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China powered much of the world’s economic growth over the last four decades. Today, its own economy faces considerable challenges. In a wide-ranging conversation, Qian Wang, Vanguard’s chief Asia-Pacific economist and global head of the Vanguard Capital Markets Model (VCMM), and Grant Feng, a Vanguard senior economist, discuss potential economic and investment implications and why China is not the next Japan.
Why is China’s economy struggling?
Wang: The pent-up demand, especially for services, that was unleashed earlier this year when China reopened its economy after extended COVID-19 lockdowns faded quickly. The weak fundamentals and the structural headwinds we’ve discussed in the past are causing the economy to grow much more slowly than we previously expected. Tremendous economic uncertainty is constraining not only households but the private sector too. Despite this backdrop, policymakers are hesitant to forcefully stimulate the economy given debt levels that have grown steadily in the last decade. Overinvestment in the property sector has led to increased debt loads, not only among private developers but also among households and local governments.
What have policymakers done to support the economy?
Wang: Policy stimulus has been focused on cutting interest rates, making it less expensive to borrow. But right now, the bigger issues are weak fundamentals and weak confidence. Chinese households have had three years of low income growth, and unlike COVID policies in much of the developed world, there has been limited government income and employment support. Housing prices have declined sharply alongside deep challenges in the property development sector; the decline is especially significant as 60% to 70% of household wealth is in real estate, based on our estimates. Household debt has risen sharply over the last 10 years and the labor market is weak. So, one, people don’t have money, and two, they don’t have confidence about the future. So even if the cost of capital is low, they don’t want to borrow. There is no credit demand.
Feng: Both business and consumer confidence is low. The average household’s debt-to-income ratio has exceeded that of their U.S. counterparts, based on our estimates. Local governments, which in the past have borrowed and spent money on infrastructure to stimulate the economy, are constrained by property values that have fallen the last two years, so they don’t have the resources or incentive to invest further. Given this backdrop, the effectiveness of any monetary policy easing will be discounted.
China’s debt ratio has increased significantly
Sources: Vanguard calculations, using data from CEIC and Wind through March 31, 2023.
How has China supported the economy historically?
Wang: China has long favored production and investment, instead of directly stimulating near-term consumer demand through consumption vouchers or providing consumers with cash, because once it’s gone, it’s gone. But this approach can bring an unintended consequence.
In the U.S., for example, the focus is spurring consumer consumption and the consequence is inflation. In China, with an emphasis on production and investment, the consequence has been overcapacity and an increased potential for deflation, which in fact occurred in July, when broad consumer prices fell compared with a year earlier.
Feng: China has in essence exported deflation to the rest of the world. Since it joined the World Trade Organization in 2001, China’s export price inflation has hovered around zero, which has helped keep down import prices for other countries. So far this year, the reopening of China’s economy has been a key force of global goods disinflation, given the country’s significant build-up of inventory and production capacity during the pandemic, notable renminbi depreciation, and weak demand for goods from Western consumers.
China has been exporting deflation to the rest of the world
Sources: Vanguard calculations, using data from the People’s Bank of China, China’s General Administration of Customs, the U.S. Bureau of Labor Statistics, and Eurostat through July 31, 2023.
Wang: Inflation in general could have been far greater if it wasn’t for the overcapacity and deflationary pressures in China. We expect this tailwind for the global economy to continue in coming quarters.
What is the likelihood that China will follow the experience of 1990s Japan?
Wang: When you compare the demographics, the real estate market, the financial risks, yes there are similarities to Japan, where economic growth stagnated for three decades after its equity and real estate bubbles burst. The chance of a Japan-style stagnation is elevated in China.
Though some recent high-profile developer defaults are worrisome, we’d highlight a key difference between China and Japan. China has a very strong central government that will do what it takes to avoid a Minsky moment.1 It will likely be a three-step process: One, China maintains strict capital controls; two, the central bank continues to inject liquidity into banks, most of which are state-owned; and three, banks continue to roll over companies’ debt, minimizing the prospect of a systemic crisis.
Feng: China has been proactive in containing potential spillover, helping to ensure near-term stability. But this could come at the expense of efficiency. Some property developers may exist only to continue to pay interest on their debt. This would weigh on productivity growth and broad economic performance, raising the risk of stagnation in the long term. The property sector will likely remain a drag on the economy in the medium term, rather than the growth engine it once was.
Wang: I should add that there is another big difference from Japan. China still has a huge domestic market, notwithstanding what’s going on with real estate. Foreign direct investment did plunge to a 26-year low in the second quarter of this year, but companies from Europe and some emerging market countries are still investing because they see untapped opportunities, particularly on the consumption and services side. 2
What are the implications for investors?
Wang: Our research shows that the long-term equity market outlook has zero correlation with long-term economic growth. Macro views do not necessarily translate to future expected returns. If we all expect that the economy will grow more slowly in the future, that has already been priced into the market.
Valuations for China are depressed right now because they have priced in not only lower long-term growth but also policy risk, financial risk, and geopolitical risk, which are significant. Though further downside is possible, at this level the median of our projected range for annualized returns over the next 10 years for Chinese equities is greater than 8%.
1 Named after economist Hyman Minsky, the “Minsky moment” refers to a market collapse after an unsustainable speculative bubble fueled by accumulation of debt. The collapse of Lehman Brothers and the ensuing global financial crisis is an oft-cited Minsky moment.
2 Based on CEIC data as of June 30, 2023.
• Our investment and economic outlook (article, published August 2023)
• At its core, why inflation still matters (article, published August 2023)
• China´s consumers to the rescue (commentary, published February 2023)
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IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk–return trade-offs, and the diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered, such as the data presented in this paper, is the most effective way to use VCMM output.
The VCMM seeks to represent the uncertainty in the forecast by generating a wide range of potential outcomes. It is important to recognize that the VCMM does not impose “normality” on the return distributions, but rather is influenced by the so-called fat tails and skewness in the empirical distribution of modeled asset-class returns. Within the range of outcomes, individual experiences can be quite different, underscoring the varied nature of potential future paths. Indeed, this is a key reason why we approach asset-return outlooks in a distributional framework.