October 18, 2021

THE CHINESE ECONOMY: A PARADIGM SHIFT

by Robert F. DeLucia, CFA
Consulting Economist

Summary and Major Conclusions:

The primary theme in ▪ The Chinese economy has developed massive structural excesses over the past decade, most
notably in the real estate and manufacturing sectors. These imbalances include increased debt,
the long-term outlook for heightened financial risk, decelerating economic growth, and economic instability.
China is a consolidation
▪ Recent developments surrounding China’s property giant Evergrande have raised investor
of power by the Chinese awareness of these worrisome underlying imbalances. Policymakers will do whatever is
necessary to prevent contagion from its collapse, propping up suppliers, healthy developers,
Communist Party (CCP) and homeowners at the expense of world bondholders.
involving a shift away
▪ Evergrande is a microcosm of the leveraged Chinese housing market. A bankruptcy can be
from Western-style managed to avert contagion, but the bigger issue is how policymakers will address the growing
vulnerability of China to its oversized property market.
capitalism toward a more
socialist economy, ▪ China’s economic model in recent decades has relied heavily on debt-fueled real estate
development as one of the primary stimulus channels through which it could promote economic
including centralized growth. However, this model is becoming unsustainable as the real estate market has become
progressively overbuilt.
control of the factors of
production. Government ▪ The Chinese economy faces daunting challenges far beyond its real estate market. Debt levels
are dangerously high in all sectors of the economy, while its population and workforce are
policy under Xi Jinping is shrinking. Its state owned and operated banking system is saddled with bad loans.
directed at breaking the
▪ In addition to a property bubble, the Chinese economy has been in a credit bubble since the
market dominance of 2008 world financial crisis. China’s growth model has relied upon a large accumulation of debt
by both the public and private sectors. China’s total debt-to-GDP ratio has increased from
China’s largest private 150% to 300% over the past decade.
companies, curbing
▪ Its economic model has also relied on a very high savings rate to create a manufacturing
rampant corruption, and behemoth, which has benefitted from the availability of cheap indigenous labor to rapidly gain
share of world export markets. Large investments in plant, equipment, and infrastructure
concentrating power in helped raise labor productivity.
the CCP.
▪ This manufacturing and export model has become increasingly impotent, resulting in a shift in
emphasis to consumption and services over the past decade. The result is that consumer
spending and the service economy combined now account for nearly 60% of total GDP.

▪ China’s crackdown on real estate is not an isolated event but rather part of a much larger shift
in government policy toward business and the economy. The primary theme in the long-term
outlook for China is a consolidation of power that involves a shift away from state capitalism
toward a more socialist economy.

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▪ The Chinese Communist Party has always believed that socialism was the future of China. State
capitalism was embraced as a temporary vehicle for more rapid industrialization and
development necessary for world economic, political, and military dominance.

▪ China’s long-term economic outlook has become highly uncertain. There are increasing odds
that the country could suffer an economic and/or financial crisis within the next five years. At a
minimum, its underlying trend growth in spending, output, and per capita income could slow
significantly.

▪ International trade is likely to slow on a structural basis, as the positive catalysts that supported
globalization in recent decades gradually fade. Chinese manufacturing supremacy will be
increasingly challenged by lower-cost countries in Asia, such as Vietnam and Thailand.

▪ Given the extremely high level of debt, China’s ability to effectively apply monetary and fiscal
stimulus to achieve faster growth will gradually diminish over time, consistent with basic
economic theory. Addicted to debt, the Chinese economy will require increased stimulus to
achieve a constant pace of growth.

▪ Economic performance — as measured by China’s productivity miracle — will gradually suffer

along with the government’s strategic shift away from capitalism and toward a command
socialist economy with increased government intervention.

▪ President Xi Jinping’s planned de-emphasis on free enterprise, his strategic goal of reducing
wealth inequality, and a large expansion of the social safety net could depress innovation and
entrepreneurship vital for a dynamic economy.

▪ There is a high likelihood that China will follow an economic growth path like Japan, South
Korea, and Taiwan during the 1960s, 1970s, and 1980s. GDP growth in each of these
countries slowed from 10% in their early development stages, to 5% at mid-cycle, and
eventually to 2% at full maturity.

▪ The Chinese economy should benefit from favorable short-term trends that could support a
temporary acceleration in economic growth over the next one to two years. The government is
likely to overcompensate for potential financial risks associated with Evergrande by injecting
excessive stimulus into the economy.

▪ Developments within China will have both medium-term and long-term implications for world
financial markets. Policy stimulus should support growth in 2022 and 2023 but could lessen
China’s role as locomotive for the world economy in the long term.

▪ The Evergrande fiasco will accentuate the thrust of policy stimulus. Europe and emerging Asia
should benefit from an expected policy shift by the government to support domestic demand.
Continued strong Chinese imports should boost export economies in the medium term.

▪ World bond markets have become a bellwether for developments within China. Periods of
economic, financial, and geopolitical risk will exert downward pressure on government bond
yields as investors stampede into safe-haven assets.

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“Xi Jinping is waging a campaign to purge China of capitalist excesses. China’s president
sees surging debt as poisonous fruit of financial speculation and billionaires as a mockery
of Marxism. Businesses must heed state guidance. The party must permeate every area of
national life. Whether or not Xi can impose his new reality will shape China’s [economic]
future, as well as the ideological battle between democracy and dictatorship.”

“China’s New Reality”

The Economist
October 2, 2021

Recent developments surrounding China’s property giant Evergrande have raised

broader investor awareness of widespread economic and financial imbalances
within China. The Chinese economy has developed massive structural excesses
over the past decade, most notably in its real estate and manufacturing sectors.
These imbalances are reflected in increased financial risk, rising challenges to
overall economic growth, and spreading economic instability. Perhaps the biggest
uncertainty is how the Chinese government will respond to these challenges. This
week’s Economic Perspective provides an analysis of the growing threats to
Chinese economic growth and financial stability.

CHINA EVERGRANDE GROUP

Evergrande is the biggest property developer and home builder in China and one of
the largest in the world. In its meteoric growth over the past 25 years, the company
has amassed $300 billion in debt and is now faced with financial failure. The
company has been in distress for months but came under intense pressure recently
with the approach of a large interest payment to bondholders. Adding to the
pressure on Evergrande, China’s central bank has been squeezing the property
market by imposing liquidity restrictions on real estate firms in an endeavor to
address the ongoing housing bubble.

Evergrande and Lehman: Investors’ worst fears are that a financial collapse of
Evergrande comparable to that of Lehman Brothers in 2008 will culminate in
another world financial crisis. These fears are largely unfounded because the
circumstances are vastly different. The most compelling reason arguing against a
financial crisis is that the Chinese government would almost certainly intervene
aggressively to prevent a total collapse of Evergrande.

CHINESE PROPERTY MARKET

Evergrande is a microcosm of the Chinese economy and financial system. China is

currently faced with a huge real estate bubble larger than those of the US in 2006
and Japan in 1990, with enormous overbuilding financed by a massive
accumulation of debt.

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Heavy Reliance on Debt: China’s economic model in recent decades has relied
heavily on debt-fueled real estate development as a primary stimulus mechanism
to promote economic growth. This model is dangerous and unsustainable because
the real estate market is both massively overbuilt and saturated. The broad real
estate market comprises nearly 30% of the Chinese economy, more than double
that of the US.

▪ Market Saturation: More than 95% of China’s urban households own at least
one home, well above the 65% home ownership rate in the US. Many
households own more than two homes because investment in real estate is the
primary vehicle for retirement saving in China — in sharp contrast to the US,
wherein stocks and bonds are the primary forms of retirement savings. Nearly
70% of retirement savings for Chinese households is held in real estate assets.

Signs of Trouble: There are numerous manifestations of the property bubble in

China. At the peak of the US housing boom in 2006, roughly $900 billion flowed
into the real estate market. During the 12 months ending in June of this year,
more than $1.4 trillion was invested in Chinese homes. The total value of Chinese
homes and developers’ inventory exceeded $50 trillion in 2019, double the size of
the US housing market. China’s property market is also massively overvalued.
Finally, very high vacancy rates and unusually low returns on investment in real
estate are clear manifestations of the unhealthy condition of Chinese real estate.

CHINA’S ECONOMIC MODEL

China’s four decades of miraculous economic growth created the second largest
economy in the world, at the same time pulling billions of people out of poverty,
both within China and across the developing world. China’s GDP has increased
forty-fold since 1980. Its economic model has relied upon a very high savings rate
and a very large pool of cheap labor to create a manufacturing behemoth and
export giant. Large investments in plant, equipment, and infrastructure helped
raise labor productivity.

Shift to Consumption and Services: Policymakers have come to understand that

the economy’s heavy reliance on manufacturing, infrastructure, and exports was
unsustainable and that resources should be shifted to new sources of growth. The
result is that consumer spending and the service economy have become the new
sector leaders in China, together accounting for nearly 60% of total GDP. The
economic implications are that the annual rate of GDP growth should slow as this
transition toward a service economy unfolds.

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China’s Debt Binge: In addition to the housing market, China’s business,

household, and local government sectors have also been in a credit bubble since
the 2008 world financial crisis. China’s ratio of total debt to GDP has risen to
300%, double that of 12 years ago and among the highest in the world.
Xi Jinping’s ongoing crackdown on excessive financial leverage within the real
estate and businesses sectors is consistent with a slower rate of economic growth.

GOVERNMENT POLICY DIRECTIVES

China’s clampdown on real estate debt is not an isolated event but rather part of a
much larger shift in government policy toward business and the economy. The
primary theme in the long-term outlook for China is a consolidation of power within
the Chinese Communist Party (CCP). This would involve a shift away from Western-
style capitalism toward a more socialist economy, including centralized control of
the factors of production. Under Xi Jinping, China will be increasingly directed at
breaking the market dominance of its largest private firms, curbing rampant
corruption, and concentrating power in the CCP.

Common Prosperity: A related theme is a set of initiatives aimed at wealth

redistribution, referred to euphemistically as “common prosperity.” Policymakers
appear intent on enhancing the social safety net in China and to improve living
standards for the middle class, including measures to make housing more
affordable. In a similar way, government is clamping down on the very large and
prosperous companies that dominate their markets, including Alibaba and Tencent
Holdings, while propping up less efficient mid-sized government owned and
operated businesses.

The End Justifies the Means: Despite the huge contribution of state capitalism to
boost economic growth and per capita income over many years, China is in the
early stages of transitioning from state capitalism toward a socialist command
economy. The CCP has always believed that socialism is the legitimate future of
China, but that state capitalism was a convenient mechanism for China to achieve
industrialization and economic development necessary to become a world
economic, technological, and military power.

▪ Economic Effects: A decisive move away from capitalism could be disastrous

for the Chinese economy. Although private firms are responsible for generating
most of China’s wealth, they are being starved of capital because inefficient
state-owned enterprises (SOE) receive 80% of government loans and
subsidies. The inevitable result will be a loss of innovation and
competitiveness as the country doubles down on regulation and government
control.

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LONG-TERM ECONOMIC IMPLICATIONS

The long-term economic outlook for China appears enormously challenging. There
are numerous credible reasons why China could suffer an economic and/or
financial crisis within the next five years. At a minimum, its underlying trend
growth in spending, output, and per capita income could slow significantly.

1. Debt has soared to unsustainable levels over the past decade.

2. The banking system is saddled with a mountain of bad loans.

3. The Chinese economy is overly reliant on a highly leveraged real estate sector,
rife with multiple layers of rampant speculation and corruption.

4. An ongoing strategic policy shift from manufacturing and export trade to

spending on consumer goods and services implies slower economic growth.

5. The Chinese population is aging and the labor force is shrinking, a

consequence of the government’s one-child policy over many years.

6. China is running out of natural resources: It is the world’s largest importer of

both energy and agricultural products and relies on imports to meet 80% of its
computing needs.

7. International trade is likely to slow on a structural basis, as the positive

catalysts that have supported globalization in recent decades gradually fade.

8. The Chinese manufacturing hegemony will be increasingly challenged by

lower-cost countries in Asia, such as Vietnam and Thailand.

9. Given the extremely high level of debt and financial fragility, China’s ability to
effectively apply monetary and fiscal stimulus to achieve faster growth will
continue to gradually diminish over time, consistent with basic macroeconomic
theory.

10. Economic performance — as measured by China’s productivity miracle — will

slowly deteriorate consistent with the government’s strategic shift toward a
service economy, with increased government intervention, and away from state
capitalism.

11. President Xi Jinping’s planned de-emphasis on free enterprise along with his
strategic goal of reducing wealth inequality and expanding the social safety net
will likely depress innovation and entrepreneurship vital for dynamic economic
progress.

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12. The primary political theme in China involves sacrificing economic efficiency
for a consolidation of government power in the Chinese Communist Party.

ECONOMIC OUTLOOK

Following a significant loss of momentum over the course of this year, I expect the
Chinese economy to rebound over the next 12 to 18 months as some of the
headwinds of the past year dissipate. There are several reasons to support this
conclusion:

▪ An improving world economy, most notably Europe, Asia, and the US

▪ A partial end to the pandemic and tight restrictions on mobility
▪ Renewed economic stimulus following a year of fiscal and monetary
tightening

In managing the failure of Evergrande, China is likely to overcompensate for

potential financial risks by injecting excessive stimulus into the economy, thereby
boosting growth temporarily to an above-average pace.

China’s Energy Crunch: A short-term risk to the Chinese economy is an extreme

shortage of electricity inputs caused by the surging price of coal, which has
resulted in production cutbacks in China. By substituting natural gas and crude oil
for coal in power generation, China has exacerbated the upward price pressures on
both oil and natural gas in world energy markets. Both China and the world
economy are at risk to slower growth in coming months until these energy market
pressures are resolved. The Chinese government has ordered coal mines to
aggressively increase production, but it will take a while for output to increase.

Japanese-Style Slowdown: The long-term prospects for the Chinese economy are
worrisome. There is a high likelihood that China will follow an economic growth
pattern like those of Japan, South Korea, and Taiwan during previous decades,
beginning in the 1960s. GDP growth in each of these countries slowed from 10%
in their early development stages to 5% at mid-cycle and eventually to 2%. My
GDP forecast for China assumes GDP growth of 5% over the next several years,
slowing to 4% within the next five years and 3% by the end of this decade.
Moreover, relative to their Asian counterparts, China is faced with two unique
headwinds that could exacerbate its adjustment process:

1. Over time, Japan, Korea, and Taiwan have adopted democratic governance,
which is more conducive to faster productivity growth and economic resiliency.
Under Xi Jinping, China appears to be moving in the opposite direction, as it
doubles down on an autocratic command economy based upon socialist
principles.

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2. A top diplomatic priority of each of these three countries was to remain allies
with the US, whereas China is clearly moving from peaceful engagement with
the US to policies that are accentuating the risk of confrontation.

These political and geopolitical forces could exacerbate the daunting economic
challenges faced by China. Progressively slower GDP growth could significantly
lessen China’s role as an engine of global economic growth and promoter of world
trade.

INVESTMENT IMPLICATIONS

Developments within China will become increasingly more impactful for the US
and global economies in future years, with significant investment implications:

▪ Developments within China will have implications for world financial markets
in both the medium and long term. Macroeconomic policy should support
growth in 2022 and 2023 but could lessen China’s role as locomotive for the
world economy in the long term.

▪ China is in the midst of another boom-bust cycle. China’s short-term

economic outlook will remain uncertain for the next six months because of
policy tightening that began one year ago. As a result, world economic
growth, world trade, and world financial markets could suffer for a while
longer.

▪ As they have always done in the past, the authorities should aggressively
ease policy in order to rescue a slowing economy, support employment, and
minimize risks in the precarious property market.

▪ GDP growth will accelerate with a lag time of two quarters, promoting world
economic growth and supporting world financial markets in 2022 and 2023.

▪ The Evergrande fiasco will accentuate the thrust of policy stimulus, as

government officials will do whatever is necessary to avoid a
financial/economic crisis in China.

▪ Europe and emerging Asia should benefit from an expected shift to a pro-
growth policy. Continued strong Chinese imports should boost export
economies worldwide.

▪ Growing disillusionment and mistrust toward China could support a “built in

America” movement that would strengthen the domestic manufacturing
sector and support economically sensitive stock groups.

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▪ China will continue to influence world bond markets, which have

demonstrated heightened sensitivity to developments within China. Periods
of rising economic, financial, and geopolitical turmoil will exert downward
pressure on government bond yields as investors shift from risk assets to
safe-haven assets.

Robert F. DeLucia, CFA, was formerly Senior

Economist and Portfolio Manager for Prudential
Retirement. Prior to that role, he spent 25 years at
CIGNA Investment Management, most recently serving
as Chief Economist and Senior Portfolio Manager. He
currently serves as the Consulting Economist for
Prudential Retirement. Bob has 45 years of
investment experience.

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