On China and the importance of scale

The sight of hundreds of millions of Chinese New Year travellers this week reminds us that one thing that distinguishes China is its vast scale.  China’s population is the largest in the world (for the moment), and China’s GDP will likely overtake the US in the foreseeable future (and has already on a PPP basis).

China is already shaking the world. China accounts for one third of global GDP growth and about 10% of world trade. China’s rise has had disruptive effects on labour markets, inflation outcomes, and competitive positions in countries around the world.  And China’s trade deficit with the US, which reached a record $400b in the year to December 2017, is a lightning rod for the Trump Administration’s trade policy.  In geopolitics, China is using its economic and strategic muscle to squeeze smaller countries, from Norway to South Korea; the BRI is a mixture of economic and geopolitical motivations; and there are increasingly evident areas of strategic competition between China and the West.

So far, so obvious.  But China’s scale also has implications for understanding its economic behaviour and performance.  Regular readers will know that my primary focus is on small advanced economies.  One key insight from this analysis is that small economies are not simply scaled-down versions of large economies: the Dutch or New Zealand economies have quite different dynamics and policy options than Germany or the US.

This principle also works in reverse, and can provide a perspective on China’s economy.  One of the difficulties with understanding China is that its scale makes it sui generis.  This limits the usefulness of the international experience to form a view on China’s economic outlook.  It does not mean that economic laws of gravity are suspended in China, but China’s mass means that they can behave differently.  Things can go on for longer than might be expected based on international experience.

There are many good reasons to be concerned about the Chinese economy: the risks in China’s financial system and housing markets, the distortions in capital allocation, as well as China’s shrinking working age population. But many of these concerns have been valid for some time, and yet betting against China has mostly been a losing trade.

Perhaps a national scale framing provides a useful perspective.  China is not a scaled-up version of Japan or the US, two economies that are frequently used as comparators.  This doesn’t mean that the international experience is irrelevant, but it suggests that international comparisons should be drawn carefully.  With apologies to Oscar Wilde, there are important consequences to being enormous.

Take China’s rapidly growing levels of non-financial sector debt (over 250% of GDP according to the BIS, which the IMF expects to grow to 290% by 2022). This is about the same level as Japan’s prior to the bursting of the bubble and the prolonged period of economic stagnation that followed.  Japan’s experience is a cautionary tale, but China’s GDP is over 2x that of Japan in USD terms (4x in PPP terms).  This scale difference matters (there is a reason that capital markets sanction small economy public debt more sharply than larger economy debt).  Economic scale and momentum cover a multitude of economic sins, at least temporarily, and of course China has many more policy levers than other advanced economies.

Similarly, China’s scale gives more scope to its investment-led model, trying to build leading positions in a very wide range of areas from manufacturing to the digital economy.  It can exploit its domestic scale, and then use exports as a ‘vent for surplus’ to address over-capacity problems.  Indeed, for a large economy, China has a very high export share: at 20% of GDP, higher than the US (12%) and Japan (16%).  And China’s mercantilist behaviour, expressed through the Made in China 2025 Plan and the BRI, suggests that this will continue.

This development path is increasingly divergent from other Asian economies.  China’s manufacturing share is relatively stable at high levels, with no evidence of the ‘premature deindustrialisation’ that is evident elsewhere in Asian emerging markets.  China’s scale and momentum may mean that the middle income trap exerts less of a hold on it.

Small economies are well-used to looking at the economic behaviours of larger countries (the US, France) and assessing their policies to be unsustainable.  But their scale gives them options that small countries do not have: they can run large fiscal deficits, with poorly designed policies, and still function.  Similarly, super-sized China may have additional degrees of freedom relative to large economies like the US or Japan.  China’s economic policy approach may be costly and inefficient, but it may be less fragile than we think.

However, the absence of guardrails and market disciplines – combined with China’s increasingly centralised political system – means that there is also a meaningful chance of excess; what US diplomat George Kennan once called ‘the hubris of inordinate size’.  This means that if (when) things go wrong, they could go very wrong because of the accumulation of problems. There are, of course, several examples of this in China’s economic and political history.

So perhaps one implication of taking China’s scale seriously is that the probability distribution on China’s outlook should be drawn with fat tails at both ends.  In any case, China will shake the world in a way that few other countries have.