Debt, not demographics, will determine the future of China’s economy

June 17, 2021, 10:30 PM UTC
Michael Pettis notes that “how well China responds to its worsening demographics will have more to do with how China’s economy adjusts from its investment-led growth model—and, primarily, how it adjusts its reliance on debt.”
Feng Kaihua—Xinhua/Getty Images

In May, Beijing belatedly released its latest 10-year census data, setting off warnings in China and abroad that the country was facing a demographic crisis. But the world may be misreading the implications of China’s population changes.

How well China responds to its worsening demographics will have more to do with how China’s economy adjusts from its investment-led growth model—and, primarily, how it adjusts its reliance on debt.

This doesn’t mean there won’t be direct demographic consequences. With China’s working population declining by 0.5% to 0.6% a year over the next several years, productivity growth per worker must be higher than it has been over the past two decades to achieve the same amount of GDP growth.

This matters when we project China’s long-term growth rates. Beijing announced last year that it expected to double China’s real GDP in the next 15 years. This requires average real GDP growth of 4.7% a year. Yet a declining working population means that China’s productivity per worker must increase at a faster rate: 5.2% to 5.3%, rather than the 4.5% it would have needed when the working population was still rising.

We can perhaps see these consequences more clearly by focusing on balance sheet implications. One advantage of a growing working population is that the amount of debt that must be supported by each worker automatically declines over time.

The opposite is true with a declining working population. Total debt in China represents at least 280% of China’s GDP, according to government figures. If China’s future GDP growth requires the same level of credit growth as it has in the past, then China’s debt-to-GDP ratio must rise to somewhere between 400% and 500%: an unprecedented level of debt, especially for a developing country.

Adjusting for a declining working population makes the numbers even worse. As the working population declines by 0.5% to 0.6% a year, the amount of debt per worker rises by an additional 2% to 3% of GDP every year.

These are bad numbers, but they do not in themselves represent a crisis. This is because China’s debt trajectory was already unsustainable, and the main impact of China’s adverse demographics will be to accelerate the adjustment. That is why China’s leadership must either resolve its overreliance on debt or—like most countries that have followed a similar growth model—be forced to do so in a way likely to be economically painful.

There are broadly speaking four ways China can “resolve” its rising debt burden.

The first—long promised by government officials—is to transform the economy away from the no-longer-productive infrastructure and property sectors. Although historically hard to execute, in principle redirecting funding into high-tech and other productive sectors allows investment growth to remain high without requiring even faster growth in debt.

The second—promised by China’s more sophisticated economic policymakers—is to replace declining investment with rising consumption to drive GDP growth. This effectively means sharply shrinking the government share of GDP and redirecting it to the household sector so as to allow China to maintain growth targets without the reliance on debt that is necessary to sustain current investment levels.

The third and fourth ways involve a collapse in GDP growth. One way would be for a very sharp—and presumably short-term—contraction in GDP driven by a financial crisis, although this is still unlikely in the case of China’s highly controlled financial system. The other would be a Japanese-style “lost” decade—or more—of very low growth as China slowly rebalances and struggles with its debt.

Unless we believe that China can allow its debt to rise at its current rate for many more years—which would be both unlikely and historically unprecedented—the four paths outlined above are logically the only ways in which the Chinese economy can adjust before it is derailed by debt. Each requires such a major transformation of the economy that it would outweigh the effect of its declining population on China’s economic future. In fact, the main effect of deteriorating demographics is to reduce the amount of time China has to address its debt, thus making an adjustment all the more urgent.

Anyone trying to predict the impact of China’s demographic changes on its economic evolution, in other words, will get it wholly wrong if they assume that the next 10 to 20 years of growth will look anything like the past 10 to 20 years. Because one way or another China will—voluntarily or involuntarily—transform its growth model, the demographic impact on China’s relative standing in the global economy will be almost wholly determined by the way in which it does.

China’s deteriorating demographics worsen an existing problem, but do not fundamentally change anything.

Michael Pettis is a finance professor at Peking University and a senior fellow at the Carnegie-Tsinghua Center in Beijing.

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