Fall of the dragon: Is everyone far too optimistic about China?

 

There's nothing particularly new about fears of a sharp economic slowdown (or “hard landing”) in China. And Purchasing Managers’ Index (PMI) surveys released in the past few days will only add to the list of worries for those who see annual growth slipping well below the Communist Party’s target of 7.5 per cent this year and next. Data released yesterday indicated that China’s services sector grew at its slowest pace in nine months in October, helping Hong Kong’s Hang Seng index to fall 0.34 per cent by the time markets closed for the day. 

 

Manufacturing PMI figures released over the weekend, meanwhile, saw a faster-than-expected decline in activity to 50.8 (where a figure above 50 indicates expansion), compared to a reading of 51.1 in September. Analysts at Daiwa Capital Markets said growth in the fourth quarter may now dip to an annualised rate of 6.9 per cent, pulling full-year GDP growth down to 7.2 per cent – below the government’s target. 

 

But what if even some of the more pessimistic forecasters have got it wrong? We’re told that the world has entered an Asian Century – the global economy’s centre of gravity is inexorably shifting eastwards – and that China will soon overtake the US as the world’s largest economy. On a purchasing power parity basis, IMF figures suggest that it already has. A recent paper from eminent economists Larry Summers (former US Treasury secretary) and Lant Pritchett (of Harvard University), however, calls this idea into question. 

 

China’s decades-long period of “super-rapid” growth (defined as GDP expansion of more than 6 per cent per annum), they say, is a complete historical outlier. Barring a few blips in the late 1980s and early 1990s (see graph), the country has grown at a super-rapid rate for well over 30 years. “China’s experience from 1977 to 2010 holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data, with a sustained episode of super-rapid growth for more than 32 years.” But forecasters who are extrapolating similar trends into the future, their analysis suggests, are in for a shock. 

 

It’s a fairly simple argument. Previous episodes of super-rapid expansion have ended sharply – they are “frequently punctuated by discontinuous drop-offs in growth.” Based on a sample of 28 countries, including the likes of South Korea, Taiwan and Singapore, Summers and Pritchett find that economies typically regress to the world mean growth rate, meaning an expected “massive deceleration” of around 4.65 percentage points. In China’s case, unless it carries on as a complete historical anomaly, this would imply that growth is likely to fall back to an average of around 3.98 per cent per annum in the years to come, from current levels of above 7 per cent. 

 

The data suggest that this regression to the mean is a highly robust finding – more so even than the middle-income trap phenomenon. 

 

All very interesting, but haven’t people been talking about a hard landing for some time? What’s this finding got to do with trading? The authors think that the specific characteristics of China’s political economy – “high levels of state control and corruption along with high measures of authoritarian rule” – make a discontinuous drop-off in growth more likely, especially as the country tries to change the political settlement on which growth has been based for so long. 

 

Almost a year ago, officials in China surprised the world with a relatively bold package of reforms. It included plans to take on vested interests in state-owned enterprises, loosen the one child policy and increase the role of markets in the setting of prices and interest rates. When countries go through such periods of institutional reform, Summers and Pritchett note, the uncertainty for business can be huge, no matter how positive the changes may be in the long term. Plenty of scenarios emerge that could disrupt the environment for well-ordered business deals, they say, and this “could easily create processes with nonlinear sudden stops.” 

 

As many have pointed out, China’s economy has long been based on a relatively top-down, credit-fuelled growth model, alongside a low level of democratic freedom. It’s not impossible to imagine the transition to a more market-based and democratic system happening smoothly, but Summers and Pritchett say that this outcome is not typically observed in the data. In other words, if authorities stick to the reform agenda over the coming months and years, history suggests that it’ll be an extremely bumpy ride. 

 

So what should market-watchers expect to see if China finally stops defying gravity? Despite the huge size of the country’s economy, Mark Williams of Capital Economics says that the relatively weak financial links between China and the rest of the world means that a Lehman-style banking collapse would be unlikely. And the authorities have plenty of ammunition to fight fires, he says. Reserve requirements at large banks are currently at 20 per cent, and they could be cut to stimulate more lending, says Williams. 

 

Rather, the immediate effects would likely be felt in commodity markets. China’s recent slowdown has contributed to the decline in the price of oil in past months (see graph), meaning that countries and companies with an interest in that market should be worried by Summers and Pritchett’s findings. Conversely, a falling oil price would probably be a boon for oil importers. And economies like Japan and Germany, which export heavily to China, would quickly see a hit to demand for their products in the event of a Chinese slump.

 

Predicting the future is a hazardous enterprise, and obviously no one can say with certainty that China is due a sharp collapse in growth. But, as Summers and Pritchett show, the country would be a historical anomaly if things continue to go smoothly.