From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Matthews Asia Funds research analyst Vivek Tanneeru explains why investors shouldn't lose sight of long-term growth opportunities when considering China's future.
Very often China watchers point to China’s investment share of GDP and make two claims. First, that it is extraordinarily high and, therefore, unsustainable. Secondly, given the combination of adverse demographic trends, a (perceived) real estate bubble and leverage, they claim China will experience a hard landing soon, and therefore suggest avoiding its equity markets.
On the face of it, the first part of the argument appears true. When looked at in isolation, China’s investment share of GDP (nearly 48% in 2010) is indeed high. That puts China in a league of its own globally. Neither countries such as Japan, Korea, Taiwan nor most Southeast Asian nations have ever experienced such high rates.
To judge whether China’s investment rate is sustainable, we must understand what, in the first place, enabled the country to have such a high rate. At the risk of stating the obvious, one can only invest what one saves or borrows. So saving and/or borrowing is a pre-condition for capital formation. Of course, it makes a big difference whether one saves or borrows to invest. A lot more can go wrong when investing with borrowed money than with savings. If returns on investments funded by borrowed money are subpar, the possibility of bankruptcy is real, as was illustrated by the 1997 Asian Financial Crisis. Alternatively, utilizing savings to fund investments leaves more margin for error—especially if one continues to generate high levels of savings. So from where does China’s investment funding stem? Its own savings or borrowed money?
An ‘Embarrassment of Riches’
As the chart below reveals, China has had a savings rate of over 50% since 2006. No Asian nation, except Singapore, has seen a higher savings rate in recent history. Therefore, China has not only been able to fund its investments entirely from its own very formidable savings, but also to export some of its savings at the same time.
Click here to see details of the link between working age population trends and savings rates.
If China’s savings rates are broken down by sectors—household, corporate and government—they are not individually exceptional when compared to their regional peers. Indian households have previously saved more than Chinese households; Japanese corporates have saved nearly as much as Chinese corporates; and the Korean government has saved more than the Chinese government. But what makes China exceptional is that the savings rates for all three of the sectors are near the top of global rankings and, therefore, the combined national savings rate ranks the country far above all other nations1. What could have been driving this? Several things.
China’s unreliable health care access and inadequate pension coverage have often been cited as major factors necessitating high individual savings. However, there are more fundamental drivers at work.
First, the one-child policy (introduced after China’s population doubled between 1955 and 1977) exacerbated an already declining dependency rate, a measure that expresses the number of a nation’s unemployed dependents (youth under 15 years old and seniors over 65) to the total working age population. While the trend of a declining dependency rate is not unique to China, the sheer magnitude of this decline in the country (see chart below) is what sets China apart from Japan and Korea.
Click here to see details of the comparative changes in Asia’s working age population.
With proportionately fewer children to support due to the lower birth rate, China’s savings rate naturally leapt. This was accompanied by large-scale urban migration, which was characterized by a massive movement of labour from predominantly rural sectors with low productivity to higher productivity, mostly urban sectors. Such a transformation also led to corporations claiming a larger share of “national income” as wages were kept low due to the abundant labour supply, and enabled massive capital accumulation in the corporate sector.
For China, these events kick-started a virtuous cycle of faster capital investment, which led to faster GDP growth, which in turn resulted in income growth. This income growth led to higher savings that funded further capital investment.
A second factor to consider is that China’s corporate sector underwent massive restructuring in the mid-1990s—this together with the benefits arising from China’s inclusion in the World Trade Organization in 2001 resulted in increased competitiveness and profitability.
Thirdly, as the government’s tax revenues shot up, its consumption remained relatively stable at about 15% of GDP. China’s pension reforms, first initiated in 1997, emphasized individual contributions and reduced the government’s own contribution, leading to a surge in the government’s savings rate. In all, about 80% of the increase in savings since 2000 came from increased corporate and government savings.
Still, the actual Chinese savings rate was much higher than theoretical estimates had forecast. This gap was to a certain extent due to the great imbalance in the gender ratio (as a result of far more boys being born for every 100 girls)—partly a result of the one-child policy2. Such a skewed ratio has led families to try to save more in an effort to enhance the likelihood of marriage for their bachelor sons amid the heavier competition.
Due to tight capital controls in China, this robust increase in savings could not leave the country. Therefore, China was able to ramp up its investment-to-GDP ratio impressively, while simultaneously running equally impressive current account surpluses. This runs contrary to deficits that its Asian peers such as Japan, Korea and India experienced during their own investment ramp up phases.
Demographic Time Bomb?
No doubt the demographic dividends that China has been reaping for the last 30 years will be slowing down as its working age population peaks, as estimated, by about 2015. Economic theory suggests that the savings rate will drop after the peak as consumption picks up. But given the very high base and the relatively mild contraction in China’s working age population (compared to the increase before the peak) declines in the savings rates are expected to be more gradual (barring a significant global economic shock).
In the recent past, more than half of the GDP growth, by some estimates, has been driven by productivity gains. While there is still plenty of room to improve productivity, the phase of easy gains accrued from the shift in labour—from agriculture to industry—will largely have subsided by 2015. From that point on, achieving incremental gains should be more difficult, and require further supply-side investments. It is also debatable whether capital productivity will rise enough to offset this slowdown, given that it requires financial sector reforms over a long period of time. Therefore, the GDP growth rate should most likely moderate after 2015.
Some market commentators worry that a combination of a peak in the working age population, a potential real estate bubble and high leverage will cause a shock. So how likely is a sharp GDP contraction and an accompanying drop in savings rate?
Japan’s savings rate did fall by almost four percentage points five years after the peak in its working age population. But in Japan, both its stock market and real estate market bubbles also peaked at the same time. Savings rates do tend to drop in the aftermath of these bubbles bursting. But in marked contrast to the frothy Japanese equity market of 1990, the Chinese equity market today is already truly deflated with a market capitalization-to-GDP ratio of 40% (vs. 140% in 2007). Also, for the past two years, the government has been actively trying to address the sharp price appreciation in certain segments of the property market through targeted policy measures. Even if a scenario mirroring that of Japan were to materialize, China’s savings rate would likely still be more than 45% by 2020, still very high by any measure.
The wild card in this equation is China’s currently high credit-to-GDP ratio. While China has successfully brought this ratio down in the past by slowing credit growth while growing GDP robustly, a repeat act might not be as easy given the likely moderation in GDP growth caused by anticipated demographic headwinds. As most of this debt is funded internally within China, however, any future deleveraging should be orderly (as long as the capital account remains tightly controlled).
Growing Rich While Ageing
By the time China’s dependency ratio bottoms in 2015, the country’s purchasing power parity per capita income would have reached only 40% of the per capita income that Japan and Korea achieved at a similar demographic juncture in their histories. Should this be the case, China will need to continue to invest in its capital stock. As we have previously written in Asia Insight, China’s net capital stock-to-GDP ratio is not excessive compared to other countries. Hence, China’s GDP composition will likely continue to be more skewed toward investment compared to its Asian peers.
Finally, China has at its disposal, the ability to engage levers such as relaxing the one-child policy and increasing the pension age to reduce the impact of adverse demographic trends on growth. But should these policies be changed, they will take time to bear fruit.
Barring an external shock that cripples China’s GDP growth, its inevitably moderating but still relatively high investment rate appears sustainable in light of the country’s ability to obtain funding via its savings. While demographic trends are turning unfavourable and leverage looks high, a dramatic economic slowdown, reminiscent of Japan, is neither preordained nor a foregone conclusion.
The likely moderation in China’s investment-led GDP growth in the medium-term will leave a set of winners and losers in its wake. Sectors such as health care, consumer services and production automation, which should benefit from the expected increase in health care spending, consumption and labour shortages respectively, might likely be in the winners’ camp. Investors should not lose sight of such long-term growth opportunities when considering China’s future.
Footnote 1: China’s High Savings Rate: myth and reality, Guonan Ma and Wang Yi, BIS, June 2010
Footnote 2: The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China, Shang-Jin Wei, Xiaobo Zhang, June 2009
The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein.
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