a ‘hard landing’ in the next decade or so;
- Unlike other major nations (eg USA), the Australian and Chinese economies are highly complementary to each other;
- China’s economic relevance to Australia does have some downside for us, especially arising from the high interest rates (and high currency) which our massive “terms of trade” are imposing on the broader Australian economy and population. (Source: Eslake, 2011, 17 October 2011).
Why is China urbanizing, how long can it last for, and what are the risks?
Deng Xao Ping realized after Tianamen Square that China’s people needed to grow in affluence and aspirations to prevent unrest and ultimately a popular revolt. In setting China on a path to modernity he was seeking to avoid the radical backlash from the disaffected that had been experienced in the “Cultural revolution” of the 1960’s – where bureaucrats and intellectuals were hounded from public life to “pay” for their failure to deliver improved prosperity.
We can see how successful this has been over several decades when we look at Chart 1, showing China’s GDP growth since 1979:
Chart 1: Source, Eslake 2011.
Notice how China’s GDP has now been growing around the 8% pa level for the last 30 years, with some years obviously stronger than others, but with its low point (around 4% pa in the late 1980’s) still being the envy of the western world. Since there has been several major cyclical shifts in western economies during these 30 years – but China has maintained excellent growth throughout – this high level snapshot tells us that China must be doing something right as it manages its economic expansion.
The key seems to be the massively competitive environment which is contained within the Communist Party of China. This now operates like the “mandarin” bureaucracy which governed China for thousands of years. Competition for promotion based on performance (not cronyism, unlike the Soviet experiment) leads to government based on meritocracy. Planning and implementation of Chinese government policy is driven by professional managers, many of whom have been educated in the west.
This is of course the source of much of the confusion about China: for those schooled in the western tradition of liberal democratic markets, it’s too tempting to suspect that government managed economic growth can’t be sustained. These critics think that the bubble is ready to burst. But as Chart 2 shows, the Chinese government has shown itself to be adept at managing cyclical risk. Hence, Chart 2 shows that China has indeed experienced its own economic slowdown already, and that as a result the risk of a hard landing (from unsustainably high levels) is not material.
Chart 2: Source, Eslake 2011
Notice how key expenditure items like retail sales, manufacturing and services, and construction have fallen from their pre GFC peaks – but have stabilized around current levels. Merchandise exports have continued to fall since the post GFC peak levels (presumably as a result of the reining in of GFC fiscal stimulus around the world) but the pace of negative growth is slowing. China is pulling back on its internal economic stimulus (to keep a lid on inflation – see below), but as Chart 3 shows, even if China needed to resume high levels of domestic fiscal stimulus (eg in the event of another global economic shock), it has plenty of capacity to do so.
Chart 3: Source, Eslake, 2011.
The next 3 charts are the “category killers” in this analysis. Chart 4 shows that China’s rapid urbanization and average per capita income levels are only just starting to move consistently above subsistence agriculture levels: meaning that the next decade or so will see an accelerationof consumption of goods (like fridges, TV’s, washing machines etc) that are manufactured using commodities. It will be another 10 years at least before demand for commodities starts to slow (although it’s unlikely to fall for decades more).
Chart 4: Source, Eslake, 2011
This trend is easy to understand. For people earning below US $10,000 pa its virtually impossible to do much more than keep a roof over one’s head, and to keep food on the table. As income rises it becomes possible to purchase time saving utilities, and as incomes grow it becomes possible to start discretionary consumption. Chart 5 shows how much higher China’s average income can rise before it catches up with the rest of the developed world (and this shows how long China’s employment costs will continue to lower than – and hence competitive with – the rest of the world).
Chart 5: Source, Eslake, 2011
Chart 6 shows how much more urbanization will continue in China before it starts to reach levels seen in the west, and key Asian nations.
Chart 6: Source, Eslake, 2011
What does this mean for the future of China’s economic growth?
China’s desire to placate – and motivate – its restless population has been incredibly well managed since 1979. This hard work has driven a large number of Chinese individuals into higher income brackets, at the point where significant numbers are now housed in large urban areas and enjoy incomes at levels which pave the way for rising domestic consumption. In turn this growing consumption will further expand the domestic Chinese economy, underpinning demand for more sophisticated goods (and to a lesser extent now, services, although demand for these is also growing over time).
Contrary to the Sino-sceptics, Chinese authorities have successfully managed somewhat of an economic slowdown, and are working to keep inflation and other bubble producing factors, under control. Chart 7 shows the reality of these measures.
Chart 7: Source, Eslake, 2011
By the way, the reason why hedge fund managers love to stimulate uncertainty about China is simple: because the main input into China’s economic growth comes from commodities, a cycle of fear and euphoria about China’s economy feeds into volatility (and massive arbitrage and trading opportunities). So when you next see a bullish or bearish story about China, check what happens to key commodity and currency prices.
What does this mean for Australian investors and advisers?
It’s vital that you increase your exposure to China and the factors behind its growth. We advocate buying exposure to key Chinese stockmarket indices like the HSCEI, as well as to key commodities. Obviously buying resource stocks with good export capacity to China is also a good idea – but beware the market volatility in each of these assets. And for an even closer to home reality check – the best way to hedge your household against RBA interest rate hikes and related cost of living expenses, is to access the opportunity for growth which these Sino – centric investments provide.
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