The broad features of China’s investment-centric political economy are by now well understood, and there is a widespread consensus that the investment-centric model is reaching its limits.3 It is not a coincidence that China has the highest investment share of GDP in the world and one of the fastest growing debt burdens in history. As economists have pointed out, these facts are related.
China’s model allowed it to maintain consistently high growth rates in response to domestic or external setbacks until the mid 2000s by unleashing waves of infrastructure and property investment. After that point, the solution itself began to cause problems. This led to a growing number of unproductive assets, especially in property, as well as rising financial leverage, which has been supported by high savings rates in the financial sector. Unsurprisingly, this has gone hand in hand with weak household consumption.
China is now at a turning point. Effectively, its growth model is unsustainable, with low levels of capital productivity, and financed by excess debt growth. The government’s ‘three red lines policy’, introduced in 2020, and its mantra ‘houses are for living in not for speculation’ have marked the start of what has been called a ‘controlled demolition’ of the relationship between credit growth, property, and the local government funding model.4
This restructuring process will be difficult and lengthy because it involves restructuring the sizeable past debts incurred, as well as changing an economic model that is dependent on continuous debt growth, especially at the local government level. There may be periods when China will have to pursue cyclical stimulus to maintain confidence in the economy amid this structural change —and we may be in one of these times now. At the heart of these views is a sense that China’s ‘40-year boom is over’, and what comes next will be different.5
That might be correct, but it doesn’t have to be an adverse outcome. Undertaken correctly, reform could be part of becoming a richer and more developed economy. Ultimately the prize for China is a more sustainable economy. It is one that requires less debt to grow, and where economic activity will become less volatile and less dependent on overseas demand (incidentally, this would be in line with China’s dual circulation policy). China will also be able to create strong demand for its own substantial production base, allowing Chinese households to have a better quality of life.6
China would still have a significant growth runway. If the government was to grant hukou-linked social benefits to the 18% of Chinese (some 250 million migrant workers) who do not have access to them in big cities, it would boost spending (and housing demand) immediately.7 China’s GDP per capita remains below Russia or Bulgaria and Chinese capital stock per worker is still below that in advanced economies.8 Former Premier Li Keqiang’s jaw-dropping statement in 2020 that 600 million Chinese people earn just RMB1000 (or $140) per month shows that there is still significant room for economic growth.
What might a rebalancing scenario look like? The basic transformation is continuous consumption growth. Within investment, the mix shifts away from property and infrastructure towards manufacturing. That would allow the economy to concurrently climb up the value chain, handle the property downturn, and increase household consumption.
Playing through that scenario, real consumption expenditure in China was consistently around 4% from 2014 to 2019. Economist Michael Pettis, who is on the more pessimistic end of forecasts, has a ‘moderate’ rebalancing scenario in Figure 1 that sees consumption growing at 3.5%, investment growth at -1.5%, and GDP growth coming out at 1.5%.9 That would reduce investment share of GDP growth from 42% to 36% in ten years (Figure 2). Within investment, infrastructure and real estate investment would shrink, while investment in other areas, like advanced manufacturing increase.
Figure 1: China rebalancing scenarios
Source: Carnegie Endowment for International Peace, October 2023.
Figure 2: Moderate scenario: Rebalancing while maintaining current consumption growth rates over 10 years
Source: Ninety One, adapted from Carnegie Endowment for International Peace, October 2023.
Is it plausible to have such a smooth rebalancing? Time is one variable, with an optimistic scenario suggesting Chinese growth would decelerate gradually over years, to the 2% rate that rich countries like the US manage, and a more pessimistic scenario showing abrupt declines, encouraging an economic crisis. We tend to see the base case as a gradual deceleration because of the policy credibility that Chinese policymakers have built up over the years in cyclical management of the economy. Moreover, Chinese authorities are institutionally incentivised to achieve this outcome.
But will not reducing investment also hit consumption? After all, many household incomes are dependent on investment spending. Certainly, the authorities will need to actively support consumption during this period of structural change. This can be done by liberalising hukou rules, which limit social benefits to those who have a household registration permit in a particular city; supporting a deeper safety net to reduce precautionary savings and reducing financial repression on household cash balances. There is evidence some of this is happening. Indeed the gradual hukou reform in provinces like Zhejiang, Jiangsu and even Shanghai has been one of the brighter spots of the reforms announced in 2023.10
We have framed China’s key economic transformation over the next decade as a shift from investment to consumption. The new growth model is lower, steadier growth that is relatively sustainable and has a decent runway given China’s starting point. We think this is the path China’s policymakers have been trying to put China on for several years now.
Is this the correct framing? There are a number of potential objections that warrant discussion.
- Why should investors get excited about 3.5% consumption growth? Is that really a ‘tailwind’?
We think it is. Consider that in the five years prior to COVID, real personal consumption expenditures in the United States grew at 2.7%11 a year and provided a healthy environment for growth for US businesses. Real Chinese consumption will grow at a rate that is 30% faster.
Also, headline economy-wide real consumption growth at 3.5% means some provinces and businesses will be growing at much faster rates. Economists have made the argument that the Chinese economy is splitting into two very different parts: ‘the 6-7 wealthier provinces and municipalities with higher incomes, diversified economies, high but manageable debts and growing working populations versus the rest.’12 Those provinces are Shanghai, Zhejiang, Jiangsu, Fujian, Guangdong, Beijing, and perhaps Tianjin and Chongqing too.13 In other words, there are bottom-up opportunities in China that will be attractive to investors.
Finally, if China manages to rebalance towards consumption, productivity would rise from very low levels. From 2011-2019 China’s Total Factor Productivity (TFP) growth was around 0.8%, less than half the level from the decade prior.14 Median TFP for countries after reaching China’s GDP per capita level are north of 1%. So China is underperforming its peer group15. Reducing capital outlays for property and infrastructure projects as well as inefficient State-Owned Enterprises would, if output levels were maintained, boost productivity. This is what matters for long-term living standards and spending power.
- China has not indicated that it will shift its investment- centric model. Why should we be confident it will do so?
China’s most recent growth roadmap does not focus on a shift towards consumption.16 In fact the latest five-year plan, its 14th, is very conservative on structural change,17 and there is no plan for manufacturing to decline significantly as a share of GDP (manufacturing is one component of investment spending). Rather, policymakers are targeting a multi-faceted focus on boosting innovation capacity, well-being, environmental targets, and security targets, instead of just focusing on economic growth. To deliver this, commitments to infrastructure spending will be substantial. In other words, China’s planners seem to be slowing down China’s shift to a service-driven, consumption-driven economy.
But that’s not the whole story. China has indicated major changes in its long- term objectives that are not captured by its most recent five-year plan. At the 19th Party Congress in 2017, China shifted its ‘principal contradiction,’ a Marxist- Leninist concept denoting the direction of social progress, to ‘quality of growth’ from ‘quantity of growth’ (or ‘unbalanced and inadequate development’). The only time this had happened before was in 1981, when under Deng Xiaoping, the party shifted from ‘class struggle’ to ‘economic development’.
Similarly, China’s shift to consumption is also consistent with the ‘dual circulation’ strategy articulated in 2020 that requires it to generate more domestic demand to consume domestic production.
Finally, in speeches over the past year it has become clear to several domestic observers that China will have to shift away from its investment-centric model, because not doing so risks perpetuating a financial model that is straining at the seams.18 China’s choice in this sense is not whether to rebalance, but how to do it while minimising disruption.
- Is China is facing a ‘middle-income trap’?
Whether or not a specific ‘middle-income trap’ exists is the subject of academic debate.19 Catch-up growth is always challenging, and there may be no evidence for stagnation at the middle-income level rather than any other level. Economist Robert Barro has gone as far as to dismiss this as a myth.
But let’s say it does exist. At the very least one could argue that China’s unique circumstances make it difficult to draw firm conclusions from comparisons with other countries, particularly those that are smaller and have lower levels of technological capability. For example, China’s large markets attract investment inflows on terms that would be considered unfavourable when applied to a smaller country. For instance, many companies have been compelled to set up manufacturing facilities or transfer technologies to China in exchange for access to the Chinese market, something they would have been less likely to do if selling to a poorer, smaller country.
There is probably a straightforward rationale that China should be treated as a separate case. Certainly, the combination of gradual real consumption growth with strong leaps in key technological areas means that the assertion China is facing a ‘middle-income trap’ does not capture the transformation underway in China’s economy.
- Isn’t the real structural challenge for China’s economy the impact of its authoritarian and tightening political system on its free-wheeling and entrepreneurial economy?
This topic is contentious, and it’s important to note that some investors may have reservations about investing in a country with China’s system of government. As a result, China may not be the right investment choice for them.
Others, while open to investing in China, may have concerns about how China’s government system could affect its markets. This discussion is intended for those investors. It is true that a heavy-handed and opaque political system can dampen animal spirits. And there is no doubt that China’s policymakers have shifted policy towards a more statist economic model in recent years, and that this transition has not been particularly smooth. China has lurched from one policy configuration to another.
However, not too long ago, Chinese policymakers enjoyed greater credibility among Western investors and businesses because of their more flexible political system, compared to democracies with more checks
and balances. In the 2010s, there was widespread discussion in the West about a ‘Beijing Consensus’, which posited that China’s mix of autocracy, technology and dynamism would fuel long-term growth.
Despite growing evidence of ideological rigidity in China’s policymaking, there have been flashes of pragmatism in recent years. These include the ending of COVID restrictions in 2022, which had been in place for too long, easing the crackdown on internet companies in July 2023, and easing the property crackdown at the margins. From a philosophical perspective, it’s worth being cautious when attributing China’s challenges solely to authoritarianism. If we argue that authoritarianism explains the clumsy policymaking observed since 2020, we must consider the counterfactual scenario. Democracies, too, have faced a mixed track record in addressing issues such as COVID-19 and property market fluctuations.
The question arises: ‘How many governments around the world – whether democratic, populist, or authoritarian – can genuinely boast about their COVID response? Furthermore, when we assess China’s remarkable economic growth since the late 1990s, it’s worth noting the performance of economic policy-makers in Japan, Europe and the US, who grappled with comparatively smaller real estate booms. Therefore, it’s reasonable to question whether China’s primary challenge lies in its authoritarian system.’20
Finally, many parts of the government do understand that China needs a vigorous private sector, especially as it transitions towards a more service-oriented economy. Nicholas Lardy has pointed out that private investment still accounts for more than half of all investment, despite a relative slowdown in recent years. If China is to have a good economic outcome over the next decade, the private sector will need to be given the space and encouragement to grow, and in our view, enough people in Beijing understand that.
In summary, China’s political system is different, possessing both strengths and weaknesses. We believe this difference is not always detrimental to businesses and markets; in fact, it can often provide significant advantages.
There are other concerns about China’s structural growth model. These include a population that is shrinking and aging, while at the same time, debt is spiralling. In the section on Demographics, we suggest China’s demographics is less of a binding constraint than the cliché ‘growing old before growing rich’ indicates. And in the Road to 2030 section on Debt, we examine the risk of a balance sheet recession in China, and why China is not Japan.
The bottom line for investors, is that China does need to shift its economic model, allowing growth to slow while becoming more balanced and sustainable. As we explore next, this decade’s shift to a consumption-led model will create tailwinds in some sectors, especially given valuations and of course headwinds for others.
Opportunities and challenges
The end of financial repression of household savings is a major consequence of the shift to consumption.
As returns on property and bank wealth management products look less attractive, Chinese household allocations to financial assets could increase, allowing the financial system to become deeper and more sophisticated. This will lead to major tailwinds for some Chinese financial services firms and the broader investment ecosystem in China. It will also lead to major headwinds for some businesses. (Interestingly, the development of Chinese financial markets is also supported by demographic shifts. Whereas Chinese citizens in their 30s today have on average 5x as many cousins as in the 1960s, by 2050 they will only have a fifth as many cousins, restricting opportunities for kinship lending/borrowing and boosting demand for financial services.21)
The shift towards consumption will bring favourable conditions.
These conditions will support for product premiumisation and improved quality of life, propelled by the expanding Chinese middle class (Figure 3). It will also provide a boost for domestic brands, supported by guochao, or nationalism-driven consumption patterns.
Figure 3: China will see a rise in the number of the most affluent households
Source: Mckinsey Global Institute.
In Chinese industry, supply-side reforms will create headwinds in the old economy.
This includes a shift in antimonopoly regulation, and the reduction of capacity in old economy industries. We can expect headwinds for these industries in the coming years - outside of cyclical turning points - at least until those reforms finish.
Falling commodity intensity will impact the $bloc.
As investment declines, a reduction in commodity intensity of production in China will generate profound headwinds on the demand of $bloc economies and their overheated housing markets, given that China is the world’s biggest buyer of natural resources.22