Over the past several years, we have written often about the views of China that are commonly promoted in mainstream news and the financial press — views that China is an economic and geopolitical juggernaut which could soon eclipse the United States in power and influence.
We do not believe that those views are correct, and we believe that they help create a level of anxiety about the relationship between China and the U.S., and the global impact of that relationship, that are unwarranted by the facts.
Geopolitics is more arguable than economics, and while we follow geopolitics as part of our analysis of macro trends, our expertise is more in the area of economics. Below, we will sketch out the basis of our view that Chinese economic achievement is not a threat to the United States — and that it is unlikely that China will overtake the U.S. is economic clout any time soon.
We continue to reiterate our view to encourage investors who may become pessimistic about the future prospects for the United States. We remain very optimistic about the future of the United States, beyond near term stock-market volatility, and even the next recession whenever it may arrive (which we believe is unlikely to occur before 2020).
As is often the case when we write about China, our analysis below owes a great deal to Jonathan Anderson of Emerging Advisors Group, who is the most perspicacious China analyst we have encountered in nearly five decades of studying and investing in emerging markets.
Chinese GDP: Set To Overtake the U.S.?
Per capita Chinese gross domestic product (GDP) lags well behind the U.S. because of China’s much larger population. But the absolute value of Chinese economic output has risen so rapidly since the turn of the millennium that it seems easy to pencil out a near future in which it exceeds that of the U.S.
Source: Emerging Advisors Group
In order to close the existing gap in 20 years, if the U.S. economy is growing at 3% per year in real terms, China would have to manage 6% real growth in U.S. dollar terms in that time. Since Chinese growth was 17% annually during the 2000s, and has run at around 7% for the past five years, it seems on the face of it quite likely that China will indeed “catch up.”
Here’s why it’s very unlikely that this will happen.
First, will China’s real growth live up to its recent past? It is unlikely that it will, for a variety of reasons.
• The real level of growth has probably not been 6.5% to 7% over the past five years. Anderson’s independent data, a bottom-up index he refers to as the China Activity index, suggests that since 2014 the real growth rate has been closer to 4–4.5%.
• China’s huge growth impulse over the past two decades came from its rapidly achieved dominance in low-end manufacturing — toys, garments, footwear, sporting goods, and the like, as well as taking a lot of global export share in IT assembly and machinery. It was all about the exports — and China’s rising wages have been pushing that export manufacturing out into China’s cheaper regional peers. By 2010, the period of China’s seemingly unstoppable dominance in global manufacturing was already beginning to slow and reverse. Yes, China is making gains in higher-value-added manufacturing — but it is not enough to make up for the manufacturing that has departed for Vietnam, Cambodia, Thailand, and Bangladesh. You can see the flatlining of the “Chinese export powerhouse” here:
Source: Emerging Advisors Group
• Another reason that growth is likely to slow is the diminishing returns that China gets from property and construction — these also led to a big growth “pop” that largely came to an end in 2010.
• Debt levels in the Chinese economy, both total domestic debt and household debt, have reached levels where further credit-led expansion will not produce the same heady results that it did in the past. Additionally, as we have noted many times, excesses in the Chinese financial system — especially in the unofficial, shadow-banking sector — could well result in a financial crisis in the next several years.
• Although, as we have noted, China has been a global leader in the transition to e-commerce and the “new economy,” the net result has not been a growth in overall retail sales, which have been in a long-term decline.
Source: Emerging Advisors Group
• And there is nothing else up China’s sleeve that could rekindle the growth “miracle” of the first decade of the 2000s.
The Other Problem — Exchange Rates
All of the above just indicates why China will be very unlikely to run a 6 or 7% growth rate for the next two decades and “catch up” with the size of the U.S. economy. But so what — China could just make 4% growth, 2% inflation, and keep its currency steady with the U.S. … And voilà, there’s the magic 6% that will gain ground against the U.S. until world dominance is achieved.
But this is also extremely unlikely, and we hinted at reasons above.
For many, many decades, the history of emerging-market currencies has shown their tendency to devaluation. Anderson notes that “Since the 1960s the emerging world has depreciated outright in every single decade except for the 2000s, when EM enjoyed a sharp but short-lived appreciation spurt.”
In other words, EM currencies have a distressing tendency to decline against the dollar — which is why we always tell would-be dollar-based investors in EM assets that they must ensure growth is rapid enough to compensate sufficiently for a decline in the currency.
China is no different from other EM economies in this regard, as the following chart shows. If China were really catching up, the blue line (GDP in U.S. dollar terms) would be rising above the yellow line.
Source: Emerging Advisors Group
And what is the future likely to hold? Anderson believes serious depreciation forces are building up in the system, first, because the Chinese monetary supply is growing far faster than foreign-exchange reserves; and second, because of the deteriorization of the current account balance. He would not be surprised if someday in the next decade, the Chinese yuan traded at 15 or 20 to the dollar — and thinks that when the decline comes, it could be rapid. It would parallel many other similar events in the history of emerging markets… and there is nothing to suggest that China is a special case.
Investment implications: China is extremely unlikely to eclipse the United States economy in U.S. dollar terms — not in the next 10-20 years. U.S. investors should not have an attitude of fear and pessimism about China dethroning the U.S. as leader of the global economy. Ultimately, we believe these realities will lead China to acquiesce to many demands made by the United States in the current trade conflict. U.S. pressure is not being exerted against a frighteningly powerful and threatening foe, but against an economy with many problems and weaknesses which has resorted to trade practices strongly criticized by many of its trading partners. This reality bodes well for a resolution to the current conflict that is positive for the U.S., although a trade settlement may take months or years to develop.
