The two words that explain why China will overtake the US as the world’s largest economy

You can sum up the reason why China is no more than one or two decades from becoming the world’s largest economy in two words. And I say this despite reading a persuasive report that China’s rise to number one status is set to hit a rather substantial road block. The report I refer to overlooks these two key words.

Article updated: 5 July 2018 at 10:00am Author: Michael Baxter

China isn’t growing like it used to. That is common knowledge, but exactly how much has it slowed? That is difficult to answer, as the official data only seems to have the vaguest correlation with the truth.

Capital Economics has its own method of measuring growth in China’s GDP, which is produced by analysing data which is hard to fudge, such as electricity output and volumes of freight transport.

By that measure, China’s growth rate slowed to less than four per cent in 2015/16, and the sustainable growth rate is now between 4.5 and 5 per cent. Contrast that with the heady days when China was growing at 11 per cent plus.

If China can carry on expanding at the rate Capital Economics thinks is sustainable, then China will overtake the US as the largest economy in the world some time before 2030.

Doubts

But Capital Economics has its doubts, and fears that the sustainable growth rate may fall to around three per cent, meaning it won’t overtake the US until around 2050.

This is a big deal, the point when the US loses its position as the world’s largest economy is about as important to global politics as you can imagine.

And whether China grows at five or three per cent has important implications for investors too. If Capital Economics is right, funds that focus on China, for example, become less attractive.

It is just that I think it is wrong, and therefore investors with a longer-term horizon need to allocate a fair proportion of their portfolio towards Chinese funds.

Before I explain why I think this pessimistic projection for China is wrong, let’s explain the pessimism. You can sum it up in four words: Trump, debt, demographics, and Xi:

  • Trump: the threat of a trade war is serious, especially if the EU, Japan and Canada were to join China and declare trade war on the US. But the row between China and the US will not have such a great impact. In 2017, Chinese exports to the US were worth around 2.5 per cent of China’s GDP. So, even if the unthinkable happened and trade between China and the US ceased altogether, the hit on China would not be so drastic. The reality is that the trade spat will exert a cost on both economies, but the impact on China’s growth is not likely to be that great.
  • Debt: it is well known that China has a debt problem, although this is largely an internal problem - Chinese savings are high too. Interestingly, China’s non-financial sector debt to GDP seems to have stopped growing. Having jumped from around 130 per cent of GDP in 2009 to around 270 per cent a year or so ago, it has now hit something of a plateau. As Capital Economics said: “If it were simply to level off and remain there, that would be remarkable: credit booms don’t typically fizzle out with no impact on growth.” In fact, Capital Economics expects Chinese debt to carry on rising again soon. One of the issues with this is that the debt seems to be going into unproductive ventures, roads and shopping centres, even new cities, devoid of one important ingredient: people, or in the case of roads, people driving cars.
  • China’s demographic problems are well known too. It turns out that the lifting of the one child per family policy was less important that commonly realised. In 2009, the policy only affected 40 per cent of the population. In 2014, a two-child policy was introduced, this led to a sharp rise in the number of families with two children, but simultaneously, China has seen a decline in the number of new born first time babies. Capital Economics says: “This trend partly reflects women delaying childbirth rather than foregoing it altogether. Birth rates have declined rapidly for women in their 20s but are rising for older women. But delaying having a first child usually results in women having fewer children overall, a finding known as the ‘postponement effect’”. It concludes: “A sizeable demographic headwind is therefore all but inevitable over coming years, compounding the slowdown in economic growth that is likely as China’s investment-driven model runs out of steam.”
  • Xi Jinping: in a nutshell, the Chinese President is shifting policy away from the economy and towards the party and state. Mentions of the economy in Party Congress Reports has fallen dramatically in recent years while mentions of politics and party have risen. Up until recently, it was widely assumed that China would gradually migrate to an economic model that put more emphasis on private enterprise. But under President Xi, the opposite seems to be happening, meaning inefficient state enterprises are likely to play a bigger role within the Chinese economy than previously expected.

For all these reasons, Capital Economics projects that China’s growth rate is set to slow dramatically, extending the time when China overtakes the US.

Why wrong

I disagree. And I disagree because of two words: Artificial Intelligence. While the US President portrays the credentials of a Luddite, China embraces AI. It is widely thought that China will lead the US in AI within ten years.

Part of the problem is data. AI needs data, lots and lots of it. And lack of data is holding AI back. By contrast, in China, where privacy sensibilities are less extreme than in say the EU, data is becoming available at a faster rate, especially in healthcare, which may yet prove to be the sector that benefits most from AI at a time when healthcare emerges as perhaps the most important sector in the global economy.

Linked to AI, China is less held back by legacy in adopting new technology. Take hyperloop, the much-hyped transport system that uses magnetic levitation and sends pods through partial vacuums inside tubes. One Chinese company is advancing plans for 30 hyperloop lines. See China's looking to one-up Elon Musk's hyperloop, and seems to be ahead of US and European companies.

Because of technology, the way the economy operates, the way it produces goods, and the way healthcare is provided for is set to be transformed.

And while there are a lot of interesting European tech start-ups, and the giant US techs currently sit in poll position, China, with Alibaba and Tencent in the vanguard, will move into the lead. For that reason, I do indeed think this is China’s Century. The next decade will see the big changes take effect.

The Share Centre has a few preferred investments focused on China. Janus Henderson China Opportunities is in their Platinum 120 fund range. HSBC ETFS MSCI China is one of their preferred ETFs.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.