The global economic boom since the fourth quarter of 2016 came to a halt in 2018. International organizations such as the IMF and the World Bank have lowered their expectations on global economic growth in 2019. Changes in the global economic outlook foretell an upcoming period of profound adjustments for the global economy.

1. Growth Drivers of Advanced Economies: the United States

Among advanced economies, the United States has experienced robust economic growth in 2018 thanks to the tax cut at the end of 2017 and a bullish stock market. However, Japan and Eurozone countries are still in recession. By the IMF’s exchange rate method, advanced economies contributed 36% to world economic growth in 2018, and the U.S. alone contributed 15%. During the Fed Reserve’s continuous rate hike, Japan’s and Germany’s 10-year treasury bond yields stayed at a level of 0.1% to 0.2%, which was far below the inflation rate. They maintained zero and negative money market interest rates respectively. The question is whether the U.S. economy is strong enough to support more rate hikes by the Federal Reserve in 2019? Interestingly, in the first half of 2016 alone, “secular stagnation” used to be a topic of heated discussions for the U.S. National Bureau of Economic Research (NBER).

In 1938, the then President of the American Economic Association Alvin Hansen mentioned for the first time the concept of “secular stagnation”: the Great Depression of 1929 had ushered in an era of lasting unemployment and economic stagnation. In 2013, former U.S. Treasury Secretary Lawrence Summers asserted once again in his speech “Why stagnation might prove to be the new normal” that advanced economies may fall into secular stagnation due to an ageing population and falling TFP.

The first reason behind the secular stagnation of advanced economies including the U.S. is a continuous decline in the labor participation rate. Since 2011, the U.S. unemployment rate has experienced the biggest reduction since the World War II, and a primary consideration behind the Federal Reserve’s decision to raise interest rate was whether unemployment rate had reached the non-accelerating inflation rate of unemployment (NAIRU). However, the unemployment rate cannot reflect a real picture of labor market. Since unemployment rate equals the ratio between unemployed populations and working populations aged 16 and above, the falling unemployment rate may have resulted either from falling unemployment or from the fact that the unemployed had exited the labor market and thus no longer entered into unemployment statistics. For this reason, another indicator - labor participation rate - comes into play, which means the ratio between working-age populations aged 16 and above and total populations aged 16 and above. During the continuous decline of the unemployment rate since 2011, the U.S. labor participation rate also registered the biggest decline since the World War II, down from almost 68% in 2000 to 66% in 2008 and then to the present 62%. Low labor participation rate means that the real unemployment rate is much higher than what statistics suggest. It also implies that household income cannot keep pace with economic recovery. Stagnation of household income, which account for 70% of U.S. GDP, presents a fundamental barrier to U.S. economic recovery.

Another reason for secular stagnation is the stagnation of technology progress. According to a study of the U.S. National Bureau of Economic Research (NBER), around 2004, U.S. TFP started to decline, which led to falling TFP and potential GDP growth rates. From 1996 to 2004, driven by IT revolution, U.S. labor productivity averaged 2.54%, which dived to 1.33% after 2004. Falling TFP had preceded and therefore cannot be attributed to the global financial crisis of 2008. The post-crisis superficial recovery did not result from a real improvement on the supply side.

Consequently, despite falling unemployment rate in 2011, the U.S. potential GDP growth still recorded a historic low of about 2%, which is inconsistent with falling unemployment rates that occurred twice in the U.S. after the World War II. The first decrease of the unemployment rate occurred during the period from the end of the World War II to the full-scale Vietnam War in 1965. The second occurred during the IT revolution from the 1990s to 2000. Falling unemployment rates during these two periods were all accompanied by spikes in potential GDP growth. Disconnection between potential GDP growth and unemployment rate is fundamentally attributable to the diminishing momentum of technology progress after the IT revolution. According to the forecast of the U.S. Congressional Budget Office (CBO), the U.S. potential GDP growth will continue to decline in the following years.

The third reason for secular stagnation is high indebtedness. After the global financial crisis of 2008, liabilities of the U.S. federal government, state and local governments, firms and households all reached historic highs. Among them, the federal government and corporate liabilities are particularly worrisome. By the third quarter of 2018, U.S. federal government liabilities were 2.92 times the size when the sub-prime mortgage crisis erupted in 2007. Interest payments on government liabilities in the broad sense including the federal, state and local government liabilities approached 800 billion U.S. dollars each year. Debt service not only dragged economic growth but brings the U.S. debt sustainability into question: First, if the Federal Reserve continues to unwind the balance sheet and the trade surpluses of countries like China and Japan with the U.S. continue to fall, the subsequent purchasing power of the U.S. treasury bonds will diminish. In fact, with the diminishing U.S. dollar credit, some central banks have already started to reduce the purchase of U.S. treasury bonds. Second, if the Federal Reserve continues its rate hike and, for instance, brings federal fund interest rate back to the level of 2005, government debt interest payments in the broad sense will shot up to 1.2 trillion U.S. dollars per year, or 6% to 7% of U.S. GDP. Even if the U.S. Federal Reserve puts a brake on rate hike, mounting U.S. government liabilities will drive up the nominal interest rate, thus forming tremendous debt service pressures. In addition to government liabilities, the size of U.S. corporate sector liabilities increased by nearly 1.5 times by the third quarter of 2018 over 2007. A key reason for the U.S. corporate sector liabilities is that liquidity released from quantitative easing allowed listed companies to repurchase their shares, thus creating a false prosperity in the U.S. stock market.

As can be seen from a century of U.S. economic history, the year 2018 at least had the following commonalities with the dawn of the Great Depression in 1928: first, a stock market upsurge; second, exorbitant corporate sector liabilities; third, the widespread inclinations of major economies to adopt a beggar-thy-neighbor policy. The Great Depression of 1929 was triggered by a stock market plunge that forced the corporate sector to reduce liabilities and sent the economy into a vicious cycle of debt tightening. Unlike the Great Depression, the global financial crisis of 2008 stemmed from real estate market adjustments, and the debts were held by the household sector. After 2009, major economies cooperated and jointly adopted an easy monetary and fiscal policy.

2. Growth Drivers of Emerging Markets and Developing Economies: China

By the IMF’s exchange rate method, emerging markets and developing economies contributed 47% to world economic growth in 2018. Among them, China contributed as much as 21% to world economic growth. Judging by China’s economic performance over the past few years, China has been grappling with significant downward pressures. China’s high savings, investment and growth rates since reform and opening up in 1978 proved to be unsustainable, and a new growth pattern is yet to take shape. These downward pressures are not only attributable to growth cycles but also reflect China’s proactive economic restructuring efforts. It takes time for new growth drivers to replace the old ones.

China’s real GDP growth is rather smooth and not suitable for assessing short-term economic cycle. A useful indicator of China’s economic cycles is its quarterly nominal GDP growth rate. In observing the data of the past 25 years, whenever China’s nominal GDP growth dipped below 10%, it can be concluded that the economy had entered a chilly winter. For instance, China’s nominal GDP growth was below 10% during (a) the Asian financial crisis from the fourth quarter of 1997 to the fourth quarter of 1999; (b) the period of the worst NPL ratios for the banks from the first quarter to the third quarter of 2001; (c) the global financial crisis from the first quarter to the third quarter of 2009; (d) the period of PPI deflation from the third quarter of 2012 to the fourth quarter of 2016. After the fourth quarter of 2016, China’s quarterly nominal GDP growth rebounded. After the second quarter of 2018, China’s nominal GDP growth rate fell below 10% once again. Secondary and tertiary industries that shared a highly consistent cycle with nominal GDP were relatively stable. Even when China’s nominal GDP growth dipped below 10%, value-added from the tertiary industry still managed to grow above 10%, which indicates that the tertiary industry is a “stabilizer” of China’s economy. As can be seen from historical data, the four periods when nominal GDP growth fell below 10% were all accompanied by a PPI deflation. For the corporate sector, PPI deflation implies a debt tightening cycle of falling product prices, diminishing profits and rising debt service pressures.

Nominal GDP growth reflects the stage of the current economic cycle, but it takes only one critical leading indicator M1 to get a glimpse of how a future cycle will unfold. Unlike the statistics of other countries, aside from a small amount of cash, 85% of China’s M1 is demand deposits of firms. Generally speaking, two factors affect the demand deposits of firms: corporate cash flow and changes in liabilities. Therefore, increasing demand deposits of firms and accelerating M1 indicate an improvement in corporate business performance or the fact that firms are willing and have the capabilities to expand credit to support business operations and investment. Hence, M1 has become a key financial variable that leads economic cycles: As can be seen from historical data, M1 cycle was ahead of nominal GDP and PPI cycles by about two quarters. Prior to the recent round of economic recovery, which was the second quarter of 2016, China’s M1 growth peaked at 25%. After two quarters, China’s nominal GDP growth in the first quarter of 2017 exceeded 10%. After 2018, however, M1 growth fell below 10%. Foreseeably, China’s nominal GDP growth outlook in the first half of 2019 offers little optimism. Meanwhile, the possibility that PPI may once again enter into deflation is a cause for concern.

Another question of concern is a credit crunch. Under the fiduciary standard, money is ultimately created by credit. Without overall credit expansion of the economy, an increase in the cash flow or liabilities of individual firms imply a reduction in the revenues and liabilities of other firms or sectors. In other words, behind the sluggish M1 growth is shrinking credit activities of the society as a whole. From the perspective of credit supply or credit instruments, overall credit activities can be divided into bank credit and non-lending credit. Since 2017, the growth of bank credit has stabilized at around 12%, but non-lending credit growth has slowed significantly. Non-lending credit can be further divided into bonds (including various non-financial bonds such as treasury bonds and local government bonds) and credit from shadow banks. After the classification, it can be found that the contraction of non-lending credit mainly resulted from a significant reduction in the size of shadow banks. At the level of credit demand or sectors with liabilities, the current credit crunch involves all non-financial sectors including the government, corporate and household sectors. As far as the government sector is concerned, credit crunch mainly occurred in the field of quasi-government liabilities, including city investment bonds, loans from local government financing vehicles, government-trust cooperation and various wealth management plans related to infrastructure investments. For the corporate sector, the liabilities of private enterprises in China have been falling since 2012, particularly after the government decided to curb shadow banking in 2017. For the household sector, credit expansion spurred by housing loan growth in 2016 and 2017 is ending. Mid- and long-term consumption loans, i.e. housing loans, in the household sector amounted to 28 trillion yuan in the third quarter of 2018, or more than two times the amount in 2015.

3. 2019: Era of Deep Adjustment Has Come

The trend of history will not be changed by a short cycle. At the BRICS Summit in 2018, President Xi Jinping noted that the world today is facing great change unprecedented over the past century. As mentioned in the reports of international organizations like the IMF, a sign that great transformation is taking place in the world today is the rise of emerging markets and developing economies (EMDEs), which has transformed the “center-periphery” pattern with developed countries at the center and EMDEs at the periphery. By purchasing power parity, the share of EMDEs in global GDP reached 59% in 2018, which was far higher than the share of 31% for advanced economies. Since the annual growth rate of EMDEs (around 4.5%) is about twice the growth rate of advanced economies (2.2% or so), the periphery will overtake the center at an accelerating pace. For global economic development, this significant change is both an opportunity and a challenge. The year 2019 is a critical year for China to embrace the challenges and turn them into opportunities.

As far as China’s economy is concerned, tremendous structural opportunities exist in 2019 despite numerous difficulties. Although value-added from China’s tertiary industry has overtaken that from the secondary industry since 2012 - a sign that the economy had entered into a service-based stage in the post-industrial era, the share of China’s service sector in GDP is still far below the global average. By 2020, China’s industrial restructuring, particularly development of modern services such as scientific research, education, culture and healthcare, will continue to serve as key drivers of its medium-high growth rate. By 2018, China’s urbanization rate was still less than 60%, roughly equivalent to the U.S. level in 1950. As we know, from 1950 to the eve of the full-scale Vietnam War in 1965, the United States had experienced a round of rapid urbanization and economic growth. According to the Report to the 19th CPC National Congress, China is poised to enter a new stage of urbanization characterized by the development of central cities and city clusters.

All in all, 2019 will be a tough year of credit crunch and PPI deflation. Nevertheless, since China has a tremendous space for fiscal maneuvers - in 2018, China’s central government leverage ratio was only 16%, which was far below the U.S.’s 86%, and China’s high statutory reserve ratio offers a broad space of monetary policy maneuvers, China as a middle-income developing country will manage to get over a “chilly winter” in 2019 if it ever materializes.