China's Great Growth Insecurity
China’s economy may be 60% smaller than we first thought.
A recent paper by Luis Martinez from the University of Chicago has found that the elasticity differs greatly between democratic and autocratic countries. By examining the correlation between GDP growth and Night Time Lights and then comparing a nation's ranking in the Freedom World index, Martinez found that authoritarian regimes are likely to overestimate their GDP growth figures by up to 35%.
This means that if an autocratic nation reported a growth rate of 1.35%, according to the paper, its actual growth rate is at 1.0%. As such, years and years of these statistical errors can compound to create an incredibly false image regarding GDP, and, China has been found to be one of these significant culprits. Dr Joeri Schasfoort from Money and Macro had taken the work of Martinez and extrapolated China’s growth to 2021 and he found that China’s economy may be 60% smaller than we first thought.
But how reliable is this claim? 60% is a very big number and should it be true, China’s debt-to-GDP ratio will swell from 71.5% to a whopping 120%. This would spell danger for the Chinese economy for more than one reason. First, China has enough empty housing space to fill 400,000 football pitches. That's 2.85 billion square metres of empty space.
Second, for an economy with a large demand for housing, this wouldn’t be a problem, but China is different. Poor demographics and home-ownership rates of 90% with 87% owning a second property mean that there is massive supply and demand misalignment in the Chinese real estate market. Yet, despite this excess supply, Chinese real estate remains strong and residential floor space grew by an extra 20% in 2018 - the fastest growth since 2010.
At the same time, with house prices rising sixfold in Chinese ‘tier-one’ cities since 2002, the data points towards a bubble. So, should it pop due to overstated GDP figures, the Chinese economy would be in trouble. Housing plays a large part in the Chinese economy, accounting for 78% of all assets and 28% of all loans in financial institutions. As such, it is estimated that due to the backwards and forward linkages the real-estate market provides to other sectors such as construction, transport, and banking, a 20% decline in activity would equate to a 5-10% fall in Chinese GDP. In the worst-case scenario, this would equate to a fall in the UK GDP of almost 3%.
We sat down with Paul Temperton, an ex-Bank of England and Merril Lynch Economist and current Founder of TIER Company, an Economics consultancy firm working with banks such as EFG & Invesco to ask his take on the issue. “There is definitely a huge amount of physical infrastructure that has been built. This adds directly to GDP growth now but (some of it) also provides the basis for future growth. China’s transport infrastructure is far superior to that of other emerging economies, for example.”
“The major downside of this infrastructure build is that some of it is ‘roads to nowhere and ‘ghost cities. Even worse, it has been financed by debt which is now clearly at risk of defaults. Indeed, that would be my major concern: that the debt workout will take a long time.”
Whether or not this bubble pops depends on two factors; China’s domestic stability, and, whether or not the economy is actually 60% smaller. The former, domestic stability, seems quite strong. China’s housing is usually protected by down payments of more than 35%, making many mortgages protected. The latter can be questioned, however, there is some more supporting evidence.
For instance, China’s provinces frequently set growth targets. If these are not met, those leading the provinces will likely be hit with the sack. As such, there is a bottom-up incentive for officials to distort GDP figures to stay in office and keep their powerful positions. Another argument supporting China overstating its GDP figures is the Li Keqiang Index. This is an index made by ex-CCP Premier, Li Keqiang who came out criticising Chinese GDP
figures due to them being man-made. Instead, Li Keqiang preferred to predict growth by examining the growth in rail freight cargo, electricity consumption, and real loans.
As shown above, the index is much more volatile as opposed to official figures. However, the index itself does not necessarily show that China overstates its figures. First, the Li Keqiang index mainly focuses on heavy industry, which is what Li Keqiang focused on when managing his province. Second, the index has a heavy correlation with commodities, meaning any global shocks to these sectors can heavily distort performance.
Moreover, when the Li Keqiang index is weighted accordingly to make loans account for 50%, it is actually found China could be understating its GDP. So, which one actually is it? Well, it could be argued that rather than focusing on China underestimating or overstating its GDP, we should look at how it is streamlined instead. China’s GDP tends to be ‘smoothed’ reduced during upturns and inflated during downturns to make GDP growth more stable there is strong evidence for this.
However, Martinez’s paper still has a very strong case. It accounts for various factors such as demographics, geography, and even stages of development. Even when considering all of these, the results still point to the same conclusion. As such, it may very well be the case that the Chinese economy is smaller, maybe not by 60%, but, smaller nevertheless.