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The Road to Recovery

by Mable-Ann Chang

October 29, 2021

Economist and author George Magnus, looks at China’s falling birth rate and the future of the economy post COVID-19

George Magnus is an independent economist and commentator, as well as a Research Associate at the China Centre, Oxford University, and at the School of Oriental and African Studies in London. He is the author of The Age of Aging which assesses one of the world’s leading contemporary economic and social challenges, and of Uprising: will emerging markets shape or shake the world economy?, which considers the rise of and prospects for emerging markets, especially China.

George Magnus has enjoyed a ringside view of the world-changing events of recent decades that have challenged governments, economies and financial systems around the world. The former Chief Economist of UBS, Magnus is widely credited with having identified the triggers that led to the Financial Crisis of 2008 and helped us understand its lingering consequences.

In this interview, Magnus discusses the impact of the huge COVID-related stimulus injections around the world, China’s debt burden and other problems that China’s economy is facing.

Q. You have studied aging populations and even written a book on this topic. China recently released its latest census results, showing a sharp fall in birth rate. What would be your sense of China’s demographic situation?
A. I don’t think the recent census was a huge shock, but it did remind us that China’s fertility rate at 1.3 (births per woman) is lower than we thought it was and that China is aging much faster than the high-speed trajectory we already built into projections. Introducing a three-child policy or lifting all restrictions on the number of children would be like chasing shadows. We know of no empirical cases where countries have succeeded in reversing weak fertility with statements, gimmicks or even cash.

With weak fertility—and rising life expectancy—the economic problem about aging is the squeeze on the size of the working age population. This started to fall in China in 2012, and will continue to do so relentlessly for the foreseeable future. It will fall about 1% per year, and take roughly that amount off potential growth. But it is also likely to mess with affordability of public pensions and healthcare, as well as with the financial and perhaps physical well-being of China’s retirees. China is already a low spender on age-related spending (in relation to GDP), compared to, say, peer countries and developed economies.

China’s task is to evolve coping mechanisms to act as offsets to the economic consequences. These comprise of immigration, higher participation rates for women and older citizens in the labor force via higher retirement ages and better childcare and higher productivity. Not all of these work for China, but the country certainly needs to work harder at those that do.

Q. The indications are that many young people are just not interested in having more than one child despite the relaxation of rules. What’s the reason for that and what can the government do about it?
A. It is no secret that rising income per capita is probably the most effective form of contraception that mankind has, and China is no exception. It’s a global phenomenon with higher income raising the opportunity cost of having children, and fertility rates holding up only in poorer countries. There are always country-specific factors, of course, and in China’s case, these include the high cost of education, the patchy availability of readily accessible and affordable childcare, and the additional upward pressure on home costs in preferred school districts in some cities.

It’s ironic that among OECD countries, those with higher fertility rates also tend to have high female labor force participation, better child care infrastructure and availability. Consequently, the Chinese government would be better advised to focus on education, childcare and women’s lifestyle and work choices to try and arrest the fall or reverse the trend in fertility.

Q. The pandemic has fundamentally changed the world in many ways. What would be your sense of how it has impacted China, its economy and its position in the world?
A. Leaving to one side the public health consequences, I suspect most people would judge that the pandemic’s biggest and most enduring effects have been to accelerate lifestyle and work style changes that were already in the pipeline, and to torpedo what was already a fractious relationship with the US and other liberal leaning democracies (LLDs), including, of course, India and Japan in Asia.

It’s certainly true that opinion about how to manage relations with China in LLDs is divided and that antagonists and protagonists of engagement are also using China relations to fight other political battles. As a result of all this, I think China now faces an external environment that’s as bad as most people can recall. This will be a hindrance to China’s economy and will get in the way of the change needed to reboot its development model. Moreover, while it might prove difficult to disentangle much of the economic integration that has been accomplished over the last 30 years, I think we will see more pushback against China in the global system.

The impact on the economy is a good news/bad news story. The good news was that by last spring, China had pretty much suppressed COVID-19, and the economy came back with speed, opening up through year-end and into 2021, save for periodic outbreaks of infection in the northeast early on this year and recently further south. The huge setback to consumption in 2020 which took the already low consumption share of GDP back to where it was in 2010, has been partially reversed this year, and the extra credit creation growth accepted last year has been pretty much unwound so far in 2021.

However, there is not much evidence, once you set aside the economic noise of the pandemic, that the economy is in a radically different place from where it was before the pandemic. In other words, it is slowing down again, partly due to official attempts to clamp down on egregious risk-taking and on private firms, but overwhelmingly because of the deadweight of excessive debt, poor demographics and stalled productivity growth. There’s little sign of a willingness to embrace education, economic and social reforms while the government maintains a sternly Leninist, supply side, and production focus on managing the economy.

Q. The pandemic has resulted in huge stimulus injections into most major economies. What is your view on the prospects for inflation and also on the ability of central banks in the West and in China to handle the consequences of such massive stimulus injections?
A. The pace of the bounce-back, highest in China first but now in the US and some other parts of the world, is certainly creating some demand pressure which is running ahead of supply responses in many markets, including commodities, shipping and semiconductors, and pushing up inflation. There are, though, also constrained supply factors at work, too, arising from trade friction, constrained foreign investment, and supply chain recalibration, all in the context of exceptionally easy fiscal and monetary policies. The current inflation scare may not yet represent a regime change, but is likely to persist for a while, and could potentially become longer-lasting.

Politicians will be slow to withdraw fiscal stimulus, but central banks, which have seemed to be similarly reluctant to upset the apple cart, may continue to send out warnings to the markets that no one should expect the status quo to last for too long. The question is how long is too long. We might start to see a shift by early 2022. China seems to be ahead of the pack, clearly signaling an unwillingness to keep policies too easy for too long.

Q. China’s overall debt levels are high, but the risk of a resultant crisis seems to be significantly lower than in a Western economy. What do you think of this?
A. Because China’s financial system is almost entirely state-owned and no major banks will be allowed to fail, I don’t see China’s debt problem ending up in a sort of Lehman moment. China’s debt is both owned by and owed to domestic institutions in their own currency. Domestic debt problems are still problems: Debt has to be paid for one way or another, and stressed balance sheets have to be restructured or unwound. Shadow banking loans and liabilities have been the target of policymakers, but much of these have moved back on-balance sheet where they are at least more visible, it should be said.

Several smaller banks and Huarong, one of the asset management companies created after the 1990s banking crisis, have gotten into trouble and needed capital, bailouts or other assistance. The funding structure of the liabilities of hundreds of smaller and regional banks is quite tenuous and will be highly sensitive to any sign of higher interest rates and or reduced liquidity.

So while China may not have a spectacular financial crisis as we saw in 2008-2009, the burden of debt will be felt though reduced lending growth, higher default risks as, for example, the authorities try to loosen the system of implicit guarantees, and liquidity issues among smaller lenders. All of these things will weigh on loan and economic growth in the coming decade as balance sheets have to be brought back into better shape.

Q. The Chinese economy is doing remarkably well, but what problems do you see on the horizon?
A. The economy is certainly doing well when you look at annual growth in GDP, but last year makes for an easy comparison. As 2021 matures, the year over year effects get harder. So for this year, I think the economy will grow by about 7-7.5%, but by 2022 and after I think the economy will be back onto a slowing trajectory due to pre-existing structural headwinds. Debt is the most pressing constraint on growth, especially if the government stays the course in trying to constrain its growth. Poor demographics is another which is more medium-term, as is stalled productivity, which may well be the most important problem to resolve for China, as for many others.

Many economists, inside and outside of China, agree that China’s development model needs a makeover, but the government seems unwilling to embark on the kind of reforms that would promote a more consumption and services-oriented economy in contrast to the current investment-heavy model. There are also serious shortfalls in educational attainment and skill formation which, at best, might take a generation to address, if the will and the financing were both available.

Q. China’s financial markets have opened up to foreign investment firms quite substantially in the past couple of years. How do you see the role of foreign investment banks and other financial institutions developing in the China market?
A. It is easy to see why foreign, especially US, financial firms want to build up their businesses in China, and why China has been especially welcoming to these firms. They bring capital, especially US dollars, to China, along with knowhow and expertise in areas in which Chinese financial firms are relatively weak, for example, investment banking, wealth management, capital market intermediation.

Until now, foreign financial firms have certainly been active in China but without really upsetting the natural order of things where domestic firms dominate, and without raising their share of total deposits or funds under management. It’ll be interesting therefore to see if and how this changes in the future. But there’s no question that foreign financials can now do things that were previously out of bounds, and it suits China in important ways to be able to show that whatever foreign politicians say, foreign finance firms are committed to China.

Both sides surely want this to continue, but we shall have to see how far politics allows it to. For example, to the extent that foreign financials are funding coal-fired energy capacity and development, how will shareholders and investors back home take this on board? There are wider ESG issues that may become problematic, along with the risk that foreign firms may become compromised if forced to choose between abiding by incompatible regulations and rules.

Q. Many economists are of the view that China’s centralized approach provides an opportunity for continued strong growth in the years ahead. Would you agree?
A. I honestly think centralized governance systems such as that which China is embedding are more likely to hold growth back than promote it. We have no empirical evidence of any nation with, shall we say, central control that has succeeded in escaping the so-called middle-income trap, and attaining the type of income per head which describes the richer members of the OECD. This is not to say that China might not be the first, but the odds are stacked firmly against.

For that to happen, China would have to use and exploit its centralized system to overcome the hurdles that I have referred to here. In other words, to clean up the debt system, so that balance sheet freedoms are restored; to develop coping mechanisms for aging; to embrace the kind of demand-side and supply-oriented reforms of institutions that would result in higher productivity growth; to evolve true innovation which is basically about business efficiencies, and better management and organization and rollout of new technologies to the humdrum parts of the economy; to address the need for higher education attainment levels for workers; and so on.

These all require root-and-branch reform and opening up, stronger redistribution and social welfare policies, changes in the tax code, local government fiscal responsibilities, hukou (China’s household registration system), state-owned enterprises (SOEs) and so on. Many reforms potentially entail political and institutional changes, which China currently looks set to move further away from, not nearer.

Q. The story of China’s economic growth over the past four decades involves a delicate balance between SOEs, private enterprises and multinational corporations. What is your sense of the current balance and the trends of that balance?
A. It seems that for all the rhetoric that is designed to make the private sector feel better, China’s priorities are firmly to support and back state enterprises and the party’s presence in private sector boardrooms and operational management one way or another. SOEs are widely seen as being favored even more in the future, with the government looking to them to steer China toward the party’s lofty and ambitious goals in technology and overall economic performance. A significant number of foreign firms in China see the politicization of business in China, with the CCP and its agencies in the driving seat, as a worrying development in the future.

China is certainly attempting to bring more certainty to business in China by passing new laws or strengthening judicial treatment, for example as these apply to intellectual property, cybersecurity, and foreign investment. Yet, the law and the legal system are nevertheless party-centric, and foreign firms see little change in things they have long complained about such as market access, negative lists, opaque licensing and approval procedures, unequal treatment, and compelled technology transfer.

The current year’s major private enterprise event so far, the take-down of Jack Ma, and the crackdown on Alibaba and other Chinese tech and data-centric firms, suggests that life for private entrepreneurs and their firms is not set to get any easier.

Interview by Mable-Ann Chang

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