China will get old before it gets rich

China’s workforce and general population are ageing rapidly, and the grievously underfunded welfare and pensions system won’t cope. That’s a recipe for structural decline and turmoil, says Jonathan Compton.


This article is the first in a two-part cover story. Read Rupert Foster's counter argument here:China: Asia's next success story

In 1983 I bought a train ticket from Hong Kong to the Hook of Holland. China and the USSR were hardly go-to tourist destinations at the time, but I was curious to see the Communist world, so I embarked on a 10,000 mile journey. Apart from the lack of the basics electricity, food or sanitation it was universally grey. Agriculture was largely horse-drawn, angry police were more abundant than cars and the locals were gloomy. It was neither comfortable nor fashionable (the only other Western passenger was a German vegan who went on hunger strike in Omsk to protest at poor service no-one cared). Ever since then, I have been convinced that controlled economies don't work.

The social contract is about to unravel

Nevertheless, both professionally and privately, I have remained intrigued by China: intrigued by its rise from global minnow to global economic superpower; and by the accepted belief that it has found a "third way" state-directed capitalism. In practice there has been a contract between the people of China and the all-powerful Communist Party (currently ruled by their most powerful autocrat ever, President Xi Jinping). The people are implicitly promised a rapidly improving standard of living which to date has been delivered along with the opportunity for individual enterprise and gain. The price is minimal individual rights: no meaningful vote, equality, independent judiciary or defined property ownership, and imprisonment for any dissent from the party. This bargain has worked wonderfully for 40 years, but no longer.

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Western commentators have wrongly predicted a China crisis for years, citing several possible causes. These include corruption, the misallocation of capital, the giant inefficient state that still dominates the economy, and a banking system riddled with bad debts. While these are real problems, analysts' spreadsheets are ignoring key structural issues, which tell a worse story.

The population is ageing...

The greatest risk can be summarised as demographics. Mao Zedong was the most murderous dictator in history, causing between 50 and 70 million deaths. One of his many insane policies was to out-breed the West, which caused widespread starvation. This was reversed in 1979 to a harsh one-child policy per couple (eased in 2016). In 1970 the fertility rate (the number of children per woman during her child-bearing years) was more than six; now it is 1.6, lower than even the UK or US (1.8 each).

As a result, the structure of China's population can be forecast with considerable accuracy for many years. By 2025 the vast army of workers which made its miracle growth possible will start to shrink. Moreover in every country, once a minimum level of wealth has been achieved and women have access to contraception, birth rates tumble. Both scenarios apply to China. The population is 1.4 billion and expected to peak a fraction above that level by 2030. The working population is about 990 million, forecast to fall by around 50 million before 2030 and by a whopping 140 million by 2050. Meanwhile there are around 130 million retired people (older than 60 for men, 65 for women depending on whether you are a white collar worker or a blue collar worker) and barring plague or famine, this figure is set to rise to about 360 million in 2030 and 510 million in 2050. That will equal 35% of the population and more than the total populations of Britain, Germany, France and Japan combined. The dependency ratio, the number of people under 16 or older than 60 for each 100 people in work, hit a low of 61 in 2011 but will rise to 117 in 2050. A shrinking minority will have to pick up the tab for a growing majority.

...and the system won't cope

Ageing populations are already a problem in developed countries, yet for all the headlines most pension and welfare systems are pretty advanced. They are slightly underfunded, but they muddle through. China's problems are about to grow like smoke. Consider the notorious 4:2:1 ratio: four retired oldies, two adult offspring and a single child. So a married couple is supporting five other people. Despite communism, people have to pay for "state healthcare", which is often unaffordable. Foreign-owned private hospitals are good but their high prices make them available only to the rich. There are about 1.5 doctors per 1,000 people, compared with 2.3 in Britain. Only half are qualified to western levels.

Then there's the pension and benefits systems which are an ad-hoc jumble. Most provinces have only just enough money to pay one year's (measly) benefits. Holes are filled by central government funds. A squeeze is inevitable. The country's stock of pension fund assets (the money the country has saved up to pay private and public pensions) is small, around 16% of GDP versus over 100% for the UK or US. To improve funding to even a modest level would take years and huge sacrifices elsewhere in the economy. Private pension schemes are booming but from a small base. What's more, to give pension money a significant fillip the authorities would have to tackle the problem of funds being "diverted" into officials' pockets and pet projects. The data on state and private schemes show returns are poor. The implicit contract between the state and the people will be sorely tested.

It's too late to fix the benefits problem

This ageing problem and the immense potential strains of higher health, welfare and pension costs exist across many developing and mature economies too. But the latter have had decades to develop their systems. Some developing countries like China with a young demographic opted for breakneck growth, aided by mass migration from the countryside which always improves productivity. But while the money rolled in, they neglected to construct a comprehensive welfare and benefits network to deal with future social problems such as the inevitable ageing of the population. Now the problem has come to roost.

There are potential solutions such as raising the retirement age, squeezing benefits, higher taxation or larger contributions from a younger age. This has been the direction of travel in the UK and many other wealthy countries. But for developing countries, especially those with rapidly shifting demographics, most people lack the surplus income to be able to contribute more. The 4:2:1 families are already stretched; grandparents' savings are often tiny. The party promised to take care of the old. It cannot deliver.

Investment and taxes will fall

Another problem with deteriorating demographics is slower growth and a shrinking tax base. Without exception, once a tipping point has been reached, economic growth slows. It is no coincidence that Japan's growth peaked with the working population. There is a strong correlation between an ageing population and lower capital investment, the fuel for future growth.

Meanwhile, China has another problem. It is one of the most unequal big economies. A good measure of wealth distribution is the net Gini coefficient. This measures wealth distribution after taxes and subsidies, thus is a good measure of inequality and poverty. The scale is one to 100. A reading of 100 means almost total misery as wealth is owned by a handful of ultra-rich. A reading of one means everyone has exactly the same (and perversely can also miserable, as communist states have proved). A reading between about 25 and 35 suggests wealth is broadly spread. Most developed countries are within this band (with the US an outlier at around 41). China's score at around 44 is not only at the level normally found in the worst dictatorships, but has deteriorated on most readings from around 30 in 1980.

The Gini ratio matters for several reasons. One is that those countries scoring high tend to be less stable with relatively weak domestic consumption a key economic driver as money is the preserve of relatively few people. Yet in even the worst countries widespread dissent can result in a largely peaceful removal of the ruling clique. In China, political parties are allowed, but only if approved by the National People's Congress, in practice the Communist Party. They are ciphers. President Xi has just had his term limits abolished. Thus China not only has a legal ruler for life, but it lacks any peaceful power transfer mechanism because the people are not allowed to dissent. Inevitable change is unlikely to be smooth.

Long-term returns to investors also tend to be worse in those countries with high Gini ratios: few people participate in the market and the pool of savings to be invested is relatively low. However, to fund its pensions, welfare and medial systems China needs high investment returns and a more efficient spread of wealth. Inflation also tends to fall as populations age: overall demand in the economy dwindles as consumption and corporate investment slow. The world would suffer badly from another bout of China exporting deflation, whilst China's financial system needs inflation to reduce the real cost of its bad debts.

Grey clouds are gathering

The short-term outlook is inauspicious too. The swooning Shanghai index is insignificant; the direction of the stockmarket has always depended on the central government's purse strings, which have been tightened. But the growth in China's corporate debt has been alarming, especially the mismatch of borrowing in dollars to invest locally. Companies have started to default because the president wants a reduction in corporate borrowing and, on this, he's right. The massive debts in the official and shadow banks will again be hidden or restructured.

And things will only get more difficult. China's surpluses will shrink as the need for domestic spending increases, so its role as a massive buyer of foreign government debt and assets which have helped to fund Western consumption will fade, forcing up interest rates overseas. China's own rate of economic growth will slow. Despite being an economic heavyweight it will be structurally weak, poor and potentially unstable as the contract with the people unravels. That's serious for us all.

Jonathan Compton was MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.