News in Charts: China on the road to Japan

China’s economy expanded by an impressive-looking 8.1% in 2021, according to official data. This came after growth of just 2.2% in 2020 amid the onset of COVID-19, and an average of 7.7% in the previous decade. Headlines can be deceiving, however. Strong growth last year was largely a result of highly favourable statistical carry-over effects – quarterly annualised growth averaged just 4% in 2021. The year-on-year pace of growth also slowed sharply in the second half of the year. Fathom’s China Momentum Indicator, which is our estimate of China’s true underlying growth rate, has also slowed sharply. Unless there is a material change in policy, away from Xi’s ‘jam today’ approach, we believe China is headed for Japanification.

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Various factors have been weighing on the economy. Key have been the government’s draconian zero-COVID strategy and the intensification of the Evergrande crisis, which have had large negative impacts on the consumer and the housing market. Nominal retail sales growth slowed to just 1.7% on a twelve-month basis in December, while in the fourth quarter the floor area of residential buildings started and sold was 30% and 20% lower respectively than the year before.

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Beijing’s concerns about the economy’s weakness seemed to intensify towards the end of last year, and economic stability was a key theme of the government’s annual Central Economic Work Conference in December. The People’s Bank of China has recently eased policy, and special bond quotas were issued to local governments in December which will be used to boost infrastructure spending over coming months.

Further policy easing is likely, including measures to stabilise the housing market. President Xi will not want to take any chances in a year when he is hoping to secure an historic third term in office. Nevertheless, downside risks to growth – as discussed in more detail here – should not be underestimated, and these are likely to be reflected in this year’s growth target, due to be announced in March. Annual growth targets have fallen over the past decade, a reflection of slower trend growth.

Looking beyond 2022, investors should brace themselves for much slower growth in China over the coming decade. Its policymakers face the unenviable challenge of reducing the risks associated with an over-inflated housing market while avoiding a sharp slowdown. Moreover, their ability to keep stimulating growth is limited by elevated, economy-wide debt levels. Ultimately, rebalancing and unwinding the excesses of the past is hard to do. It requires short-term pain for long-term gain, which typically proves too unpalatable.

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Meanwhile, Beijing’s unpredictable and aggressive regulatory measures against key parts of the private sector in recent years, its increasing penchant for state control, and frayed relations with the West, are likely to weigh on domestic innovation.[1] These potential headwinds to productivity growth from weaker innovation will occur at a time when demographics are becoming decidedly less favourable. As the chart highlights, China is growing old before it grows rich, with its old-age dependency ratio rising at a much lower standard of living than elsewhere.

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Furthermore, it tends to be democracies and resource-rich countries that succeed in making progress towards US levels of income per capita. China’s policymakers are tugging in the opposite direction, exercising greater state control to control nagging COVID-19 outbreaks and tightening their grip more broadly in the economic and social realms. All in all, Fathom believes that China is headed towards Japanification — characterised by weak growth, low inflation and low interest rates. Hence, we continue to favour government bonds as the most attractive Chinese asset, a position we have held since Q1 2019. Any moves by Beijing to distract from the slowing economy through nationalist adventures could have implications for Taiwanese equities, as Fathom discussed in a recent research note, which can be accessed here.

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[1] The IMF suggests that the productivity gap across sectors between state-owned enterprises and private companies is around 20 per cent; see People’s Republic of China: 2021 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People’s Republic of China (imf.org)