Paul Diggle: Hello and welcome to Macro Bytes economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

Luke Bartholomew: And I'm Luke Bartholomew, Senior Economist at abrdn.

Paul Diggle: This week we are talking about China. On the day we're recording this Premier Li Chang has just delivered his work report to China's ‘two sessions’ and announced a variety of economic targets and policies. Now, the Chinese economy has struggled somewhat over the past year and inflation has turned negative and there have been ongoing challenges in the property sector. But on the other hand, monetary and fiscal policy has been loosening with government support measures, most recently also trained on the equity market. And China did beat its 2023 growth target, in the end, expanding just over 5% on the official numbers. And over the long term, there are I think, plenty of both challenges and opportunities in China's future growth trajectory. So there's a lot to discuss. And we are joined by Robert Gilhooly, who is a Senior Emerging Market Economist here at abrdn, Welcome, Bob.

Robert Gilhooly: Thanks, Paul.

Paul Diggle: So Bob, hot off the press on the day we're recording this is that Chinese policymakers have announced the 2024 GDP growth target of around 5%. I think that was in line, maybe slightly above expectations. But what's your initial reaction to the target Bob? Is it realistic given what you're seeing in the Chinese economy?

Robert Gilhooly: Yeah, I mean, first of all, I think I agree with Premier Li Chang that this target will quote unquote, not be easy. And it's not actually the first time he's used this phrasing. Last year, he also said the 5% target wouldn't be easy. But given an exceptionally depressed 2022 with the zero COVID lockdowns, and then a very substantial kind of reopening bounce associated with the end of that, in fact, last year's target was exceptionally easy to achieve. And I think in that context 5.2% growth last year was pretty tepid.

I guess we have been somewhat on tenterhooks waiting for the rumored ultra-long government bond issuance. And that was in fact confirmed at the NPC this morning. So that's a 1 trillion renminbi package to fund strategic sectors and security capacity in key areas. I think this, you know, should keep fiscal policy moderately supportive. We've also got the Chinese version of a ‘cash for clunkers’ scheme for white goods, and electric vehicles, you know, maybe giving household consumption a little bit more support. But it's also the case that there's not really a kind of major step shift in policy being signaled. Little new information, for support for the beleaguered property sector. And you know, national security just continues to run through government policies and communications as a top priority. Military budgets are set to expand by 7% for the second year running, funding for science is going to rise by 10%. And with a specific aim of boosting self-reliance.

So, I think this all just kind of implies a more targeted policy approach, still incremental, you know, the policy bazooka that everyone in markets keeps hoping and wishing for, I think, has been firmly retired. And, you know, with this set of policies, I think it's still going to be quite hard to turn around economic market sentiment.

Paul Diggle: So as you say, there, Bob, part of China's disappointment post-reopening has been the drag from the real estate sector, which of course, is a considerable part of the Chinese economy and has faced a number of headwinds. Could you put some figures on the size of the real estate adjustment? How far through that process we might be?

Robert Gilhooly: Yes. Look it's been quite amazing how far some of the key real estate metrics particularly those on the kind of pipeline of activity have fallen since the three red lines kicked off real estate de-risking at the start of 2021. I mean, if I was to pick one key measure, so new starts, and that's essentially new building projects that have had ground broken - those are down a pretty staggering 70% since early 2021, so feel free to insert your own mind-blowing emoji there. And how you judge the adjustment overall, I think just depends really what you think fundamental demand is, and this is quite a difficult one overall to have much confidence on.

The good news, relatively speaking, anyway, is that you know, Chinese population might have started to fall in absolute terms in 2022. But I don't think that signals an impending collapse in fundamental housing demand. Urbanization is incomplete, there should still be some scope to upgrade housing stocks - knocking down some of those old buildings and rebuilding. And even if there are kind of concerns about excess vacancies particularly in the lower tier cities, I don't think it's the case that China's housing stock is complete and doesn't need any more new building. You can get this by thinking about kind of demographic shifts. Here it's the composition that matters as much if not more than the total moves. So, if you think about household formation in kind of five-year age buckets, well, actually, demographic change still gives you this sort of reasonable batting average effect, such as the change in population composition should be driving household formation, adding, you know, sort of roughly about 4 million households or so each year.

And that’s still a lot lower than what it used to be, but it's not nothing. So now, assuming vacancies can be kind of held, roughly, as is, I think that would imply the flow of housing, the adjustment of the flow of housing, is actually around about 90% done in terms of what we need to see to get that back to what we would consider a kind of fundamental or underlying demand. Now, fortunately, you know, given lags between kind of construction, and fixed asset investment within national accounts, would probably put that at around about only two-thirds of the adjustment being done in terms of the drag on investment and GDP. The remaining drag, thankfully, best guess that's probably still going to weigh on growth by around about one-quarter percent over the next year or two. And that kind of thing helps explain why we're, you know, we're a bit below consensus on our growth forecast. And you know, we're a bit skeptical that a 5% growth target for this year is actually going to be hit.

Luke Bartholomew: So, on top of those real estate challenges, there are concerns that China faces other structural headwinds to its long-term growth potential around demographics, albeit nuanced, I think, by some of those composition points that you were making there, Bob, and then crucially, around productivity. Indeed, weak productivity growth, has moved up the agenda of policymakers recently. So I wondered why has productivity performance been slowing over time, and in particular, it's been poor post-pandemic, I mean, it does stand somewhat in contrast with the recent US performance. So what is going on there in China?

Robert Gilhooly: Yeah, China’s certainly bucking that global trend, or the US trend. I mean, if we consider productivity over the last 25 years, so taking longer sweep first before we get into this post-pandemic, stagnation. We can think of it as kind of three phrases informing how we think about productivity. So in the first phase, China’s integration into the global economy shortly before and after its accession to the WTO. This involved massive sectoral reallocation of workers from low-productivity, low-wage jobs in agriculture, to higher-productivity jobs in manufacturing, and services. This was helped by large-scale infrastructure investment, which kind of had a positive externality effect of just making it easier to do business when you've got better roads, rail communications, and transportation links as well.

And simultaneously, the printer private sector was allowed to take a much larger role in the economy, foreign investment was bringing in better business practices. So this all was just kind of helping resources flow to more efficient uses. And that kept productivity growth in that kind of golden age of growth, exceptionally high. In the second phase, and think of that as post-GFC to pandemic, productivity growth slowed very notably. In part, I think some of this reflects some of those kind of easy gains having been used up, but I think it also reflects a degree of capital misallocation beginning to build in the system. You know, there was this credit bazooka launched after the global financial crisis to counter the drag on the Chinese economy. I don't think all of that went to very productive uses. And then we actually also saw a kind of more statist approach emerge as President Xi took office, the leeway enjoyed by the private sector really began to kind of diminish over this period. And that's continued into the post-pandemic period too. The third phase, post-pandemic you know, this is I think, the most concerning one. Now you should know, first of all, it's quite hard to disentangle this, we need to be mindful of productivities inferred rather than directly measured, but our estimates of total factor productivity imply near stalling since the end of 2020. And that is very alarming to say the least.

Now, as we're just kind of discussing, it does seem likely to me that in transitioning from a real estate sector to one that's going to be more state-dominated probably will weigh on growth for some time to come given these kinds of substantial upstream and downstream linkages. You add on to that China's relatively late move to endemic living, which probably negatively impacted household and corporate expectations by the need to self-insure You know, unlike the massive fiscal transfers that US households enjoyed, there was very little to no support given to Chinese households. And finally, you know, just national security, as I said, at the start, just continues to move up the policy agenda. And I think this kind of secondary kind of the state trying to insure against geopolitical pressures, probably also necessitates kind of moving down the efficiency to resilience spectrum. So I think the kind of trillion dollar RMB question is really kind of whether Chinese productivity is actually going to bounce back. I think, you know, are these headwinds to productivity going to fade as we kind of normalize, or is it going to be something much more protracted that's really going to weigh on Chinese growth, and therefore the global economy, for a much longer period to come.

Luke Bartholomew: And then it is worth saying, outside of those headwinds to productivity and the uncertainty around those questions that you laid out, there are, of course, still considerable tailwinds that have allowed Chinese growth to be in an absolute sense, you know, very high, on a global basis or on a historical basis. So what do you see as the key engines of Chinese growth over the medium-term?

Robert Gilhooly: Yeah. Look, I mean, it's certainly harder to appeal to what you kind of consider the more traditional engines of growth - those things that powered some of the Chinese productivity, you know, infrastructure investment that has been so rapid. I think the scope there from major projects to drive growth has surely fallen. I think, you know, Chinese policy is kind of pushing infrastructure investment into kind of areas where you don't get that kind of positive externality effect. You know, you've built all the kind of roads and rail you largely need. You’re kind of pushed into more unglamorous infrastructure projects. You know, if you have to redo Beijing sewers, that doesn't provide much of a long-lasting boost to the economy's productive capacity in the same way that kind of building road or rail or airports might do. Similarly, you know, China’s probably been hitting up into the limits of export-led development strategy, just given its sheer size and the global economy. And as you said, look, some of these engines of growth aren't out of gas, yet. Scope for sectoral reallocation does remain. China's share of workers and agriculture remains, I think, roughly where you’d expect it to be actually given China's stage of development.

So similarly, you know, while we have concerns about property, urbanization has also got a bit of a bit of room to run. As you know, workers can move out of out of agriculture and more into city jobs. And even if the workforce is falling, you can still swap quantity for quality. Returns to education and skills should help offset some of the near-term drag on the labour forces as that's declining. And China has shown some ability to tap into new growth engines. China dominates green investment production, some products such as solar, its electric vehicle production has absolutely surged over the last three years. China just overtook Japan as the world's largest exporter of autos. And then if you look at some other kind of less tangible indicators, China does do quite well on several measures of innovation, particularly related to kind of STEM, which should be positive for productivity. So to name a few, China’s R&D spending is second only to the US. China's triadic patent application - so these are ones that need to be approved by the US, Europe and Japan – and that's a pretty high bar - you know, those have risen quite notably over the last 10-years or so. They've overtaken that of manufacturing powerhouse Germany. Chinese academic research now actually, you know, comprises more than a quarter of the world's top 1% most frequently-cited scientific papers.

So, you know, they are I think some positives there around kind of innovation and science that we shouldn't ignore. And, you know, as I said before, there's a lot to be concerned about, but I think a more balanced assessment needs to consider why China has maybe been so resilient to date, and therefore kind of whether some of these aspects of hidden strength and resilience could persist.

Paul Diggle: Well, let's turn Bob from the activity picture to inflation prices then because inflation has of course, been negative in China. Now some of that reflects, I think, cyclical economic weakness, overcapacity in the pork market specifically, but people do worry as well about a possible deeper Japanification of the Chinese economy. Do you think that kind of concern is justified or maybe a related concern that China might be heading into the so called ‘middle income trap’?

Robert Gilhooly: Yeah, I don't think it's a surprise. The comparisons with Japan are pretty obvious aside from the obvious around falling population and real estate risks. Obviously, Japan had a lot of tensions with the US on trade policy as well. And then when your policy continues to favor this kind of incremental supply-side biassed approach which could risk embedding deflation in a more permanent manner. And I think it's hard to fully rule this out, particularly over the longer term. But there are reasons to think that this Japanification, or the Japanification risks are overstated, both in terms of how the channels could operate and also of the immediacy. I don't really see it as a very near-term risk myself now. So thinking about the channels a bit more. Deflation becoming ingrained could be fairly damaging for the Chinese economy. Your real interest rates will be pushed up, weighing on economic growth. This could potentially set the stage for a balance sheet recession, in which the state is struggling to offset a private sector retrenchment.

And given some concerns about the fiscal position the China authorities may be a bit loath to loosen fiscal policy - to the extent really needed to turn the economy around. But even if this nominal backdrop feels somewhat risky, particularly over the medium to long term, you know Japan was an advanced economy, not an emerging market, when its bubble burst at the end of the 1980s. China's low levels of GDP per capita, I think, still imply a large potential for catch-up growth difficult to achieve, but that potential is still very much there. I think this should reduce the risk that real growth steps down to the same degree, as was the case in Japan's slide into its lost decades. Your Chinese policymakers are also quite aware of the Japanese experience, which I think is worth noting. State-owned banks remain a very powerful lever to shore up lending within China, bad loans can be carved out by the asset management companies as they've done in the past. They did that in the late 90s.

And then you know, China’s relatively closed capital account and trade surplus I think also removes this kind of risk of sudden stop capital flight dynamics that could really squeeze the economy more forcefully. Put simply, if money's effectively trapped within China, you do have a bit more policy wiggle room to go there.

Paul Diggle: And then given this, this growth in inflation backdrop we’ve been talking about then Bob, of course, stimulus has been gradually stepping up, and I think a big part of the Chinese macro story is the push and pull of the macro headwinds. On the other hand, increasingly accommodative monetary and fiscal policy. How stimulative of this is the stance of Chinese policy? And indeed, in an economy where there are so many levers, how do we even measure that? I mean, I know that this week, we've seen more in the way of easing announcements. Are we likely to get to a point at which policy stimulus is more than offsetting the growth headwinds?

Robert Gilhooly: Yeah, it's always a really tough call to judge the policy stance in China, even in a backward-looking sense. As you said, lots of policy levers are being pulled at any one point in time. Which ones are the primary instruments being used tends to vary. I think there's good reason to expect that the impact of different policy levers also changes over time, reflecting structural change in the economy, and also change in the way financial markets run. You know, financial markets have become much deeper, more efficient and advanced over time too. Now our preferred approach is to summarize using principal component analysis for our China Financial Conditions Index.

This has, I think, some advantages, in that it puts a bit more emphasis on the combined outputs or end results rather than just taking the policy variables at face value. Now, our Financial Conditions Index actually implies that this plethora of small, incremental policy easing measures has been adding up and has been gaining traction. And we estimate that the current financial conditions have been pushed into a kind of position of, it's not great, but modest accommodation over the course of 2023 and into 2024. So that policy backdrop, I do think is adding up and should be providing more support to the economy. Our modelling also suggests that there could be around an eight-month lag from the loosening to the peak impact on activity. You know, we've had pretty decent government bond issuance over the last five months. This should help build on some of the recent economic momentum and probably negate some of the downside risks too.

Luke Bartholomew: So another thing that policymakers have recently become concerned about is the weakness of the Chinese stock market. So I wanted to ask a little bit about the role and the importance of the stock market to the to the Chinese economy. I mean, we often talk in the US and developed markets of he importance of equity markets as part of broader financial conditions. They have an impact on growth through wealth effect if they’re a large vehicle for savings in many households, have a role through sentiment that, you know, they're an easy barometer for some people to latch on to as a measure of how well the economy is performing. Whether that's true or not, I guess is quite different to whether it has a sentiment effect, which it tends to, and then, of course, as an important source of capital for firms as well. But I'm not sure if any of those factors are quite as strong in China as a savings vehicle or as a vehicle to raise finance. So what is the relationship between the stock market and the economy in China? And why are policymakers become so concerned about it recently?

Robert Gilhooly: Yeah, I mean, look, take the latter part quite quickly, they don't like see big falls, where this kind of instance of sub-structure products, which are called snowball derivative contracts. They unwound, as the stock market continued to fall, and this generated a very sharp fall, particularly within the SME small-cap equity index. The authorities never like a sharply declining equity market just for financial stability reasons or fear that it triggers even larger falls. So, they did intervene. And those markets are back up. They're still down very substantially off their peaks, but I think that fear of financial stability risks or contagion has largely passed. But going back to your more fundamental question, you know, I’d say there’s a fairly, if not very, weak relationship between the stock market and economy in both directions. I mean, first of all, much more household wealth is tied up in property in China, compared to other major economies. So perhaps double the share - compared to the US. And reflecting this tilt towards property - exposure to equities is correspondingly quite limited. And then lastly, I think there's this political economy dynamic. The authorities don't want to risk financial stability, condoning this crash, as we kind of mentioned before, but allowing a stock market boom doesn't really fit in with their de-risking agenda, either. I think they got quite burnt during 2015 and 16, when there was a very rapid spike, and then deflation of the stock market bubble, and in a sort of Communist Party in shock indifference to capitalism, I reckon they'd actually just rather have firms raising money through the state-dominated banking system, which can help alight landing with strategic industries rather than necessarily using the equity market as a kind of primary channel for firms to raise money.

Luke Bartholomew: And then, of course, finally, there is a US presidential election looming later this year with potentially quite significant impacts on China. So two questions, Bob. So first, what is the current state of US China relations, there seems to have been something of an improvement a bit of a thawing recently, but that is still in the context, perhaps of a wider structural deterioration. And then secondly, what would ‘Trump 2.0’ to coin a phrase, mean for the Chinese economy?

Robert Gilhooly: Yeah, I think I think it would be fair to say there has been some stabilisation in the US-China relationship. Both sides certainly have put in some effort to stop that kind of freefall over the last year. Taiwan elections, perhaps the kind of dog that didn't bark. In this case, there was no reaction to the quote-unquote unofficial US delegation trip to Taipei. But you know, he could compare that to a very substantial show of military force when Speaker Pelosi visited in 2022. And I think that could speak to a desire to hold on to some of the progress made in repairing the dialogue between the US and China. But you know markets also have short memories. It was only 13 months ago when the US shot down a Chinese alleged spy balloon or meteorological balloon. I think that's a good illustration of the dynamic which swings between relative optimism and kind of maybe extreme pessimism about the US-China relationship. I think one can still argue national security, concerns about trade, growing Chinese economic might all probably push for a kind of ongoing deterioration in the relationship. And then there's Trump, as you mentioned. It seems highly likely, I think, the Biden ‘small-yard high fence’ national security approach would be jettisoned under Trump 2.0. Across the board tariffs, you know, perhaps this morphing into a kind of ‘large-yard’ protectionist strategy. Trump can do an awful lot tariff-wise without congressional approval to trade and US-China relations are an area where other political forces in the US just don't act as a check in the same way they might do on domestic policy setting. And, you know, a ‘tough-on-China’ line is fairly bipartisan anyway.

So ‘even if they could push back would they?’ is a kind of open question. In terms of the impact on the Chinese economy, you know, an interesting feature of Trump 1.0 tariffs was that it pushed down on the Chinese currency, almost one-for-one with the rise in the weighted average tariff rate. So we could see some very substantial downward pressure on the renminbi which would maybe mitigate some of the shock on the Chinese economy.

That said, you know, FDI is already fallen very notably. And a kind of Trump's shock, which could include actions beyond just tariffs, this time round could certainly amplify these reshoring pressures, perhaps creating a longer drag on the economy. The depreciation, frankly, won't do very much to offset at all. So this kind of severe decoupling scenario could potentially also push the Chinese authorities further down the efficiency/resilience spectrum, probably amplifying the negative impact over the medium to long term too. So I'm not very optimistic on what Trump, the second round, could mean for China.

Luke Bartholomew: All right, well, I think that will be the note on which we leave it for today. As ever, please do like, review and subscribe wherever you prefer to get your podcasts and then all that remains is for me to thank Bob for joining us today and to thank you all for listening. So thanks very much, and see you again soon.