China's long-term growth outlook is solid, but there will be rocky times along the way. Figuring out when those rocky times will hit is difficult. Businesses involved in China for the long term can be confident of economic growth, but the company that needs strong sales in one particular year is much less certain.
In this article we'll look at the drivers of China's long-term growth, then address the short-term challenges. I'm not a China expert, but the country is important to some of my clients so I take an outsider's view of the statistics and stories coming from the country.
First, though, let's address the question of whether we spend too much time talking about China. China is the second largest economy in the world and the United States' second-largest export destination. Many commodity-based economies have risen in recent years with China's growth. Moreover, China's opportunities and challenges are similar to what other emerging countries are facing, so it's a bellwether for a larger group of countries.
China's long-term growth story is fairly simple. In the late 1970s, Zhou Enlai (Chou En Lai) enacted reforms to allow farmers to cultivate family plots rather than communal farms. He tolerated small entrepreneurs. A migration from poor rural areas to cities with opportunities was ignored though it was illegal. These reforms substantially raised the productivity of poor people in the country. Foreign investment followed, further increasing productivity. Trade with other countries increased, again tolerated by the government. In short, economic reforms allowed poor people to become more productive, and they earned rising incomes.
This story won't go on forever, but there's substantial room for further gains. China ranks 93rd in the world on GDP per capita, indicating substantial room for improvement. China's per capita output would have to grow by 32 percent just to match the current world average. It would have to more than triple to equal the European average. There's no reason China won't eventually get close to the output level of the developed world. That will drive above-average growth rates for many years.
The Economist has noted a decline in the number of Chinese who are of working age, caused by the one child policy. The policy began in 1979, so the first wave of only-children is now 35 years old, about halfway through their working years. The Economist calls the phenomenon "peak toil," but it is less relevant to China than to a developed country such as Japan. In China, increased productivity of existing workers is the huge force, while growth of the total labor force is a relatively small factor.
Although the long-term outlook is positive, the country's transitions create stumbling blocks. Environmental concerns are one major issue. By some reports, some domestic coal and iron ore is not being used because it's too dirty; instead, steel and coal are imported. Factories are expected to clean themselves up, with short-term adjustment costs.
The mix between exports and domestic consumption is another short-term issue. Early on, the great surge of output was for international markets. Rising incomes have caused a growing consumption economy, and the transition is not totally smooth.
With rising incomes have come rising real estate prices, leading to a housing boom. Some analysts anticipate a hard landing from the boom, but so far it's been fairly soft. However, this is another transition that presents an obstacle to a smooth path for the Chinese economy.
Rising wages have also caused a loss of some of the substantial cost advantage that China has had, with additional loss from the rising foreign exchange rate. Some American companies are "re-shoring" their operations. Costs are still lower in China, especially for labor-intensive work, but lower costs don't always cover higher transportation costs, quality monitoring costs and the economic loss from a longer supply chain.
Chinese consumers are increasingly concerned about the quality of the products they buy, especially after the 2008 contaminated milk scandal. This concern is strongest in food products, but also extends across all locally made products, including apparel and kitchen gadgets. Local companies producing for the local market, however, are used to cutting corners. Chinese companies that produce high quality exports for the likes of Apple are not producing much for their own market. Eventually, companies will match their production to the quality that consumers are willing to buy, but the transition is likely to be ragged.
China's political leaders understand, or at least give lip service, to the need for further structural reforms, especially in credit allocation. The first default on a bond issue in the country is actually good news in this regard, indicating that problems will not always be swept under the rug. Political leaders have also begun an anti-corruption campaign, which sounds like foxes guarding the chicken coops. Altogether too much cronyism occurs in the nation's political-economic decisions.
An economy is not really about aggregates such as gross domestic product or industrial production. Actual goods and services are produced and sold to particular consumers, businesses and government departments. A smoothly-functioning economy gets the right goods produced and sold at the right prices. A good economy also adjusts the composition of output to reflect changes in tastes, technology and materials costs. However, the more changes that need to be made, the harder it is to get all of the production and consumption decisions right. China has many changes to make. Their economic system still has too much cronyism and protection of state enterprises, which slow down adjustments.
China is likely to have a pronounced slump in the next few years-but a temporary slump. Continued smooth growth is simply too much to hope for in a somewhat-clumsy economy subject to numerous major transitions.
When this slump occurs is impossible to predict. As in the United States, some analysts are always bearish and some always bullish. It's unlikely that anyone will switch from bull to bear at exactly the right time.
The IMF predicts very gradual deceleration in the coming years, and that's a fine forecast-if nothing goes wrong. My advice is to plan for long-term growth, but also do contingency planning for a sharp, short-lived recession sometime in the next few years. Just when it will occur, however, I cannot say.