How Fast Will China Grow?

China GDP

For many years China experienced extremely rapid economic growth, with its GDP often growing by more than 10% in a year. In the last few years its growth has slowed a bit, and the International Monetary Fund (IMF) projects that its growth rate will fall to 7.3% next year and 6.5% by 2019. While this is a substantial decline from some of its sky-high growth rates in previous years, these numbers still represent very rapid growth. By comparison, US economic growth has averaged less than 2.5% per year during the past 5 years.

But can China continue to grow so quickly? New research from two Harvard economists, Lant Pritchett and Larry Summers, suggests that China’s growth rate may fall more than the IMF projects. They find that how much an economy has grown recently doesn’t tend to have much impact on how much it grows in the future. Their calculations show that China’s growth rate is likely to average less than 4% over the next 20 years.

There’s only a weak link between a country’s economic growth rate and how well its stock market performs, so a slowdown in China doesn’t necessarily spell doom for Chinese stocks. It’s very plausible that Chinese stocks could do well even if the country’s economic growth continues to slow as the IMF projects.

But part of the reason the link is so weak is that investors can anticipate when the growth rate is going to increase or decrease and “price in” this change before it actually occurs. It’s unlikely that investors have already priced in a decline in the Chinese growth rate as dramatic as the one Pritchett and Summers project. If their pessimistic forecast comes to pass, the performance of Chinese stocks is likely to suffer.

Should You Prepare for a Long Period of Slow Growth?

Larry Summers 2

More than 5 years after the most acute phase of America’s financial crisis, the US unemployment rate is still far above its pre-crisis level. In a series of articles during the past few months, former Treasury Secretary Larry Summers suggested that the economy may be in a persistently depressed state (a “secular stagnation” in the technical jargon). The article sparked renewed debate among economists about whether such a prolonged slump was theoretically possible, and if so, whether the economy was in one right now.

An extended period of slow economic growth should be good for bonds (due to low inflation and interest rates) and bad for stocks and commodities (because of weak demand for goods, services, and raw materials). Yet there are reasons to think that even if the pessimistic side of the secular stagnation debate is correct, trying to adjust your portfolio in response could be a mistake.

One reason is that there’s only a very weak link between economic growth and stock market returns. A long period of low economic growth and high unemployment would hurt companies’ ability to grow their revenues, but it would also keep a lid on how much they have to pay their employees. The lack of pressure to raise employees’ wages is part of the reason corporate profits in the US have been so high since the financial crisis.

A second reason is that Summers and the other proponents of his hypothesis aren’t arguing that a prolonged slump is inevitable, but rather than the government would simply have to use some different policies to overcome it. They argue that policy changes such as increasing government spending on infrastructure, raising the central bank’s inflation target, and allowing more immigration would help boost investment in the economy and reduce the unemployment rate.

Shifting your portfolio to prepare for an extended period of weak economic growth therefore wouldn’t just be a bet that the pessimists are correct; it would also be a bet that the government wouldn’t properly adapt and that no unforeseen occurrences lead to a surge in investment. The secular stagnation idea was previously peddled by an economist named Alvin Hansen in the 1930’s, when he argued that trends such as a declining population growth rate would lead to persistent high unemployment. The unexpected baby boom following World War II invalidated his prediction.