Chinese trend growth, part one: The demographic perspective
A number of economic arguments are advanced on the basis of the Chinese demographic outlook, but the typical thread runs as follows:
- China’s demographic dividend is exhausted
- There is no room for further capital stock growth
- Trend growth must therefore decline rapidly from now on
We are not entirely unsympathetic to the reasoning, but we believe bearish sentiment predicated on this thesis is overdone.
There are reasons to expect a declining trend growth rate, and it is true (Chart 1) that the working age population is in decline, but there are still ways to eke out further labour gains.
Urbanisation, for example can transfer more workers from less productive to more productive industries, and further capital growth will be required to support this process.
Chart 1: China’s working age population is already in decline
Source: UN, Schroders Economics Group. 11 December 2015
First of all though, we should challenge the perception that China’s growth has been entirely reliant on its population growth.
Chart 2 shows the results of analysis from Capital Economics, decomposing Chinese GDP growth over the last 30 years.
While it is clear that the increase in the workforce was a powerful growth driver in the 1980s and 90s, it ceased to be particularly important at the start of the 2000s.
Far more relevant have been urbanisation (the shift of workers out of agriculture), and the increase in productivity.
To support the bear case, we would need to show that these components would suffer as the result of a shrinking workforce. But, at a glance, there seems no strong evidence to support the view that the decline in the working age population should see growth rates collapse.
In what follows, we will examine the prospects for further urbanisation and productivity growth, and then project Chart 2 ahead for the next 15 years to reflect our conclusions.
Chart 2: Population increases have not driven growth for some time
Source: Capital Economics, Schroders Economics Group. 11 December 2015
The importance of being urban
Chart 2 provides some demonstration of the role urbanisation can play in boosting economic growth, but it warrants some discussion.
The growth boost comes chiefly (at least, at first) through the transfer of workers from low productivity agriculture to high productivity manufacturing.
While data on agriculture versus manufacturing productivity is difficult to obtain, we can approximate the gap by looking at the difference between output-per-worker in the primary and secondary sectors, which amounts to roughly 90,000 yuan, or $14,000.
That is, for every worker we transfer from agriculture to manufacturing, we add $14,000 to Chinese GDP. With over 200 million people employed in the primary sector, the potential gains would appear to be huge.
Of course, it is unrealistic to assume the entirety of the agricultural workforce will be transferred to factories, if only because the country needs to produce some food.
With that in mind, it would be useful to find some way of estimating the limits of urbanisation. Fortunately, China is far from the first country to undergo this process, and so we can turn to history for a guide (Chart 3).
In general, an urbanisation ratio of around 80% seems to be the ceiling, though we do find some exceptions.
Japan, for example, is over 90% urban. However, this is likely due to factors unique to Japan rather than a likely end point for China, so we will focus on other, more relevant, examples.
Chart 3 shows the experience of the US (which has a similar geographical scale to China) and Korea (which provides the most recent example), both of which more or less topped out at 80%, so let us assume the same applies to China.
Beyond this end point, it would also be helpful to estimate how rapidly the process will occur, as this has further growth implications.
We have rebased Chart 3 such that each country starts from the same level of urbanisation, to compare relative progress.
Evidently, the US urbanised much more slowly than did Korea, and without looking at the Chinese data one might expect China to be similar, given that Korea is far more compact.
Yet it turns out that China has so far followed the Korean path very closely. We suspect this at least partially reflects the advances in transportation and telecommunications technology since America’s urbanisation process.
China’s own urbanisation plan calls for an annual 0.9% urbanisation rate, lower than the Korean experience would imply, so we adopt this as a cautious estimate. It is not implausible that China would face greater difficulties over time given the vastly larger land area relative to Korea.
Charts 3 & 4: The limits of urbanisation (as implied by history, and by Lewis)
Source: Thomson Datastream, IMF (2013), Schroders Economics Group. 11 December 2015
Expect a slowdown
However, this is not the only consideration. Another limiting factor for urbanisation’s growth contribution is the so-called Lewis Turning Point.
At some point during the urbanisation process, the agricultural sector cannot lose further workers to the rest of the economy without experiencing a labour shortage.
Wages then climb in both agriculture and industry, outpacing productivity and so squeezing industrial profits and investment.
This necessitates a change in the growth model, requiring a shift to a greater reliance on productivity growth rather than amassing production inputs. This is also the point at which growth likely slows markedly, and is the nub of many of the bear arguments.
Chart 4 shows the estimates from a 2013 International Monetary Fund (IMF) paper for when this turning point will be reached in China. The authors estimate surplus labour will be exhausted between 2020 and 2025, with the exact date depending on which scenario plays out.
Boosting labour force participation (currently far below the average elsewhere for the over 50s) would push the fateful date back to 2025, for example.
So, we should expect to see a marked slowdown in Chinese trend growth by this time. Interestingly, this coincides with the time at which the Korean urbanisation path would also imply a slowdown.
One final ingredient needed before we can model trend GDP growth is some assumption for labour productivity growth; a major driver for GDP growth in Chart 2.
Using data from the St Louis Federal Reserve on capital stock and labour productivity, China today resembles Korea in the late 1990s in terms of its capital stock per worker.
We therefore assume China follows the Korean path and sees a gradual reduction in labour productivity gains, an assumption which imposes the Lewis Turning Point we discussed above and implicitly includes a reduction in the rate of capital accumulation.
Combining these assumptions, we have a forecast for Chinese trend growth based on demographic considerations (Chart 5).
Chart 5: Decomposed Chinese trend growth forecast
Source: Thomson Datastream, NBS, Schroders Economics Group. 11 December 2015. Please note: LFP stands for labour force participation
We also model a scenario in which China slowly raises its labour force participation rate to Korean levels over the 15-year period. Labour force participation rates are reasonably high in China as a whole, but are below Korean and Western levels for the over 50s.
China’s average participation rate for this age group is around 30% compared to around 70% in Korea; convergence would see an addition of around 90 million workers, or 10% of the existing workforce.
There may be a range of reasons for this disparity. We would speculate, for example, that it is harder to employ older workers in an economy with fewer service sector (and less physically demanding) jobs.
Hence we model only a gradual and incomplete convergence to Korean participation rates, as we do not see the two economies becoming structurally identical in the timeframe.
In the “no LFP change” scenario, trend growth is estimated at around 5.7% today and forecast to fall to 3.4% by 2030. While undeniably a slowdown, it is probably not the apocalyptic scenario often imagined.
Furthermore, when we look at the breakdown, it is clear that the declining population is not a significant driver until the tail end of the period, when it shaves around 0.5 percentage points from the growth rate.
The model also suggests that reforms aimed at boosting labour force participation would balance out the declining population until 2029/2030, so a declining population represents little threat to Chinese growth in the medium term.
Instead, the real challenge lies in the falling productivity growth, which accounts for almost all the fall in total GDP growth.
Unfortunately for China, there are few policy tools available to fend off this decline, which is an inevitable end point for any emerging market economy experiencing “catch up” growth. We will examine this further in a future Talking Point piece.
No crash landing ahead but a much slower China inevitable
One question that arises from this is whether China is now due a hard landing. After all, GDP growth, officially on track for 6.9% in 2015, is far above trend, and has been for some time.
A significant correction is apparently needed to bring activity into line, so perhaps the bears are right after all?
The problem for the bear argument now, however, is that no self respecting doom-monger would accept the official GDP number of ~7% growth. Depending on who you talk to, some would have it as low as 2% (and possibly even lower).
But in that case, the correction has already happened, and we should expect an upturn in Chinese growth to return to a trend growth number of over 5%.
Our view would be that Chinese growth is somewhat overstated, though chiefly through statistical errors and perhaps a tendency to round up, instead of down.
Capital Economics, for example, estimate that incorrect calculation of the GDP deflator might be overstating real GDP growth by 1-2% in the first half of 2015 - which brings the true growth number much closer to our estimate of trend growth.
Aside from this, there are few of the usual signs of an economy growing above trend; inflation pressures are extremely muted, and the Producer Price Index (PPI) is in fact in deflationary territory.
IMF analysis of the Chinese output gap estimates a negative gap under the usual methodology (i.e. the economy is below trend), but a positive gap when using a “credit augmented” measure , and this is where we see the risk.
So, by traditional metrics, China is below trend in that spare capacity is rampant. But this spare capacity has been achieved through above-trend credit and investment growth which has to now unwind.
We include a “China hard landing” risk scenario in our economic forecasts, but it arises from financial instabilities rather than an overheating economy.
The high and growing level of indebtedness and the opacity of balance sheets create concerns over lurking asset quality issues beyond those officially stated by banks.
A financial crisis would have the potential to take growth significantly below trend, and could, as in the West, see a prolonged period of below-trend growth as the rubble is cleared. But again, this is not a result of the usual overheating typical of the end of a business cycle.
Equally, however, we would caution against looking at Chart 5 and expecting a smooth ride for China.
Slowing productivity growth rather than population decline
It would be extremely unusual for the economy to undergo such an adjustment without some cyclical volatility, and a recession at some point seems a certainty.
Further, investors will need to get used to a world in which China in all likelihood posts a lower growth number every year for at least a decade, depending on the speed of adjustment.
Rather than taking comfort from government stimulus, we would become concerned if policymakers became modern day King Canutes, trying to halt, in their case, a receding tide by unleashing stimulus after stimulus.
The more adjustment is deferred, the more painful it will ultimately prove, and there is no policy that can successfully prevent this kind of structural slowdown.
To our minds, every attempt to hold the growth rate above trend increases the risk of crisis, notwithstanding the measurement errors we mentioned above.
However, importantly this inexorable downward grind is due not to the population decline, but to slowing productivity growth, a topic we plan to explore in a later note.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.