China’s dimming growth outlook and the end of the Golden Age - Capital Economics
The Chief Economist’s Note

China’s dimming growth outlook and the end of the Golden Age

Clouds are continuing to gather over the outlook for China’s economy. We’ve argued elsewhere that a slowdown in China won’t derail recoveries in other major economies. But there will be significant consequences for China itself and for investors there. We explored these in detail in a webinar last week. (Recording here.) 

There are three strands to the challenges now facing China: one that’s macro related, one that’s policy related and one that’s virus related. 

On the macro front, our proprietary measure of Chinese growth – the China Activity Proxy – is starting to show the first signs that China’s economy is slowing. As we’ve noted before, context is crucial – a slowdown in growth was always likely given the economy had been operating above its trend level of output since late last year. But the slowdown is a reminder that China’s long-term growth challenges haven’t gone away. And it provides a weaker economic backdrop against which other concerns are now playing out. 

Foremost among those is a growing unease about Beijing’s commitment to open and free capital markets. This follows a clampdown on the private education sector that sent the equity market into a tailspin in the last week of July, which was itself preceded by a crackdown on the ride-hailing firm, Didi, and has been followed by reports of measures targeting online gaming firms. 

The market has since recouped some of its losses, thanks in part to official reassurances and rumours of buying by the ‘National Team’, a group of state-owned financial institutions known to step in and support the domestic stock market during bouts of heavy selling. But these events underline the political risk associated with investing in China and the leadership’s ambivalence towards markets. Indeed, in many ways Beijing’s heavy-handed intervention in key sectors and China’s weakening long-run growth outlook are two sides of the same coin and get to the heart of the structural challenges facing the economy.

If all of that wasn’t enough, coronavirus infections in China have risen to their highest level since January, caused by the spread of the Delta variant. Mass testing and quarantines are being implemented in places with confirmed infections, and some provinces have responded by reintroducing travel restrictions. 

Virus numbers are still very low compared to other countries. But the spread of the Delta variant calls into question China’s ‘zero-COVID’ approach. Whereas most governments are now starting to acknowledge that we are likely to have to live with the coronavirus for the long term, China’s ambition remains to keep it out of the country altogether. That will be difficult if it can spread easily among a highly-vaccinated population. 

Without a shift in approach, this suggests that China will have to continue with occasional local lockdowns and restrictions on movement. This in turn will prevent a full return to pre-pandemic norms of consumer and business behaviour, and is likely to mean that restrictions on foreign travel remain in place for some time to come. 

A combination of slowing growth, deepening policy concerns and recurrent flare-ups in the virus is likely to make for difficult terrain for investors. We have argued for some time that Chinese equities will deliver lower returns than equities in other major markets over the next two years. The events of the past few weeks reinforce the case for underperformance. 

Investors can take some comfort from the fact that the turbulence in Chinese equities over the past few weeks has had few spillovers to markets in other countries. But this could yet change. The potential for problems in highly-indebted sectors such as property to develop in ways that have unintended and systemic consequences for China’s financial system remain a key tail-risk that would have implications for markets elsewhere. 

There is a larger point here, however, which is that the economic prospects for China – and indeed for other large emerging markets – have soured in a way that few thought likely only a few years ago. Five years ago this October we published a piece arguing that the golden era for emerging economies was over, and that they had entered a period of structurally weaker growth. 

Back then, the consensus thought that EMs would continue to grow on average at 5–6% a year. We argued that 3.5–4.0% would instead become the norm. Since then, EM growth has averaged 4% a year (excluding 2020, which was affected by the pandemic) and returns on EM equities have been half those of their DM counterparts. We’ll be revisiting our End of a Golden Era analysis on our EM service over the coming months. But many of the structural headwinds that we anticipated five years ago have already begun to build – and there’s so far little sign of policymakers changing course.

In case you missed it:

  • Our Senior EM Economist, Shilan Shah, assesses how the rapid spread of the Delta variant could hit tourism in emerging economies.
  • Our Senior US Economist, Andrew Hunter, looks at how President Biden could reshape the Fed.
  • Finally, as we await publication later today of the report by the UN’s Intergovernmental Panel on Climate Change, a reminder that tackling global warming doesn’t mean sacrificing economic growth. Read more here and here.