China's faltering economy has sent shivers through the global markets in 2016, and for good reason. As the world's second-largest economy and leading source of global growth for the past decade, China matters more than ever.
Guessing what comes next for China and the implications for the rest of the world is an exercise fraught with uncertainty, but we believe China's arrival at two major and near-certain inflection points will alleviate some of that uncertainty. First is China's economic rebalancing. As we've argued for the past five years, excess capacity across broad swaths of the economy and mounting bad debt will force a transition to consumption-led growth. The second inflection point concerns China's demographics. The country's working-age population will shrink by 43 million by 2030, by which time China will have more seniors than the European Union, Japan and the United States combined.
These two inflection points shape much of our long-term outlook, which we've summarized here with 10 predictions for the next 10 years.
1. Slowing GDP growth. We expect China's GDP growth to slow to less than half the pace of the past 10 years. The historical experience of economies making the transition from investment-led to consumption-led growth shapes much of this outlook. In every case, the rebalancing economy experiences not only a sharp deceleration in investment growth, but also weaker consumption growth. Historical precedent also suggests magnitude matters; the bigger the boom, the weaker the ensuing GDP growth. China's boom has been greater in magnitude and duration than anything that has come before. In our view, consensus expectations, while moderated, remain too optimistic in the 5%-6% range. We expect GDP growth to average 1.5%-4.5% in the next 10 years. Attaining the upper end of that range would require major reforms to unleash household consumption, reallocate credit from the state to the private sector, and boost productivity at China's bloated state-owned enterprises.
2. Market reforms. We believe reforms are likely to disappoint, making even 4.5% GDP growth a challenge. Our skepticism is rooted in the inherent conflict between key reforms and Beijing's two overriding political aims: control and stability. For example, we think it is unlikely Beijing will allow the major defaults that would be necessary to eliminate state-owned enterprises' preferential credit access and reallocate credit to more productive borrowers. Doing so would risk massive social disruption and diminish the state's control over capital allocation. For similar reasons, we doubt meaningful interest rate liberalization is a near-term prospect, as many state-owned borrowers would be unable to afford market-set interest rates. Consequently, the implicit wealth transfer from household savers to state-owned borrowers is likely to persist, hindering consumption growth.
3. Monetary policy. Stimulus is likely to prove ineffective at best. Questions of whether Beijing will go back to its old growth playbook overlook evidence that the government has been trying to stimulate the economy since November 2014. Multiple interest rate cuts and reductions to the portion of deposits that banks must hold in reserve haven't delivered the sort of boost they did in prior years. This is partly because of borrowers' unwillingness to invest amid a deteriorating economic outlook, a reticence reflected in all-time low readings on the central bank's loan demand survey. It's also because of capital outflows from China, which we estimate at roughly US$640 billion in 2015. The case against stimulus extends beyond doubts over its efficacy. Many of the problems China is dealing with today, from excess capacity to bad debt to falling prices, are the consequences of too much stimulus. At this point, stimulus is a shot of whiskey to cure a hangover.
4. Demographics. Despite looser family-planning laws, we expect births to fall by 25 million versus the past 10 years. The female population of child-bearing age will fall by 50 million by 2025, with 41 million of that decline concentrated in women with the highest fertility rates: those ages 20-29. Assuming no change in age-specific fertility rates, births would decline 30% by 2025. A comparison of Chinese fertility rates versus those of neighbouring countries at similar points in their economic development suggests economic and cultural factors account for China's low birth rate, not government policy.
5. Urbanization. China's urban population growth will fall by nearly half. Over the past 10 years, as China urbanized roughly 200 million people, it traversed the steep portion of the urbanization-to-income curve we observe globally. Looking ahead, that curve will flatten considerably, with lower urbanization growth for each percentage point of GDP growth. Moreover, China will be moving along that curve at a slower pace because of weaker GDP growth. We forecast China will urbanize 115 million over the next 10 years. While this would mark a significant deceleration, it would nonetheless see China add the equivalent of Japan's entire urban population.
6. Currency. We believe the yuan will fall 20% against the U.S. dollar. Defending the de facto dollar peg amid massive capital outflows has cost the People's Bank of China billions in foreign exchange. Unless the underlying causes of capital flight are addressed, including expectations of falling interest rates and a weaker yuan, we see little reason for those outflows to end. By devaluing the yuan to a level approximating market expectations, Beijing would reduce a major incentive for capital to leave China. A fair value estimate that draws on the global relationship between market exchange rates and purchasing power parity exchange rates across income levels suggests that level is roughly CNY 8 per US$1.
7. Commodities. We expect China's economic rebalancing to trigger another "Dark Age" for industrial commodities such as copper, coal and steel. China is the dominant consumer of industrial commodities and has accounted for the overwhelming majority of global demand growth in the past decade. We forecast China's industrial commodity demand to decline in the next several years as investment growth wanes. As a result, demand growth globally is likely to expand far more slowly than global GDP. Historically, sub-GDP demand growth has been associated with falling real commodities prices, a situation that prevailed in the decades before China's investment boom.
8. India. We doubt India will fill China's shoes as far as commodity demand is concerned. India is the only country that can match China's demographic heft. The fact that Indian GDP per capita now approximates that of Chinese GDP per capita 10 years ago has led many to suggest that Indian commodity demand is on the verge of takeoff. This line of thinking confuses the origins of China's commodity demand growth. It wasn't so much China's level of development a decade ago nor the economic growth it registered in subsequent years that led to the country's insatiable appetite for commodities. Rather, it was the heavy investment orientation of the Chinese economy. Unless India duplicates China's growth model, India will not deliver the same boost to global commodity demand. Because of India's pluralistic political structure and because New Delhi lacks Beijing's tools to shape economy-wide capital allocation, we doubt India's growth pattern is likely to follow that of China.
9. Health care. We believe China's health spending will more than double. We expect health-care outlays to grow far faster than GDP for a couple of broad reasons. First is the tendency of health care to claim a larger share of total spending as incomes rise. This trend is evident globally and within China itself. Second is the fact that China is aging at an incredible pace. China's population 65 and older will be 50% larger by 2025 and 130% larger by 2030, by which time it will have more seniors than the EU, U.S. and Japan combined. China will be an "old" country by middle-income standards, and we expect it to spend proportionately more on health care than the typical middle-income country.
10. New global leaders? Despite many high-profile predictions that China will overtake the U.S. as the world's largest economy in the relatively near future, we don't see that happening in the next decade. At prevailing exchange rates and assuming the U.S. musters 2.2% annual GDP growth (in line with the International Monetary Fund's forecast) while China grows at 4.5% (the upper end of our 10-year forecast), the U.S. economy would be roughly 30% larger than China's by 2025.
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