By Adriaan Pask, CIO at PSG Wealth

For decades, China has been the driving force behind global economic growth. Population growth and cheap labour, combined with government spending on infrastructure and large quantities of exports to the rest of the world served as major growth drivers. But in recent years, China has transitioned from relying on excessive government spending for economic growth to prioritising consumer spending. However, concerns have emerged regarding the sustainability of its rapid economic expansion, especially considering the high levels of debt (particularly amongst corporates and local government) and deteriorating demographics.​

Although government debt is consistent with patterns observed globally in the aftermath of the pandemic, the alarming part is their corporate debt now stands at more than 150% of China’s GDP. ​ In addition, household wealth in China sits latent in its property values – a sector that is currently facing material development debt issues. ​On the demographic front, the labour market is ageing, resulting in reduced labour force participation, while productivity levels appear to be on a downtrend. Youth unemployment in China is yet another eyesore, having increased by 4.60% since the beginning of 2023, while the country recorded its first population drop in six decades in 2022. Research suggests that if the situation deteriorates further, China’s population could go from the current 1.4 billion, to 488 million by 2100. ​All of these factors pose challenges to the country’s growth story over the longer term, but also to that of its key trading partners and global economic growth​.

Chinese debt as a percentage of GDP

Source: Bank for International Settlements

Investors were previously willing to look past the risks to the Chinese economy because their booming middle-class population, combined with economic modernisation, development, and diversification were thought to be able to bulldoze over challenges on the road to super-economy status​. However, population reduction and declining productivity are not easy challenges to overcome. These issues compromise the core of the initial investment case for China, which was premised on very high levels of economic growth for decades to come due to scale advantages.​

Economic failure in China also has repercussions for the global economy.​ China currently constitutes approximately 18.80% of global GDP (PPP adjusted in dollars), and its projected share of global growth in 2023 is 34.90. Where will the enhanced growth, and more importantly the coinciding demand, come from if not from China?

Given these risks, it is unsurprising that Chinese stocks have sold off, down 40% since April 2021.​ Over this period, the price of iron has also halved, albeit off a very high base at $220 per ton, which provides an idea of the severe impact on commodity exporters if Chinese demand deteriorates. ​In addition, their real estate sector sold off aggressively - down 80% since peaking in May 2021 - considering the material risk of debt default, and the anticipated increase in bankruptcies.

There is no doubt that both risks and opportunities exist in China’s case, but identifying risks is the easy part. The more important and challenging component is figuring out what the likely impact could be down the road.​ The market seems to suggest that a debt crisis is not unlikely. Typically, these events can set back markets north of 40%. But if Chinese equities have already fallen by 40%, and their real estate sector is down by about 80% from its prior peak, is the risk not reflected in the price already? ​

If a broader debt event is to unfold, naturally, markets will sell off, but therein lies the opportunity. Markets always recover and most of the pain is almost always already priced in.​ But what about the demographics? Let’s focus on population decline to try and contextualise the numbers. The average mortality rate in China is about 0.74%. Thus, an equivalent birth rate is required to maintain population size. China’s current birth rate is only 0.68%, hence the decline in population size. For the population to fall to 488 million by 2100, it would need to decline by 1.40% per annum over the next 77 years. To offset this decline a population growth of 1.41% would be needed each year, combined with increased consumer or government spending, inflation, exports, tax cuts or accommodative policies to counterbalance the negative effects.​

China’s population is likely to fall below a billion people before 2100

Source: Pew Research Center

It seems that a significant amount of negative information has already been considered when determining prices. As a result, there is a lack of confidence in both the economy and businesses, thereby preventing any adjustments or improvements to future forecasts. Consequently, this manifests as reduced stock prices, which investors are seeing today. Perhaps the biggest challenge with China is the unpredictable nature of its investment case.

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