“ The multiple challenges China faces – exacerbated by demographics – are unparalleled in modern history ” Lake Geneva, July 2014
Abstract: Many observers expected a major Financial Crisis or Meltdown in China over the past 12 months. A fear Christian did not share. Extensive light has been shed lately on the Financial Sector, exposing a massive credit build-up, but with the unreliable data, it is hard to predict when the correction will take place. This report aims at adding value by analyzing the macro & external factors that are shaping the decision-making process in Beijing. The list is not conclusive, but we believe these are the most underestimated yet influential forces going forward. Among them demographics is probably the most misunderstood. Too much emphasis is placed on the aging process, and too little on simultaneous rapid deterioration of the labor force, dependency ratio (for elderly) and health care costs. China may be forced to support Consumption with massive direct and indirect subsidies, which in turn may be have to be financed by higher taxes. All of North East Asia (including Japan, South Korea and Taiwan) faces a dramatic demographic deterioration and deflationary forces.
Christian believes that the unfolding Financial Crisis will not undo China – it is rather the tremendous build-up of un-addressed macro imbalances overlapping with the global convergence of geopolitical forces that poses the greatest risk to China. While Beijing invested most of the cash of the “boom years” in prestigious projects, a massive military build-up, surveillance & public safety, she neglected to build a pension, health care and social security system to meet the demographic tsunami awaiting her after 2014. Demographics is highly complex and most studies are only scratching at the surface. Chinese experts are admitting in private that Beijing is simply too late to address the rapid demographic deterioration. The softening of the Strict One-Child Policy comes at least ten years too late. Young people can’t simply afford kids before securing support for their parents. Therefore we have attached a special report on it here. Bejing’s target of replacing investments & exports with private consumption is destined to fail. To save face Beijing will have to mobilize gigantic resources to support and subsidize private consumption (towards housing, elderly health care & services to) and adjust national statistics to support GDP growth. She will raise taxes, also on corporates. The problem for Beijing is that the simultaneous implosion of the workforce, explosion of elderly people and the impending correction of massive credit excesses work all in the same direction – they tend to shrink balance sheets and reinforce deflation. A balance sheet recession as Japan experienced is likely. A totalitarian state has nevertheless more choices than a democratic one: it can dictate what people read and influence behavior more directly.
Since the Labor Force has begun its implosion, Beijing may prove smarter than Tokyo in targeting “Nominal GDP per capita” or “Net Wealth per capita” instead of trying to maximize Real GDP Growth, a hopeless case. China has roughly ten years to overcome its Perfect Storm, re-engineer politically & economically and challenge the USA. Swift positive changes will take investors by surprise: to boost rural economic growth Beijing may give up harsh religious repression and revamp local governance. But domestic liberalization will accompany tougher Foreign Policy. From 2025 onwards the USA will enjoy several decades of enviable demographic tailwind, while China demographics will deteriorate further. With 5 times more clean Arable Land and Water Resources than China and less exposed to the Middle East for trade, the USA shall power ahead and distance China for the rest of the century. Nevertheless geopolitical trends are playing into China’s hands, and China’s increased geo-strategic proximity to Berlin and Moscow shows she is seizing the moment. With growing pressures at home Beijing might be forced to use external conflict and all geopolitical “weapons” at her disposal to catch up. In a nutshell: China is headed for significant changes domestically, but is likely to step up its assertive Foreign Policy. Most investors are pricing in continuity and peace.
Not only is China entering a highly challenging period internally: China’s neighbors are also facing historic challenges that will complicate China’s maneuvering room. With Japan’s Labor Force imploding since 1999 and showing all Asian neighbors what expects them (deflation and economic contraction), South Korea and Taiwan both face the implosion of their Labor Force in the near future and the further explosion of the number of elderly. Faced with the risk of economic stagnation and political unrest, they may rather opt for the German solution. South Korea may seek reuniting with the North to tap on the vast underutilized and slightly younger North Korean labor. Taiwan may embrace Mainland China to avert economic stagnation and political unrest. Given the accelerating military build-up in all these nations and their growing nationalistic and often violent hardliner movements, the geopolitical landscape in North-East Asia promises to be extremely complex and possibly mired with violence and political risks. A military conflict may as well pave the way for reunification. It is after all Asia, where national honor has to be served first.
The following Macro forces are converging over China – they are already beginning to affect Beijing’s policy mix and planning:
1. Demographics deteriorating rapidly – approaching crucial median age of 37 years – When the USA reached the age of 37 in 2007 it suffered a massive crisis. When Japan reached the age of 37 in 1989 it also suffered a massive crisis. China’s Labor Force is beginning to implode, just as the number of elderly is exploding – that massive gap will squeeze discretionary consumption and economic growth.
2. Asian Trade sheds light on China’s growth – it is deteriorating. Very few are connecting this deterioration of trade activity in Asia with the “Arms Race” (German: Wettrüsten) and growing tensions between Asian nations. The strong Military Build-Up and rise of Nationalism are beginning to affect FDI flows and Long-Term Potential Economic Growth in Asia.
3. China’s over-crowded Growth Model is no longer sustainable – too many populous economies are trying to export their way into prosperity
4. China is the most vulnerable economy to disruptions in Maritime Transport Safety and Middle East Security
5. Geopolitics – negative and positive forces are converging
6. China’s toughest Emerging Competitor yet: USA – it may come down to demographics and costs
7. De-Clustering: Manufacturing shifting away from China to regional hubs
Christian has analyzed most of these macro forces since 2009 (when Beijing embarked on aggressive money printing) in his personal geopolitical research and is putting a summary together. He has conducted also rather extensive Time Series Analysis and performed statistical analysis of demographic trends.
Christian concludes that not only China and Japan, but also South Korea, Taiwan and Thailand are facing rapid demographic deteriorations ahead. The markets seem to disregard this risk and are assuming the attitude that the problem is for next decade. Christian’s in-depth data analysis has convinced him the problem has already arrived for these nations. Thus, faced with growing economic pressures these Asian governments will increasingly deflect into Foreign Policy and Nationalism. Christian expects growing geopolitical and military tensions in the whole Orient: the Far East, South Asia and the Middle East. China’s GDP growth could decelerate to 5% over the next 3-4 years, unleashing currency depreciations and shifting more deflation to the West. Rather peaceful resolutions may lead only to unemployment and significant losses for stock investors & home owners. Less peaceful resolutions may involve full deflection into military conflict with neighboring nations. Something that would shock all the Western firms that shifted their manufacturing to East Asia, one of the most undemocratic and conflict-packed regions in the world. A region with a high number of unresolved simmering conflicts, where no nation yet has truly repented of former aggression to neighbors. Domestic unrest in China will be severe, but just like in Iran, it will be met with brutal repression while the West looks away.
Christian Takushi, Macro Economist MA UZH – 2014