Will China follow Japan into economic stagnation?

Japan's economy has been a basket case for two decades, while China’s has boomed. Yet Robert Keavney suggests that China may face some of Japan’s problems.

Everyone who thinks about the future of the world's economy must form a view on China.

The prevailing view is that China will roll on inexorably, even if at a lower growth rate.

I have dissented from that view, even going so far as to call the Chinese economy a Ponzi scheme.

Today I will go further and suggest that, in certain respects, the best indicator of China’s future could be Japan's present.

Lest you consider this to be an irresponsible attempt to be controversial, I will shortly quote the views of the Governor of the Bank of Japan in support of this position.

The first step in this process is to understand what has caused Japan's malaise.

Western economists and politicians are fond of pointing out what the Japanese should be doing to fix their economy. It is claimed that they need to overcome cultural issues, reduce their savings surplus, fix their mismanagement, stop the depreciation of the yen, print more money, etc.

Everyone explains the solution according to their pet theory.

However, there is one fundamental problem faced by Japan which cannot be fixed – short of genocide of the elderly.

 Demographics

We have heard a great deal about the baby-boomers and the forecast impact their retirement will have on Australia’s future dependency ratio.

The term ‘dependency ratio’ refers to the ratio of adults of retirement age to those of working age.

This is often measured as those 65 or older as a ratio of those aged 15 to 65. We will adopt this formula in what follows and express it as a percentage.

Of course this is an imperfect measure of the number of the elderly needing to be supported by those working: some of working age could be unemployed; some retirees could be self-funded; some under 65 could be retired; some over 65 could be working; some over 15 may be studying full- time and not working, etc.

Nonetheless it is widely used as it is a reasonable indicator of the ratio of those too old for work compared with those working.

No one knows quite how the ageing of Australia will affect our economy, but it will certainly bring challenges.

With a larger and larger proportion of the population retired and thus reducing both labour supply and consumption – leaving a smaller percentage of the population working – pressures must emerge.

But this lies in our future; it is current reality for Japan today. According to the World Bank, the global average dependency ratio is 11 per cent (ie, 11 of retirement age to 100 workers).

In North America the ratio is 19.6 per cent, almost identical to Australia’s. The ratio is 25.9 per cent for the European Union.

In Japan there are 35.5 people of retirement age for each 100 workers. This ratio has increased inexorably and at an increasing rate, and will continue to for many years (see Table 1). The rate has doubled since 1990, the end of their boom years.

This ever-increasing number of non-working people creates a growing weight for the economy to handle – typically retirees reduce both consumption and the labour supply.

The view from Japan

The Governor of the Bank of Japan (Japan’s central bank), Masaaki Shirakawa, presented a paper to the Bank of Finland’s 200th Anniversary Conference in 2011.

In it he explored the reasons for Japan’s economic collapse and explored whether there may be any lessons in it for China and India.

Mr Shirakawa reminds us that Japan’s average rate of growth over the 15-year period from 1956 to 1970 was nearly 10 per cent per annum. He notes this is very similar to China’s average growth rate over the 15 years from 1990 to 2005.

Japan's growth reduced from these levels through the 1980s but remained above that of most advanced economies. China's growth since 2005 has been stronger than Japan in the 1980s.

Shirakawa explores the reasons for Japan's spectacular growth from 1956. The first cause he points to is favourable demographics.

Not only was the population relatively youthful, supporting both production and consumption, but also, he adds:

“The migration of surplus labour from the rural areas to the cities enabled the rapid growth of a high productivity manufacturing sector.”

But wait! That is exactly what's happening in China: double digit growth, fuelled by migration to the cities. Perhaps there are some similarities… (Naturally, other factors were also described as contributing to the boom period, but they lie outside the purpose of this article.)

Then Shirakawa turned to the causes of Japan's subsequent struggles. He noted the bursting of Japan's bubble created problems.

Next he noted that Japan's superior operational efficiency was lost as competitors caught up. He then turned again to demographics, referring to the growth in dependency ratio, noting:

“Such rapid aging has never been seen in past economic history.”

In short, Shirakawa says that Japan had a “population bonus” during its boom years, which has since become a “population onus”.

Then he went on to point out that China is on a similar path.

One-child China

The one child per family policy was introduced into China in 1978. This policy has one unintended demographic consequence: it guarantees that at some time the dependency ratio will be horrific.

To understand this, consider a family of two parents and one child. When the two parents retire only one child will be left in the workplace.

We therefore need to consider the future of China's dependency ratio. The United Nations (UN) has done this, making forecasts using a range of assumptions.

We will consider their ‘medium variant’ forecast, as there is historical as well as forecast data for it.

This data is presented in Graph 1, ‘China's dependency ratio’.

You can see that China's dependency ratio begins to accelerate from around 2010, and is forecast to reach and then surpass Japan's current rate.

It must be acknowledged that long-term forecasting is an uncertain business, so the actual figure may be above or below these projections.

For this reason forecasts beyond 2050 have not been shown (though we can note in passing that, under the UN’s worst-case scenario, a dependency ratio of 76 per cent is forecast by 2100).

Even though it is not possible to forecast with precision, we can say for sure and certain that, like Japan before it, China faces a seriously deteriorating dependency ratio which will create challenges for the economy.

This time it’s different, again

There are many similarities between the over-confidence in Japanese equities in the 1980s, the over-confidence in technology stocks in the 1990s, and the prevailing attitude to China in recent years.

In each case investors mistook a phase in a cycle for an enduring trend. Investors persuaded themselves that the fundamentals were so favourable that prices would continue to rise.

In other words, they extrapolated the recent past into an ever more favourable future. In short, they believed that ‘this time it's different’.

A dangerous tendency to make the same mistake has emerged with regard to China. Many people are utterly persuaded that it will sustain strong growth for the foreseeable future, and that strong long-term equity returns will follow.

Once again, this time is different – nothing will go wrong.

This form of thinking does not have a good track record: the Japan and technology bubbles resulted in savage losses for investors.

In order to counsel caution about this, I have devoted a series of articles to exploring China as an investment theme.

Historical evidence was examined demonstrating that there is no correlation between economic growth and equity returns in emerging markets.

In other words, the mere fact that China is growing strongly is not evidence that it will produce a superior equity return.

We also reported that 50 per cent of China's gross domestic product (GDP) consists of investment. This has no historical precedent and would appear to be a form of artificially propping up the economy. It is not sustainable.

Yet this is a good part of the argument for the China growth story: look how many roads, cities, power stations, etc they are building.

We pointed out that China had built a number of brand spanking new ghost cities, with virtually no residents.

I recently heard further anecdotal evidence of over-building, in a report by a traveller in north-west China, driving for hours on a six-lane highway and hardly seeing another car.

If large road building is seen as evidence of a healthy China, then we would be twice as impressed if this highway was expanded to 12 lanes. Never mind that no one uses it.

We reported an acknowledgement by a leading figure in China’s government that there is an element of public relations (ie, spin) in China’s published growth figures.

In this article we have explored the new ‘great wall’ of China: ie, the demographic wall that China will need to climb while attempting to grow its economy.

There are serious risks to the China investment story. These need to be weighed fully before allocating an exposure to, or allocating an overweight exposure to, resources on the basis of China's ever-growing demand.

India

Incidentally, Shirakawa notes that India is at a very different demographic stage.

“India has yet to enter the population bonus stage,” he says.

India’s dependency ratio is becoming favourable and is forecast to keep improving until around 2030.

Europe

It may be interesting to cast a demographic eye towards Europe. Germany has the world's third highest dependency ratio, at 30.8 per cent.

This rate is also growing markedly, having increased by 29 per cent over the last decade (compared to a 41 per cent increase for Japan). Over two decades, German dependency has grown by 43 per cent, compared to more than doubling in Japan (source: United Nations). 

Germany does not appear to face the scale of demographic problems which Japan does and China will.

Nonetheless, at a time when Germany is seen as the possible saviour for all of Europe, it is worthwhile recognising that it faces issues of its own.

There are 15 countries beside Japan with a dependency rate of 24.9 per cent or higher. These are: Austria, Belgium, Bulgaria, Croatia, Denmark, Estonia, Finland, France, Germany, Greece, Italy, Latvia, Portugal, Spain and the United Kingdom. (Special mention goes to Italy with the second highest level of dependency at 31 per cent.)

All these nations except Croatia are in the troubled European Union.

It should be expected that advanced economies would have a higher dependency ratio due to a longer life expectancy and a generally lower fertility rate (ie, number of births per woman).

However, the situation in much of Europe is worse than Canada, the USA and Australia.

On a per capita GDP basis, Bulgaria, Croatia, Estonia, Greece, Latvia and Portugal are not nearly as wealthy as the leading European states. Nor are Italy and Spain, though the margin is not so great.

Though their dependency is not growing as rapidly as in Germany, the standard of living of these nations will remain under pressure from their high dependency ratio. In passing it can be noted that immigration could provide relief from a difficult dependency ratio.

It may therefore be unfortunate that Europe is experiencing an anti-immigration phase, especially of Islamic immigrants.

The point being made is that demographics will not help Europe grow out of its current difficulties, though they don't face the challenges of Japan and China. 

Conclusion

China’s dependency is only beginning to accelerate more quickly. Their dependency problem will only develop slowly. And certainly there are differences between Japan and China. Dependency is only one factor in a complex modern economy.

Nonetheless, an excessive dependency ratio has the potential to stifle China’s economic growth, as it did in Japan.

Shirakawa said that there were concerns about Japan’s demographic trends in the 1980s, but they were “considered vaguely as an issue for the distant future.” It would be easy to take the same attitude to China today.