Apocryphally, Napoleon said that when China awoke, she would shake the world, and indeed since Deng Xiaoping’s rise in 1978 that is what the world has experienced. Over the last five years, the narrative has certainly been complicated by China’s economic troubles. Investors have experienced a shadow bank implosion, bankrupt local authorities, record high youth unemployment, a property market collapse, and relative incoherence in central government economic policy. For investors over the last few years, there is no sugarcoating it, investing in China has been a very difficult experience.
What is the next stage of China’s rise, how will it impact the world, and what tailwinds and headwinds should investors be mindful of?
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
| Consumption growth | Investment growth | GDP growth | |
| (A) Optimistic scenario: Rebalance with a surge in consumption | 6–7% | 0–1% | 4% |
| (B) Moderate scenario: Rebalance while maintaining current consumption growth rates) | 3–4% | -1–2% | 1.50% |
| (C) Difficult scenario: Rebalance with a sharp decline in consumption growth | 1–2% | -2–3% | 0% |
| (D) Crisis scenario: Rebalance with a sharp contraction in GDP | NA | NA | NA |
| (E) Rebalance over a much longer period | 3–4% | 0–1% | 2.50% |
Source: Carnegie Endowment for International Peace, October 2023.
Figure 2: Moderate scenario: Rebalancing while maintaining current consumption growth rates over 10 years
| Average 10-year growth rate | 3.5% | -3.5% | -3.5% | 1.5% | -1.5% | 1.5% | ||
|---|---|---|---|---|---|---|---|---|
| Year | Consumption | Trade surplus | Infrastructure investment | Real estate investment | Other investment | Total investment | GDP | GDP growth |
| 1 | 54.0 | 4 | 14.0 | 13.0 | 15.0 | 42.0 | 100.0 | NA |
| 2 | 55.9 | 4 | 13.5 | 12.5 | 15.2 | 41.3 | 101.2 | 1.2% |
| 3 | 57.8 | 4 | 13.0 | 12.1 | 15.5 | 40.6 | 102.4 | 1.3% |
| 4 | 59.9 | 4 | 12.6 | 11.7 | 15.7 | 39.9 | 103.8 | 1.3% |
| 5 | 62.0 | 4 | 12.1 | 12 | 17.5 | 42.5 | 115.9 | 4.00% |
| 6 | 64.1 | 4 | 11.7 | 10.9 | 16.2 | 38.8 | 106.9 | 1.5% |
| 7 | 66.4 | 4 | 11.3 | 10.5 | 16.4 | 38.2 | 108.6 | 1.6% |
| 8 | 68.7 | 4 | 10.9 | 10.1 | 16.6 | 37.7 | 110.4 | 1.7% |
| 9 | 71.1 | 4 | 10.5 | 9.8 | 16.9 | 37.2 | 112.3 | 1.7% |
| 10 | 73.6 | 4 | 10.2 | 9.4 | 17.2 | 36.7 | 114.3 | 1.8% |
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.
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’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.
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.
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.
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)
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.
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.
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
Headwind on demand for $bloc economies
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.
No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.
1 Smil, V., Making the Modern World – Materials and Dematerialization, 2013.
2. The World Bank.
3. Pettis, M, How China Trapped Itself, Foreign Affairs, 5 October 2022.
4. Tooze, A, Adam Tooze’s Top Links: Is Evergrande “China’s Lehman moment”, 19 September 2021.
5. Lingling, W. and Xie, S.F., China’s 40-Year Boom Is Over. What Comes Next?, The Wall Street Journal, 20 August 2023.
6. Premier Li Keqiang, quote from the National People’s Congress based on an extract from China’s 2019 Statistical Survey, May 2020.
7. JZhu, H., JP Morgan China 2023 Mid-Year Outlook, 4 July 2023.
8. Brandt, L et al., China’s Productivity Slowdown and Future Growth Potential, World Bank Group, June 2020.
9. Pettis, M, Can China’s Long-Term Growth Rate Exceed 2–3 Percent, Carnegie Endowment For International Peace, April 2023.
10. Yu, E, Rules to Promote Equality Bloomberg, July 2023. In April, citizens without Shenzhen Hukou can apply for an additional NEV plate number without 24 consecutive monthly local health insurance payment. In August Jiangsu 1) to scrap household registration restrictions in most areas except Nanjing and Suzhou. In August, Ministry of Public Security also announced on Aug 3 to help push for ‘comprehensive lifting’ of Hukou registration restrictions in cities with a permanent resident population of less than 3mn, part of the 26 measures that day.
11. Bureau of Economic Analysis, October 2023.
12. Cang, A., Li. C., “Bankers Chasing Deals in China Turn to ‘Throwing Eggs’ Card Game”, Bloomberg 7 August 2023.
13. Pettis, M. (2023) [Twitter] 10 August. Available at: https://twitter.com/michaelxpettis (Accessed: 6 November 2023).
14. The Conference Board, Total Economy Database, April 2023.
15. Clark, H.L, Higgins, M, Can China Catch Up with Greece?, Liberty Street Economics, 19 October 2023.
16. In 19th Party Congress in 2017, China shifted its ‘principal contradiction,’ only the second time this has been revised. 1981 it was changed from ‘class struggle’ to ‘economic development.’ In 2017 it was changed from ‘quantity of growth’ (or ‘unbalanced and inadequate development’) to ‘quality of growth’ or the need to improve people’s lives. A ‘principal contradiction’ in Marxist-Leninist thought is the interaction between progressive forces pushing towards socialism and the resistance to that change.
17. In the 14th Five Year plan documents released in 2021, China is targeting a growth in per capita disposable income in line with GDP growth, a sign that consumption is not expected to rise faster than investment. Similarly, policymakers named three imbalances in Section 2 of the document that they wanted to fix; a shift to consumption is not considered one of the main imbalances ‘Our capacity for innovation is insufficient for the requirements of high-quality development. The agricultural base is relatively weak. The disparities in development and income distribution between rural and urban regions remain stark. We have a long way to go in environmental protection, there are shortcomings in livelihood protection, and weaknesses in social governance.’
18. Shangxi, Liu. The tendency to hold on to the money bag is still obvious. What is the key to recovery?, Economists 50 Forum, 6 July 2023.
19. The middle-income trap has little evidence going for it. The Economist, 5 October 2017.
20. Tooze, A, Whither China? Part III: Policy hubris and the end of infallibility, August 2023.
21. Eberstadt & Verdery, China’s Revolution in Family Structure: A Huge Demographic Blind Spot with Surprises Ahead, American Enterprise Institute, February 2023.
22. Project Syndicate, Helen Thomson Says More, July 2022. As Helen Thompson has pointed out, China’s growing energy consumption has caused two big price shocks over the past two decades. The first was an oil shock in the mid-2000s, when sharply rising Chinese demand ran into stagnating supply, which culminated in an all-time oil-price peak in June 2008. The second episode was a gas shock in 2021: Chinese demand for LNG imports grew by nearly a fifth last year, sending spot gas
prices soaring in Asia and Europe. By analogy, moderating Chinese demand in any of these areas could have fairly profound implications fairly quickly.
23. Tooze, A, The US is addicted to greatness – and haunted by its loss, 9 December 2022.
24. This framing of multi-polarity is a return to normal is based on works published by Niall Ferguson and Dani Rodrik.
25. IMF. See figure 4.9, page 94 of the original document and JPMorgan, Great Supply Chain Disruption, 22 June 2023.
26. Mahtani, S. Will the pandemic spur deglobalisation, Ninety One Investment Institute, May 2020.
27. Can the West win over the rest? The Economist, 13 April 2023.
28. Shin, H.S, Globalisation: real and financial, Bank for International Settlements. ‘Shin connects the regression in trade to a parallel regression in the degree of financial globalization as measured by global cross-border bank lending. In 2008 this touched 60 percent of global GDP and now has fallen back to c. 37 percent.’
29. Trade (% of GDP) - China, World Bank.
30. Kuo, M.C, Wall Street Journal, November 2022.
31. FDi Markets and calculations provided by the IMF, April 2023.
32. Financial Times, September 2021.
33. European Central Bank, The globalisation of inflation: Isabel Schnabel speech, May 2022.
34. IMF World Economic Outlook, April 2023.
35. Mahtani, S, The Dollar May Be Knocked Off Its Pedestal, Wall Street Journal, May 2019.
36. Tooze, A, The World Is Seeing How The Dollar Really Works, August 2022.
37. Eichengreen et al., Mars or Mercury? The Geopolitics of International Currency of Choice, December 2017.
38. Eichengreen et al., Is Capital Account Convertibility Required for the Renminbi to Acquire Reserve Currency Status, Banque De France, November 2022.
39. Pozsar, Z, 7 March edition of his Global Money Dispatch newsletter Credit Suisse.
40. Foothills comment.
41. Ferguson, N, Cold War II: Niall Ferguson On The Emerging Conflict With China Hoover Institution, May 2023. Indeed, some observers have framed the Ukraine war as the first hot war in a Cold War between the US and China, in the same way that the Korean war of the 1950s proved to be the first hot war in a proxy contest between the US and the Soviet Union.
42. Tooze, A, European defense spending, Africa’s multi-speed demographics & would you work in Germany, March 2023. Estimate from NATO Public Diplomacy Division via BCA research via Tooze Chartbook.
43. Mahtani, S, Europe’s new ‘strategic autonomy’, Ninety One Investment Institute, March 2021.
44. Samuel, J, Ben Wallace’s farewell revelations are indefensible, July 2023.
45. Pentagon will increase artillery production sixfold for Ukraine, New York Times, January 2023.
46. X. Historian Nick Mulder on the basis of ‘King of Battle: Artillery in World War I’, History of Warfare, Volume 108: Sanders Marble.
47. The Economist, How to survive a superpower split, April 2023.
48. Jinping, Xi, Speech at the Work Conference for Cybersecurity and Informatization, China Copyright and Media, April 2016. In 2016, President Xi Jinping said, ‘the fact that core technology is controlled by others is our greatest hidden danger.’
49. Renewable Energy Market Update - Outlook for 2023 and 2024. International Energy Agency, June 2023.
50. The World Bank, 2022.
51. Lecture by Barry Naughton: Made in China 2025 and Chinese Industrial Policy, July 2021.
52. Jie, Y, China’s new scientists, Chatham House, July 2023.
53. Cheung et al., China’s Roadmap to Becoming a Science, Technology, and Innovation Great Power, July 2022.
54. Miller, C, China’s tech revolution: unprecedented scale, mixed results, Ninety One Investment Institute, October 2021.
55. Haro, K, China Cultivates Thousands of ‘Little Giants’ in Aerospace, Telecom to Outdo U.S., The Wall Street Journal, March 2023.
56. China leads US in global competition for key emerging technology, study says, Reuters, 2 March 2023.
57. Described in our paper with Bob Ash of SOAS on rural China.
58. Jung, E, Vietnam and Mexico could become major players in global supply chains, PIIE, August 2020. Mexico’s advantages are its demographics, low labour costs, an experienced manufacturing sector, available logistics, industrial network, and an array of free trade arrangements. ASEAN’s advantages are its supportive policies,
cost competitiveness, industrial development, linkages to existing manufacturing hubs and rising middle-income consumers, all of which should keep FDI rising.
59. JP Morgan, 22 June 2023.
60. European Central Bank, The globalisation of inflation: Isabel Schnabel speech, May 2022.
61. Dempsey, H, ‘Colossal’ central bank buying drives gold demand to decade high, Financial Times, January 2023.
62. IMF World Economic Outlook, April 2023. There is already evidence that since 2018 geopolitical alignment, measured by similarity in un voting patterns, has become ever more important in determining the location of foreign direct investment. AidData also finds that a 10% increase in voting similarity with Beijing at the UN is associated with an increase in Chinese projects in that country.
