One of the biggest issues for global investors over the next 3-5 years is that China may be running out of prospective home buyers as the prime household formation age cohort shrinks, creating a secular slowdown in a sector which directly generates 13-15% of GDP and in its wider spillover impact closer to 22-25%. Consumption in China doesn’t neatly fit the Western ‘life cycle’ model of neoclassical economics (e.g. housing tends to be bought in advance of marriage/household formation and left unfinished and empty until that point) but the structural demographic shift will transform housing demand as much as the shape of monetary and fiscal policy. Beijing’s efforts since 2015 to boost the birth-rate by easing restrictions on family size always looked likely to fail, given the ever-rising costs of child rearing and fertility trends across developed urban Asia.
Japan’s experience in recent decades indicates that when rapid growth begins to slow in an economy with very high corporate and household savings driving fixed investment, demand can prove extremely difficult to manage, particularly when demographic decline sets in simultaneously. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. The tactical stance has been overweight China and AXJ despite still poor earnings and macro momentum but structural growth constraints are becoming binding as rising debt and declining demographics interact to radically change policy trade-offs, while the US is now intent on blocking or at least slowing significantly the technology upgrade path.
The real story behind China’s well documented economic imbalances is not just about structurally weak consumption versus investment as a share of GDP but also a large-scale net transfer of savings from abroad (and particularly the US) to the mainland corporate sector, a process which the White House, with broad bipartisan political support now seems committed to ending, whether a new trade deal is concluded or not. China’s plan to move up the value chain rapidly by ‘acquiring’ foreign IP to boost productivity as the workforce and investment intensity declines will now be much harder to achieve, even if it doesn’t in the worst case lose access to advanced semiconductor imports.
The country has an ongoing growth tailwind from urbanization (currently at 59% on official data, but by global standards likely 5-6 points higher), a remarkably advanced digital economy and payment systems, first world transport infrastructure in and between the major cities (and soon communication via 5G), and a growing number of globally competitive companies in mid-tech industrial and consumer markets. However, its economic dynamism will face a growing demographic drag as resource are diverted (whether public or private) to fund rising healthcare and pension costs.
Births last year dropped by 2m to 15.2m, and the median age will reach 48 by 2050, or about 10 years older than the US now. The total number of working-age adults (aged 16-59) fell by 0.44 % to just over 897m while the growth in the pool of rural migrant workers fell sharply, rising just 0.6% to 288m, down from 1.7% in 2017. The national old-age dependency ratio is already at 15%, and twice that in some depopulating peripheral provinces. The population on official data grew by 5.3m last year or 0.38% and Beijing has estimated that China’s population won’t peak until 2029 at around 1.44bn, but some demographers believe that tipping point has already arrived.
The ‘extensive’ growth model of adding more workers and capital becomes untenable as demographic decline starts. So too is the highly expansionary monetary policy that saw the PBoC balance sheet and M2/GDP ratio explode. That never generated much consumer inflation, as it was largely sterilised via housing which absorbed excess migrant labour and industrial capacity as a concrete inflation sink isn’t sustainable much longer. At the same time, the sterilisation of exporter dollar earnings and build-up of net foreign assets on the PBoC balance sheet and Treasury buying by SAFE is also winding down, as FX reserve growth peaks peak.
US demands to eliminate the bilateral deficit simply hasten the existing trend toward a current account deficit. Whatever the exact demographic glidepath, China is going to have to employ its human capital much more efficiently over the next couple of decades and refocus on intensive, productivity led growth. Global investors are going to have to adjust to the perpetual motion machine that drove global capital flows from the late 1990s not just stalling but going into reverse i.e. China will likely become a substantial net portfolio capital importer over the next decade, as it needs to fund soaring fiscal deficits, just as aging households begin running down savings…
With 12% more males than females in the 15-29 age cohort, having an apartment boosts prospects for marriage, and that factor as well as migrants buying properties to retire to in their home provinces helps explain much of the 45-50m ‘empty’ apartments that generate scare headlines. In China, housing has taken on the role of a ‘dowry’ for male offspring that gold has traditionally for female ones in India, but the 34m overall male surplus will rise and create a growing pool of involuntarily unmarried men (so-called “bare branches”). The home ownership rate among young Chinese households is consequently very high, thanks to help from parents who in a major city will have built up huge housing equity. Demographics will clearly begin to impact this cultural support for real estate, as the number of 20something males enters steep decline.
The 20-29 age cohort, the main source of new demand for housing, will have declined by about 80m by the mid-2020s from its peak in 2012/13 and the proportionate decline is similar for the teenage cohort behind them, slowing pre-emptive parental demand. A rising divorce rate and proportion of never married (in the case of many males, not by choice but economic circumstance) will offer some support to housing demand, but alongside a dramatic slowdown in migration, the overall fundamental demand picture will deteriorate materially.
Pension coverage is now relatively high for a country at China’s income level but the income generating assets to fund defined benefits are hugely inadequate and this is where boosting private assets and returns becomes critical to maintaining systemic solvency. The pension funding deficit covered by central government is likely to reach over $150bn annually by next year. Deeper capital markets (including ultimately access by foreign mutual funds with local distribution partners) supported by pension savings inflows are a key part of the wider reform agenda. Current contribution rates for state/SOE pensions are far too low; private pensions and employer annuities (i.e. the addressable market for the insurers) are just over a quarter of total assets with the basic pension/national social security fund comprising the balance.
That ratio will gradually shift over the next decade in favour of private assets – the public pension system’s 43% replacement rate (ratio of annual benefits to final salary) implies a significant cash flow deficit will open up that could amount to over $1.5trn within a decade. Insurers will be a key part of the funding solution – weak capital markets and regulatory changes slowing premium growth have been a drag but they remain a key China exposure as inadequate social provision, from healthcare to pensions, is funded directly by individuals.
Total pension assets are just over 10% of GDP compared to 35% in Korea and HK. Assets will have to grow dramatically over the next decade to close the funding gap and the private share of total pension assets (currently sub 30%) will become dominant. Beijing already has the fallout from local government deleveraging and SOE restructuring to absorb which will see central government debt/GDP double to 70-80% over the next 3-5 years from the currently reported 37% – bailing out the pension system as well simply isn’t realistic. Assets managed by Chinese insurers have already reached over $2.6trn, even as new policy premium sales have slowed since 2016. Solvency rules are now closer to international norms – capital requirements had been based on simple metrics of size but will now vary in line with how quickly policies turn over and how premiums are invested. Firms that rely excessively on short duration policies or invest heavily in equities must hold a much bigger capital cushion.
The slide in bond yields and A-shares has inevitably hit investment returns (as evidenced by the recent China Life profit warning), but offsetting this is an improving competitive landscape. The restrictions on wealth management product issuance (bank WMPs were offering yields of about 5.4% a year ago versus an average guaranteed rate offered by universal insurance products 30-70 bps lower) has seen retail investors return to insurers. Even with foreign firms likely to grow their share from the current low 5% base as the market opens, investors seem too bearish on life insurer growth prospects, with the key stocks on sub 1x price to embedded value multiples. As with education, investors in the asset gathering/private pension theme have to see through regulatory volatility to focus on the secular tailwind for revenue growth.