What’s Really Behind China’s Falling GDP

The headlines grabbed attention: “China’s economy grows at slowest rate in nearly 30 years,” noted the Financial Times in a typical example. China’s GDP growth in the second quarter had slowed to 6.2%, the smallest gain since 1992, back when the country’s economy was first shifting into high gear. But the recent drop was not such a big fall from the 6.4% GDP growth rate of the first quarter, nor from the 6.6% rate for all of 2018. The big picture shows that China’s GDP has been falling for a number of years and the new number is just the latest in a series.

And while some analysts were connecting the sluggish growth figure directly to the current trade spat with the U.S., that’s not the central problem, according to experts from Wharton and Stanford University. Rather, the challenges to China’s economy are deeper, structural, longer term, and have been building for years. They include over-investment, high savings and modest, if growing, consumer spending, high debt and low industrial productivity.

Those are the views of Wharton emeritus management professor Marshall W. Meyer, a longtime China expert, and Richard Dasher, director of the U.S.-Asia Technology Management Center at Stanford. Overcoming those problems requires big shifts in how the country’s economy is organized, an overhaul the government is attempting to execute.

“The tariffs and trade friction with the U.S. is a relatively small part of what is going on,” notes Dasher.

Less Export-dependent

One reason the current head-butting on trade issues between President Trump and China’s President Xi Jinping is not deeply affecting China: Net exports as a percentage of China’s economy have shrunk sharply for years and now are under 1% of total GDP. And Dasher says that China’s exports to the U.S. make up just 5% of total exports. So while China’s U.S. exports fell 7.8% in June, the result is not exactly a death blow to the nation’s $13.6 trillion economy.

More generally, the graph of China’s economic growth has sloped downward since 2009, Meyer notes. The last quarter’s number was related to internal problems. Three of the most important in his view are the following: (1) demographics, “China is getting older” and the workforce is beginning to shrink; (2) “regression to the mean” – countries that grow quickly “almost always encounter … very rapid deceleration in growth at some point;” and (3) “excessive reliance on capital investment,” particularly in infrastructure.

“The tariffs and trade friction with the U.S. is a relatively small part of what is going on.” –Richard Dasher

Added to overspending on infrastructure, China also is boosting consumer and industrial spending by expanding available credit, Dasher says. “They are really very debt-ridden.” He found it interesting that financial markets did not react “too unfavorably” to the very low GDP growth rate “because consumer spending is up over 9% (in part due to recent tax cuts). And industrial investments are higher than GDP growth. The only way you can do that is through extending more credit.” And officials have done that by giving banks a lot of funds to lend out.

Dasher and Meyer offered their comments on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

But the most fundamental — and crucial — issue for China’s economic future is lagging productivity, according to Meyer. Productivity – “the amount of output we get per level of input” – is the most important driver of GDP in the long run for every economy and it has been low in China. In most industrial sectors, “some economists say it has been negative since as early as 2007. And certainly, I would say with a little more certainty since, say, 2012, 2013.”

In the meantime, the country has been piling up debt – by consumers and local governments in particular. “Who’s going to repay that debt? No one knows,” Meyer says. To repay it China will have to increase productivity, which almost certainly means moving up the value chain into “leading-edge industries.” Related to that, China analysts have long said that the nation must move from investment-led growth to consumption-led growth as a way to avoid the so-called middle-income trap.

Racing Towards Innovation

And China has to try to do this rapidly. The list of industries it is hotly pursuing and that fit the bill run from “green energy to artificial intelligence to 5G and beyond,” Meyer explained. China is in a race to get a foothold in industries “where productivity will increase” in time to pay off its mountain of accumulating debt.

While China is pushing hard to restructure its economy, pressures are mounting. There is an increasing gap between the rich and the poor, just as there is in the U.S. “Wages in East Coast Chinese cities are going up drastically while the wage gap between the coast and interior is [becoming] greater and greater,” notes Dasher. “You really have tension inside the country.” Chinese officials may not have to worry about getting re-elected, but they do “have to worry about people seeing them as legitimately improving the quality of life for people.”

This Financial Times article agrees that China’s chief economic problems are domestic and creating social pressure. “Asset prices, particularly housing, have risen so high that many young professionals find themselves priced out of the market in China’s booming cities.”

Taking trade out of the picture for a moment creates more clarity around what are the central differences between the U.S. and China. Some argue that the real competition between China and the U.S. ultimately is not over trade, but rather about who will lead the future in innovation and technology. That idea also helps to explain the related disputes involving U.S. tech sales to Huawei and objections to accepting Huawei into the 5G space in the U.S.

In the U.S., meanwhile, “we complain about our productivity levels which seem to be a 0% to 1% increase a year — my gosh, that’s low,” says Meyer. “Why aren’t we seeing the benefits of automation, etc.? But in China, in most industrial sectors, productivity has been going down.”

The U.S. should “worry a little more – maybe a lot more — about what would happen if Xi were precipitously pushed out of power.” –Marshall Meyer

Despite the productivity advantage, the U.S. does not have a company that can compete with Huawei, Meyer points out, noting that the “strongest Western competitors are Nokia and Ericsson,” both small compared to Huawei. “So the question is why aren’t we in this space? Why are we complaining that the Chinese are unfair, which they may be by U.S. standards but probably not by their standards. Why aren’t we competing?”

The U.S. has to grow “its fundamental industrial capacity” just as China needs to build a more balanced economy. But another key question for Meyer, given that Huawei enjoys significant government aid, is this: How much should the U.S. government help guide the effort for U.S. companies? “There’s a lot of evidence out there that government support has been critical in many of our technologies, even today in Silicon Valley.”

Meyer also thinks the U.S. should realize the risky game it is playing with the trade war. The U.S. should “worry a little more – maybe a lot more — about what would happen if Xi were precipitously pushed out of power. Is this going to be a good thing or not a good thing? And use that to calibrate the amount of pressure we put on China.”

As for the tariffs themselves, Meyer calls them a “a blind alley…. They often end in economic downturns.” And it is worth noting that U.S. exports to China were down 31.4% in June.

A Blunt Instrument

Dasher, meantime, finds the tariffs a “blunt instrument” that are ineffective in solving the problems the U.S. faces with China. “We really need to move back towards a rule-based kind of international system. We need to worry about IT. We need to try to encourage China to join the club of other advanced nations that have intellectual property to protect, and recognize each other’s need to protect intellectual property.”

President Trump, meanwhile, recently said that U.S. tariffs “are having a major effect on companies wanting to leave China for non-tariffed countries.” There appears to be some truth in the claim. Some countries are benefiting from shifts in sourcing as result of the 25% tariffs imposed on many Chinese goods. Those countries range  from Vietnam – the biggest winner — to Taiwan, Malaysia, Chile and Argentina, according to a report by Nomura, the Japanese investment bank.

Other reports suggest that Mexico, and even France and Germany have benefited. On balance, however, the impact on third-party countries from the trade disputes will likely be negative, the report noted. Certainly if the disputes slow China’s economy, others will feel the effects because China remains the world’s largest generator of economic growth.