For 30 years the Chinese economy enjoyed a 10% growth rate that resulted in, as some predicted, the “Super Economy”. Supported by sizable investment campaigns and widespread migration to industrial zones, China’s share of global growth is estimated at 25% since opening its borders to free trade in 1990 according to the United Nations Research Institute for Social Development. After the economic downturn in 2008, however, subdued conditions around the world resulted in lower demand for Chinese goods and growth began to slow.
In 2014, The Wall Street Journal published a report stating that to uphold employment levels, Chinese GDP would have to grow at an annual rate of at least 8%. In an attempt to maintain its strategic growth initiative China embarked on a dangerous, debt-fueled investment campaign where, according to Morgan Stanley estimates, debt issuance was 120% of national income that same year. To put this in historical context, no other developing country has taken on as much debt in such a short amount of time.
In August, after again reporting growth below target levels, the Chinese government decided to take additional measures as part of its growth initiative. China began an unprecedented devaluation of the Renminbi which sparked a wave of uncertainty and market volatility, causing risk premiums to rise across the globe.
Are market waters calm again?
In October markets stabilized. China’s devaluation strategy is believed to have jump-started its economy, and it seems that for many investors, life is good. We see things differently. Due to changing population dynamics and diminishing returns to capital, we believe China must continue its devaluation of the Renminbi in order to meet historical levels of targeted growth.
Neoclassical economic theory recognizes three determinants of growth: capital, labor, and technology. While these have been supportive of Chinese growth in the past, we see headwinds for at least two of these inputs in the future.
Since 2003, capital investment has accounted for about two-thirds of China’s GDP growth. China has borrowed at an unprecedented rate in recent years to make substantial capital investments, yet their effect on growth has thus far been muted. So while the amount of capital available has not been an issue, it has been subject to diminishing returns due in part to the way it has been allocated. One sign of the misallocation of capital can be found in the disparity of returns between state-owned enterprises and private industrial enterprises. According to Accenture, since 2008, privately owned enterprises have enjoyed a return on assets of between 10 percent and 14.2 percent; for state-owned enterprises, this has hovered between 4 percent and 6 percent. The combination of this misallocation and naturally diminishing returns to capital has impeded the effectiveness of this critical growth factor.
Over the course of China’s economic boom, labor also played a critical role in contributing to growth. Migration from rural areas to large, industrial cities has allowed for workers to be more productive, and a growing workforce supported greater economic output. These dynamics have changed. According to the Financial Times, China’s surplus of rural labor migrating to cities has dried up, and its working-age population is now on the decline. These changing population demographics are unlikely to support the spectacular growth witnessed during the 30-year boom.
In targeting growth equal to what was previously experienced, China will no longer be able to rely on the same impact from capital and labor as the driving forces they once were. We believe the Chinese government will be forced to depreciate the Renminbi, as witnessed in August, in future attempts to generate growth at targeted levels. Given this scenario, we expect new bouts of uncertainty and market volatility resulting from direct intervention in currency markets. These conditions are likely to persist, and while challenging, we have seen them before, so investing in a smart, balanced, and diversified way is a formula we continue to stand behind over the long term.
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By Mark Landis, Co-Founder & Christopher Scobell, Investment Strategist
