The way the global economy begins a decade reveals little about how it will end. In 2000, the Anglo-Saxon economic model was ascendant and the tech revolution was sweeping the globe. Emerging nations were a mere sideshow to the great Wall Street carnival, attracting less than 5 percent of the money in global stock markets. A decade earlier, the spotlight was trained on Japan, a star that had redefined the global economic stage in the 1980s. As late as the 1992 U.S. presidential campaign, one candidate reviewed the performance this way: “The Cold War is over and Japan has won.” Today, Japan is widely viewed as a washout, and all admiring eyes are on the boom in China, a force so powerful it has lifted the performance of many other economies. Resource-rich countries like Brazil and Australia have achieved global economic acclaim, mainly by selling iron ore, copper, and other commodities to feed the construction spectacle in China. Many big-name investors believe the China boom is set to continue, driven by investment spending. Investment now represents 45 percent of the Chinese economy, a level that is historically unprecedented, both in China and in any major economy. Yet China has been able to maintain this rate of spending for several years in a row, mainly because it has been industrializing a largely rural economy. With many laborers still available to move to new factories in manufacturing boomtowns, the government could keep pouring money into highways and factories. Analysts expected that the global recession of 2008 would cut demand for Chinese exports and drag the economy down. Exports did drop sharply, but the Chinese leadership launched a massive stimulus plan, centered around yet more infrastructure spending, extending the investment boom, and keeping economic growth above the long-cherished annual goal of at least 8 percent.
Now, however, evidence is mounting that China’s growth “miracle” is on the verge of a major slowdown, which could bring the 10 percent growth rate of recent decades down to 6 or 7 percent in coming years. Recent high-profile labor strikes have dramatically called into question the China model, built on cheap labor and exports. And the rate of growth in spending is about to slow, because there are only so many new highways, railways, and ports China can build, and because land and labor costs are rising sharply. Government targets for spending in all these areas are shrinking; the mainland already has more than 65,000 kilometers of highways, the second-largest network behind the United States’ 80,000-plus kilometers. After adding more than 6,000 kilometers in 2008 and 8,000 kilometers in 2007, China’s ministry of transportation plans to construct only 5,000 kilometers of new highways per year from 2010 onward. Spending on railways is also likely to peak this year. In the wake of the financial crisis, banks are also facing greater credit controls and higher reserve requirements, which will further slow investment.
So the story of the coming decade could well be that China runs out of growth drivers. Those who believe the economy can keep growing at close to double-digit rates often argue that it can do this by replacing investment with consumer spending, and exports with domestic sales. This would rebalance the economy not only of China but also of the world, giving struggling Western economies more opportunity to sell to Chinese consumers. But this hope is built on a big myth, namely that China has deliberately prevented the emergence of a consumer economy. For the last 30 years now, Chinese consumer spending has increased at a robust inflation-adjusted rate of nearly 9 percent a year. For it to grow any faster would defy the history of economic development, in a dangerous way.
The myth of China’s slow-growth consumer economy is built on misleading data. Consumer spending did fall as a share of the economy in 2008 to a record low of 36 percent but only because growth in investment spending was much higher than growth in consumption. This is typical of rapidly industrializing economies; during their decades of “miracle” growth, Japan and Taiwan had a similar profile, though China is even more dependent on investment spending and exports. Consumer spending in Japan and Taiwan never grew faster than 10 percent a year, and it’s not likely to accelerate much faster in China.
Now China appears to be reaching a critical turning point, at which it has become too big to continue growing so rapidly. When Japan’s per capita income in the mid-70s reached levels similar to those of China today ($4,000 in current dollar terms), investment spending slowed down markedly and so did the economy’s overall growth rate from a trend rate of 9 percent to 5 percent.
There are big differences, of course. Only 46 percent of China’s population lives in cities, compared with 55 percent in mid-70s Japan, leaving more room to grow through urbanization. Still, the trend line is clear. Though exports have rebounded in 2010, there are limits to future growth, as China is already the world’s largest exporter with a 10 percent share of the global market. Eventually, China will be forced to revalue its currency, as Washington would very much like it to, and that will make exports less competitive, increasing the consumption share of the economy, with slower growth the natural result.
The unrest among Chinese workers will only fuel this trend. The bargaining power of labor will increase, in part because tight enforcement of the one-child policy is shrinking the size of the workforce. Only 5 million people age 35 to 54 will join China’s core labor force this decade, versus 90 million in the previous decade. Wages will have to rise a lot faster to compensate for the fall in the growth rate of labor. That will mean a more balanced domestic economy, but it also will mean that low-end, high-growth manufacturing will continue to migrate to cheaper parts of Asia and Africa.
That’s not necessarily a bad thing, as far as the Chinese leadership is concerned. Outsiders who think Chinese policymakers care only about fast growth miss the growing focus on social stability, and concern about how quickly the labor market tightened and inflation surfaced after the downturn. Property prices have rocketed in the major cities as the more cash-rich Chinese have been buying multiple homes, encouraged by the very low cost of borrowing. After doubling between 2003 and 2008, property prices in premier cities rose by more than 30 percent on average over the past 12 months, making houses increasingly unaffordable for the vast majority. The most popular television show these days is Woju, or “Snail’s Home,” which depicts the despair of average Chinese people amid spiraling apartment prices. To get developers to cut back prices, the government is cracking down hard, increasing minimum down-payment requirements and suspending lending for some new projects. Given that property constitutes a third of all investment spending in China, growth will inevitably slow.
Ironically, the Chinese are far more open and honest about the growth challenges they face than outsiders are. One good indicator of this phenomena is that China’s stock market, still largely closed to outsiders, has been drifting lower for months, retracing its way to levels seen a year ago. But across the world, “China plays,” or investments that assume a continued boom in China, kept rallying through April, and today remain much higher than they were a year ago. Those plays range from currencies of major commodity-exporting nations to various materials stocks. At a recent China conference, a leading mining-company executive compared talk of China slowing from 10 percent to 6 percent growth to speculation about a train hitting someone at 100 or 70 kilometers an hour. The end result is the same, he argued.
Nothing could be further from the truth. Slower growth in China could, for example, upend the world of commodity producers. In 2000, they were investing very little following a 20-year secular decline in commodity prices, and hardly anyone foresaw the coming boom in demand from China. When it arrived, unexpected, the spike in prices lead to windfall profits. Now producers of commodities from iron ore to oil and copper have been adding capacity based largely on expected demand from China that may not materialize.
A slowdown in China could shock the star economies of the past decade, including Australia and Brazil. China accounts for 30 to 60 percent of global demand for most industrial commodities, and commodity exports account for 64 percent of exports from Australia, 55 percent from Brazil. Today the fundamentals look great in Brazil and Australia, but every country always looks best at its peak. Australia, now more than ever, considers itself the “Lucky Country,” as mining metals for China generates jobs and investment. Brazil expects blowout growth of 7 to 8 percent this year, making it a current darling of global investors. Both Australia and Brazil are running current account deficits, suggesting they have saved little of the windfall from recent commodity sales and expect no end to the China boom. They are far from alone. Rising demand from China has accounted for nearly half the jump in global oil demand over the past decade, and the assumption that oil prices will keep rising underpins the budget outlays of countries from Russia to Venezuela. A slowdown in China could change all this in a flash.
For investors, the time has come to think of a world beyond “China plays.” At one level, this implies looking at markets in China that may grow even if the economy slows. One example could be PCs and LCD TVs, for which there is still wide, unmet demand. At another level, it means looking at commodity-importing countries that could benefit from a decline in prices, like India and Egypt. A decline in commodity prices would ease inflationary pressures that can be one of the major obstacles to growth in these nations.
No one gains if the slowdown comes hard and fast, and some China bears think it will, given the scale of the boom and the related credit excesses. One commentator compares China’s possible fall below the 8 percent official growth target to the Hollywood thriller Speed, in which a bomb on a bus is set to detonate if the vehicle slows to below 50 miles an hour. In China, the bomb would be triggered by the slump in job creation and explode in the form of labor unrest.
The current debate on China’s future has just two camps, the extremely bullish majority and a very shrill, bearish minority, but the truth may lie in the middle. China could well be like Japan in the mid-1970s, a period when Japan began to downshift, but remained a compelling growth story for 15 years. China’s share of global economic output has more than doubled in the last decade, but is still just 8.5 percent. If China moves smoothly to 6 or 7 percent growth in the coming years, it will hardly be a cataclysmic event, except possibly for those who have bet it all on the story of the last decade.
Sharma is head of emerging markets at Morgan Stanley investment management.