China: The Next $10 Trillion Economy
Andy Xie (Hong Kong)
Summary and Conclusion
In 2000, the US economy crossed the US$10 trillion mark while the Chinese economy hit US$1 trillion. A further four economies are bigger than China's. However, we believe that China will be the next economy to reach US$10 trillion in today's dollar terms. It will probably take place within two decades and could happen in 15 years.
The key we see to China's rapid growth is aggressive restructuring to improve capital allocation efficiency and to remove institutional barriers to growth. We believe that China's restructuring is real and is greatly facilitated by the application of IT. We believe China can realize its full potential from its scale, high savings rate and low base in an unfettered growth environment.
The Basis for Takeoff
China's development in the past 20 years is widely judged a great success. We share this view. Real GDP has risen by 468% and per capita income quadrupled since 1981. However, the past two decades did not represent China's takeoff period, when the way is paved for a low-income economy to join the ranks of middle-income economies. Rapid growth in the past depended to a significant extent on a cheap currency. In 1981 dollar terms, China's economy has merely doubled, which, of course, would reflect the cheap currency approach to generating growth.
China's labor cost is extraordinarily low. But China has still had to cheapen its currency to achieve rapid growth. This is the price that had to be paid for China's gradualist approach to reform. Chinese gradualism is essentially a special economic zone (SEZ) approach, which gives more economic freedom to certain areas, sectors or investors. Often, such SEZs grew at the expense of the economy as a whole through the arbitrage of differences in incentives between the SEZs and the rest of the economy. This is why financial successes in certain areas are often viewed as somewhat dubious.
The SEZ approach magnifies inefficiencies in the economy, escalating the cost for carrying the system. Rapid economic growth was necessary because of the failure to revamp the economy; hence, a cheap currency was used to inflate exports and generate nominal growth to keep the inefficient economy afloat.
We argued repeatedly during 1997-98 that this approach was not sustainable for two reasons: First, the inefficient economy was leveraging export income into low-quality investments funded by debt. The balance sheet trouble was slowing investment, causing widespread deflation. Second, the economy was too large to be sustained by a cheap currency alone.
The Chinese government reached a similar conclusion in early 1999 and decided to join the WTO to impose a reform agenda on the country. We turned positive on China's prospects at that time and emphasized the importance of China's WTO membership. Using globalization to impose reform has worked even better than we expected. We believe that it is now time to upgrade our view on China's prospects and to raise substantially the probability that a takeoff to a middle-income economy is about to occur.
The Case for Convergence
Solow's growth model describes capital deepening as the main reason for convergence, i.e., moving toward middle-income economy status. From an income flow perspective, this model describes high returns on capital in an economy without much capital. Such a condition increases the incentive for people to postpone consumption and increase savings for investment. Capital markets, hence, naturally support convergence.
In reality, however, convergence has been the exception rather than the norm. Most developing economies have not converged (see "Emerging Versus Converging Markets"). The US and Japan are the most important convergence stories in the past 150 years. The four small economies in East Asia, Hong Kong, Korea, Singapore and Taiwan, are also relevant stories. In all of these cases, globalization, rather than domestic demand, was the most important reason for convergence. European capital played a critical role in America's capital deepening. Rapid export growth and forced high savings were the main reasons for the rapid convergence of Japan, Singapore and Korea. Hong Kong grew rich mainly on China's economic distortions.
The low-base effect should be more powerful in a globalization context. Arbitrage activities in goods trading should magnify returns in low-cost economies and attract foreign capital to accelerate capital deepening. Sadly, the so-called cost of doing business eliminates the benefit of low cost on capital returns in most developing countries. The most important factor is, of course, corruption. A related factor is the lack of infrastructure. These two factors feed on each other and keep most countries poor.
In addition to a low base, China has two other favorable factors for convergence: scale and a high savings rate. The advantage of scale is related to infrastructure. One notable feature for China is its ability to put infrastructure in place. China's infrastructure is making a critical transition from patchy regional developments to integrated national networks. This should substantially reduce the cost of doing business.
A high savings rate reduces the cost of capital and makes capital deepening an easier proposition. This is likely to remain the case for the foreseeable future. China's high savings rate derives from two peculiar features. First, when China switched to a more market-led development strategy two decades ago, the household sector started out with zero wealth. Second, China's demographics are heavily influenced by the one-child policy that it has pursued for two decades. The labor force will represent a high share of the population for the next two decades.
The Path to a Middle-Income Economy by 2020
The best definition of convergence, in our view, is high economic growth accompanied by real currency appreciation for a decade or more. Poor countries need undervalued currencies to offset structural inefficiencies and the high demand for jobs. When restructuring has removed most inefficiencies and the employment rate is sufficiently high, a developing economy will become a converging economy. During 1955-74, Japan's economy expanded by 9.7 times in 1955 dollars; real currency appreciation accounted for half of the increase. During 1960-1989, Taiwan's economy expanded by 6.4 times in constant dollars, one-third of which came from real currency appreciation. Korea's economy expanded by 6.8 times during 1970-89 in constant dollars, half of which came from real currency appreciation.
China is likely to experience an even faster rate of convergence during 2005-2020 for two reasons. First, the scale factor was not present in Taiwan or Korea. Even Japan did not have the same scale. The network effect from infrastructure is about to take place. Second, the gradualist approach in China's transition to a market economy required an even greater undervaluation of the currency to pay for the inefficiencies. The real currency appreciation should also be greater as a result.
Exhibit 2
Comparison of PPP and US$ Exchange Rates
Ratio of PPP to Per Capita Population
$ Ex. Rate (98) Income ($, 99) (million)
Brazil 73 4,420 168
China 24 780 1,250
Indonesia 39 580 207
Hong Kong 110 23,648 7
Japan 151 32,230 127
Korea 83 8,686 47
US 100 30,600 273
Source: The World Bank
We see three possible scenarios.
(1) China does not restructure aggressively and has to continue to depend on a cheap currency and a high investment rate for growth. The low base should sustain about 7% growth for the foreseeable future. Currency appreciation is limited to improving the employment situation only. We see 3% real appreciation per annum beyond 2005. By 2025, we estimate China's currency will trade at 43% of the PPP value and GDP will pass US$10 trillion in 2000 dollar terms.
(2) China sticks with its WTO commitments and transits to a market economy by 2005. FDI and asset sales support economic growth at 7% during restructuring. During 2006-15, China reaps the benefit of a higher efficiency level and grows at 9%. The currency appreciates by 7% in real terms during this period. The economy slows to 7% and the currency appreciates by 3% a year in real terms during 2016-20. China's economy reaches US$10 trillion in 2000 dollars by 2020 or US$6,700 per capita. Its currency will trade at 53% of its PPP value by that time, still below the average for economies at such a level of per capita income today.
(3) China moves more aggressively on its restructuring than what the WTO framework dictates for internal and external reasons. The global community puts pressure on China to conform to global norms quickly, as China's size makes its trading partners anxious. Furthermore, systemic problems at home convince the government that the only solution is to separate the economy from the government to the maximum extent possible. During 2006-15, China grows by 10% a year on a combination of high efficiency and low base. The economy slows to 7% during 2016-20. The currency appreciates more quickly by 10% a year during 2006-15. China passes the US$10 trillion mark in 2000 dollar by 2015. Its currency would trade at 59% of its PPP value at that time.
We believe that there is a high probability that the optimistic scenario could unfold. We see the key driver as the ongoing personnel changes as the country's management passes to the next generation. If the new leaders are strongly pro-reform and capable, the optimistic scenario becomes likely.
Sharing the Upside with the World
The rise of a large economy like China's is not just an economic event. It has significant geopolitical implications and could not take place without an alignment of global interests on China's development. We see just such a scenario for the next two decades.
The world economy experienced rapid growth after WWII. The sources of demand were mainly reconstruction in Europe and Japan until the end of the 1970s. The restructuring of the US and relocation of manufacturing jobs to developing countries created growth through income and wealth effects. Falling prices of tradable goods improved the purchasing power of American consumers, which in turn boosted the profitability of US-based service companies. This caused US asset prices to appreciate and boosted consumption further from the wealth effect. This phase of growth is probably coming to an end. At most, the Fed can sustain it for one or two more years by talking up asset prices.
Global companies are used to earnings growth that is faster than GDP growth. The world economy may not be able to sustain such a trend. China comes quite conveniently into this picture. The wealth that can be created in China is quite staggering. The wealth to GDP ratio is probably around 1.5 now. When its economy reaches US$10 trillion, the wealth to GDP ratio should reach a more normal 4. This implies that China could generate US$38.5 trillion in today's dollars in 15-20 years.
China evidently understands the need to share its upside with the global community to align global interests for its development. Joining the WTO is one practical step. Multinationals already control about 10% of China's economy, the highest among all major economies. This ratio could hit 20% in five years, if we just extrapolate the current trend. This implies that China approximately wants to share 20% of its upside with multinationals, or US$7.7 trillion in 15-20 years. This is probably a sufficient incentive for the world to support China's development.
The Bear Cases
China has disappointed many times before. The last two decades are exceptions rather than the norm in China's attempt to modernize over the past one and a half centuries. A short period of success is often followed by disasters that last longer. This time is different, in our view.
Most bear scenarios for China fall into four categories: (1) social instability, (2) corruption, (3) damage to the environment, and (4) containment by the West. The risks associated with all these factors look substantially lower than some expect.
Social instability usually takes place in China in the following circumstances: famine, external conflicts and struggle over power succession. China has accumulated sufficient capital that its economy is unlikely to suffer catastrophic decline. Exports are now US$250 billion. Unless the world goes into depression, China would not have a famine. It seems clear that the government is trying to minimize the risks of external conflicts by pursuing agreements on border disputes and achieving considerable success. The current leadership succession appears to be taking place peacefully. The next success cycle is at least five years. By then, reforms should have made the economy more independent of the political system.
Corruption is the most serious issue that blocks development everywhere. It has been a serious problem in China also but has not yet blocked development. China's response to corruption is to launch political campaigns that raise fear among the officialdom. This approach has its downside but is usually effective. IT may be the best weapon against corruption. China is building a national tax system based on the use of IT. This cuts out layers of bureaucrats that come between the central government and taxpayers. This is a milestone in China's fight against corruption. The use of IT should spread further to other government functions. IT is such a powerful tool that sheds light in so many previously dark areas in the economy that corruption may become a marginal issue in China over the next decade.
Harm has been inflicted on China's environment at an unprecedented speed. In just two decades, China has managed to turn a large chunk of densely populated areas into the most polluted in the world. However, the public response has also been equally dramatic. There is essentially no country at China's income level that is so focused on containing the deterioration of the environment. In our view, the worst is over.
Containment by the West is certainly a possibility but would not be a high probability unless China makes a mistake that frightens the West. As long as China shares a big part of its upside with the global community, interests should remain aligned to support growth.
Two Milestones by 2005
What do we think should investors look for as indications that the above structural bull case is unfolding? First and foremost, China must join the WTO. Joining has been delayed for several reasons. The markets clearly expect it to happen soon. We agree.
The next milestone is the separation of businesses and government. The government is taking the first step in that direction; large industries are corporatized and listed on the stock exchanges in Hong Kong or Shanghai. These capital markets now have some disciplinary effect on such companies. To complete the process, the government should sell down its stakes as soon as possible and allow independent boards to choose their management.
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