Thirty years of constant growth is making it difficult for China to transform an economy too reliant on investment and exports. Maybe a crisis will help.
China’s economy has grown on average by around 10% per year for the past 30 years, and it is predicted to surpass United States as the world’s largest economy within the next two decades. This impressive growth has not gone unnoticed by investors. However, China is facing many challenges; currency valuations, an overreliance on fixed-asset investments, and a real estate bubble all have investors wondering if China’s long streak of growth is coming to an end.
To get a sense of the state of the Chinese economy, where it’s headed, and what it will mean to investors, we invited Zhiwu Chen, a Yale professor of finance, to participate in this issue’s Morningstar Conversation. Chen, the author of nine books on China, is one of the world’s foremost scholars on the Chinese economy and investment markets. Our discussion took place on Oct. 24 and has been edited for clarity and length.
Peng Chen: Let’s talk about the long term. We’re seeing a number of organizations predicting that China economically will soon overtake the United States as the world leader. What do you see? Do you agree with these predictions?
Zhiwu Chen: For the most part, all these predictions and analyses assume that some steady growth rate will go on forever without any setbacks. Clearly, such an assumption is hardly supportable. There was a book titled Finance in China published in 1913 in Shanghai, just before the First World War and right after the end of the Qing Dynasty in China. It predicted that China would take over the West, because China had a much larger population than all the Western countries combined and because labor was much cheaper than it was in the West. Then, with the same aptitude for imitation that the Chinese population was known for at that time, media commentators and economists made the same prediction—that pretty soon after 1913, China would take over the West. But, of course, after 1913, we know what happened: the First World War, then China was invaded by Japan, the Second World War, the civil war in China that went on for many years, and then the Cultural Revolution.
I’m not saying that this time the prediction will be proved totally wrong. Instead, what I’m saying is that first of all, we cannot linearly extrapolate the past 30 years of economic growth into the next 30 or 50 years. The past 30 years of growth has taken place because of some historical reasons, but those historical reasons will not necessarily give China another 30 years of growth.
I think the next 30 years may look more like the following. Within the next five to 10 years, there will be some significant financial/ economic crisis that will set Chinese economic growth back. The total size of the Chinese economy will be dented. But that will set the stage for major institutional, political, and privatization reforms, and such reforms are really necessary to prepare China for another two decades of steady, but not as fast, growth rates.
So, it may take until 2027–28 for the Chinese economy to exceed the U.S. economy based on purchasing power parity. But in nominal terms, it may have to wait until 2049–50 for China really to catch up with the United States in terms of economic size.
Unless there are major revolutions in China, it will be inevitable that the size of the Chinese economy will exceed the U.S. economy. The reason is not based on the past 30 years of growth experience in China. Rather, it’s the very long-term trend of correlation between population size and GDP size. In the 17th century, roughly speaking, there was a 98% to 99% correlation between a country’s population size and economic size. By 1820, the correlation was still high at 97%. But by 1870, roughly one century after the Industrial Revolution started in England, the correlation dropped to 83%. In 1950, the correlation dropped to 39%, and during the peak of the Cold War period, 1970–73, the correlation between population size and economic size reached a bottom of about 35%. But in the late 1970s, China started opening up and conducting reforms, and then pretty soon after that, in the 1980s, many countries all around the world started privatization and reforms and so on. As a result, the correlation between population size and economic size reversed its direction. It’s now about 62%.