What's Ahead for China – and How Will That Affect the Global Economy?

October 2019 -

China’s faltering economic expansion has been an ongoing concern for economists and world financial markets since at least 2010, the last time its annual growth rate – real GDP – hit double digits. Yet in recent months, amid a persistent trade dispute with the United States, and as Germany and other global economic powers with close connections to China seem perilously close to recession, questions about the outlook for China have taken on increasing urgency. How much is the trade war affecting the economies of China and its trading partners? Will the Chinese government take further steps to push the growth rate higher? And what can U.S. importers and exporters expect from China in the months ahead?

Mary E. Lovely, professor of economics at Syracuse University’s Maxwell School of Citizenship and Public Affairs and a senior fellow at the Peterson Institute for International Economics, says that China’s slower expansion today is an inevitable result of the nation’s more explosive growth in years past, which made its economy too large to continue growing at such a breakneck pace. Yet the Chinese economy continues to grow, she says, and the country’s middle class continues to do well, attracting the attention of companies around the world. “International firms still very much want to be there, selling to that market,” says Lovely, who shared her thoughts with OUTLOOK about China’s challenges and opportunities and about how what happens there resonates globally.

OUTLOOK: Where does the Chinese economy stand right now?

Mary Lovely: Putting precise numbers on the Chinese economy is a challenge, but the economy is likely growing somewhere between 5% and 6%, which is considerably slower than in recent years. This is something we’ve expected for a long time, and there are fundamental reasons. China is now an upper-middle-income country. When you’re at that level, you can’t get the 10% growth China had become used to. For years China’s economy was growing by double digits, and it was one of the most extraordinary growth periods in the history of the world.

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OUTLOOK: What’s behind that slowing growth?

Lovely: Until recently, China could get a lot of growth simply by moving labor and capital from industries such as agriculture, with a low or even negative rate of return, and where surplus labor was sitting around or even getting in the way, to industries such as manufacturing. This tremendous internal migration to manufacturing drove China’s export push. It created enormous wealth simply by moving unproductive resources into productive uses.

Now, after 40 years of rapid economic expansion, opportunities for that earlier type of gain are smaller. China’s labor force has stopped growing, and workers are more or less in the right places. So, they’re not getting any GDP increase just from adding or shifting workers. Now, in order to grow, they have to raise overall productivity. That’s been China’s goal since the turn of the century. They have to create productivity by advancing their technology, but that’s much harder.

OUTLOOK: What are some of China’s main challenges to raising productivity?

Lovely: One of the most important is misallocation of capital. Nicholas Lardy, my colleague at the Peterson Institute, has written about this in his new book, “The State Strikes Back.” He shows convincingly that investment flows flipped after 2013, before which most investment was heading to the private sector. Now it’s going to the state-owned sector. The state sector, as a whole, earns much lower rates of return on assets. Nick estimates that this shift is taking about 2 percentage points away from Chinese growth. In other words, without that shift, China’s growth would be 7% to 8%, not 5% to 6%.

OUTLOOK: Why are private companies having trouble getting capital?

Lovely: In part, it’s because of economic reforms such as the government’s crackdown on shadow banking – in which state entities get loans and then repackage them through intermediaries for private companies. In China, it’s easier for state enterprises to get loans from state banks, so shadow banking has been a vital source of financing for private businesses. But the Chinese government is concerned about rising debt in the economy, and they’re trying to control credit growth, which is the reason they’re clamping down. Their concerns are understandable, but the crackdown is having a negative effect on growth.

Another barrier for private businesses comes from the government’s current anti-corruption campaign. Now, clearly, corruption is a bad thing for society. It erodes trust in government and creates all kinds of other distortions. But “greasing the wheel” was present throughout China’s rapid growth, and companies had more or less gotten used to the rules. You might not get that business license without playing ball with the local government or bribing certain officials. The anti-corruption campaign has severely limited all of that, but the new rules aren’t always clear. There’s also concern that the crackdown is being used to reduce political opposition to President Xi and to Communist Party decisions. Uncertainty makes businesses afraid to move forward, so the anti-corruption campaign has taken some of the wind out of the sails of the economy.

OUTLOOK: What companies or industries tend to be dominated by state versus private control?

Lovely: More than half of the economy is now devoted to services such as education, health, airlines and railroads – many of which are dominated by the central or provincial governments. Other areas of government ownership include heavy industry and mining, steel and petroleum. That said, a lot of the country’s growth and exports come from private firms, which are concentrated in areas such as manufacturing, and the state doesn’t have that much direct impact. But from there things get a little murky. Giant stateowned companies such as China Telecom have minority stakes in lots of smaller firms with mixed public-private ownership. That’s always a concern, when the state can exert influence on the behavior of companies, even when it doesn’t own a majority. All told, about 25% of Chinese GDP comes from state firms, 65% from domestic private firms, and 10% from foreign firms.

OUTLOOK: How is slowing growth in China affecting other parts of Asia and the global economy?

Lovely: China’s key suppliers are feeling it the most. South Korea, which sends cell phone components and other items for final assembly in China, saw its overall exports decline by 8.6% in the second quarter of 2019. And that’s going to intensify if the U.S.-China trade war continues to escalate. For example, if the United States taxes Chinese-made cell phones, the price for U.S. consumers will rise. You would probably see supply chains moving away from China, which would in turn affect those Korean companies. That will take some time, but for now, the Koreans are suffering a bit.

The other place we’re seeing a clear impact is in Germany. Germany has been a major beneficiary of China’s growth through exports of capital equipment, as well as from German firms operating in China. Reports out of Germany are that its manufacturing sector is shrinking already. So that’s a direct hit for the German economy.

OUTLOOK: What is happening with the rising middle class, which has been such a big part of the Chinese growth story?

Lovely: Keep in mind that the Chinese economy is still growing between 5% and 6%, which is considerably higher than most developed countries. And inflation, for the most part, is tame, so people are still seeing real income growth. And China’s low population growth means lower expenses for families, whose well-being continues to rise.

Chinese consumers face two challenges. One is that despite little overall inflation, food prices are rising. The price of pork, in particular, has gone up dramatically because of African Swine Fever, and pork is an important part of the Chinese diet. The other concern is fear of unemployment, which is higher in areas such as manufacturing. The services sector, which employs more than half of urban workers, has yet to feel the effects of the growth slowdown. So the risks faced by service sector workers in the cities aren’t the same as, say, what factory workers in Shenzhen have to contend with, but the concern is there nonetheless. Overall, though, the Chinese middle class consumer still feels pretty good, and international firms still very much want to be there, selling to that market.

OUTLOOK: What long-term vision do Chinese leaders have for their economy and its place in the world?

Lovely: Their long-term strategic plan, “Made in China 2025,” is a natural outgrowth of science and technology ambitions dating back 15 years. They are focusing on emerging areas such as biotechnology as well as those that advance high-quality manufacturing. They’re spending a lot of money on robotics, artificial intelligence, advanced electronics, and chemicals used in electronics. What they’d like to do is replace Western companies currently in their supply chains with their own companies. For example, they’ve been trying to develop a domestic semiconductor industry, though not terribly successfully so far. These are places where they’re spending money and focusing attention. So they’re moving up the value chain.

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One problem they’ve had is in completely miscalculating how the West views these efforts. Quasi-government Chinese documents have targeted achieving specific market shares in certain industries, which calls into question how serious they are about market competition. You cannot have market competition and say, “Oh, by the way, I’m guaranteed to have 80% market share by the end of the process.” That’s just not how competition works.

OUTLOOK: How is the ongoing trade war with the United State affecting China’s economy?

Lovely: Certainly, it’s having some impact, though not as much as people may assume. China by now is a huge, highly-diversified economy, much like the United States. As I mentioned before, services now account for more than half the economy, and Americans don’t tend to buy services from China. And given the complexities of global supply chains and the U.S. and Chinese economies, the effect of U.S. tariffs even on Chinese manufacturing exports is somewhat limited.

Last summer I wrote an op-ed for The New York Times about the difficulties of trying to “win” a trade war with China. Consider the Chinese electronics sector, which is a huge part of what they export to the United States. Above and beyond the foreign components that go into Chinese products, a large amount of the country’s electronics exports are made in China by foreignowned companies. All told, the total share of Chinese manufacturing revenue that comes directly from American purchases is about 3%. That’s an important amount, but not enough to have a deep impact if it’s reduced. The economic risks China really faces in its conflicts with the U.S. have less to do with tariffs and more to do with their ongoing access to Western technology.

OUTLOOK: What are those risks?

Lovely: China is increasing its ability to produce higher-value goods, but they are still very aware that they need access to foreign technology and foreign investment. They don’t need that investment because they lack capital. They’re swimming in capital. They need that investment for access to know-how.

In the West we often paint this as China’s long-term effort to destroy us or to replace our industries. Actually, they’re doing this to save themselves. With no population growth, how do they keep the middle class growing? How do they meet the needs of an increasingly elderly population? We’ve seen other major economies move up and grow in much the same way – for example, Japan after World War II. So, there’s a lot at stake for China and they understand that, which is why they’ve been somewhat pragmatic and moderate in their approach to the trade war. They have retaliated against the United States on products where they believe they can have an impact, such as soybeans. But they haven’t really taken steps to harm our firms operating in China. And while intellectual property theft remains a big problem, by some measures that’s actually getting better. They’ve set up courts to hear claims, and Western companies have gotten better at protecting their trade secrets.

OUTLOOK: What economic risks do the intensifying Hong Kong protests present?

Lovely: So far, the repercussions have been more political than economic. But, clearly, this is a highly-charged subject. Because Hong Kong is seen as having a rule of law, it has always served as an important bridge between China and the West, particularly in the area of finance and business services. So Hong Kong remains very important to China from an economic standpoint. And, as the recent controversy over the National Basketball Association and tweets supporting the protesters have showed, there are risks all the way around. For American corporations, that includes the risk of a backlash from Chinese consumers.

OUTLOOK: How would a global recession affect China?

Lovely: China was able to escape the worst of the global crisis in 2008 because it had little foreign-currency denominated debt and modest domestic debt. The former meant they could maintain a stable exchange rate while the later meant they had space for debt-fueled expansion. It’s somewhat more constrained today because domestic debt levels are higher. A lot would depend, of course, on the nature of the recession. At this point, it’s very hard to know where the global economy will go next. A lot of predictions suggest that even if there’s a recession, it would be a mild one. Whatever happens, China will surely get through it.

Also in this issue:

  • Interest Rates and Economic Indicators
  • Cobank Announces Board Election Results
  • Read the Report