Can China transition successfully?
Tristan Hanson, Head of Asset Allocation at Ashburton Investments.
The current global focus on China is testament to the enormity of the country’s economic transformation over the last 35 years, and its impact on world markets.
In 1980, just after Deng Xiaoping had secured de facto control of China’s ruling apparatus, GDP per capita, adjusted for purchasing power parity (‘PPP terms’), was just 2.5% of levels in the United States and only a little more than half of India’s levels. The next two decades saw China introduce market-driven reforms with a huge acceleration in growth. On the eve of joining the World Trade Organisation (WTO) in 2001, GDP per capita had reached 8.5% of United States levels and 145% of Indian levels.
“This year GDP per capita will likely reach 25% of United States levels, making China the biggest economy in the world in PPP terms.”
It was after WTO entry that French emperor Napoleon’s prophecy about China shaking the world came true. China’s export growth accelerated to over 25% per annum after adjusting for inflation, from 12% previously. The transformation wasn’t only about exports. Urbanisation triggered a huge property and infrastructure boom, creating enormous demand for basic materials. These trends propelled China to become the world’s biggest industrial producer by 2011. Chinese demand for raw materials transformed the terms of trade for commodity exporters such as Australia and Latin America. Although there were slowdowns during the Asian crisis of the late 1980s and the late 1990s, growth on the official statistics on a five-year rolling basis never fell below 7.5%. This year GDP per capita will likely reach 25% of United States levels, making China the biggest economy in the world in PPP terms.
This extraordinary level of growth has generated scepticism for years. At the heart of these concerns have been fears that China is massively over investing. Overcapacity hasn’t just been limited to heavy industries such as aluminium and steel (where China produced over half of global output last year) but also new sectors such as solar panels. By 2005, investment had reached 40% of GDP - a level in excess of the peaks seen in Taiwan and Japan during their economic transformations. Even the authorities recognised that this was unsustainable and there was a need to rebalance towards greater consumption.
However, in response to the global financial crisis of 2008-2009, China unleashed a huge infrastructure programme. Growth was maintained but the investment share of GDP rose even further to 44% of GDP. Short-term stability was bought at the cost of postponing long-term rebalancing. With stories of numerous ghost towns, worries grew that the debt which financed
these schemes would default and that China would enter a financial crisis that could cause a collapse in growth.
In recent weeks these fears have built to a crescendo. There are several reasons for this. Firstly the economy is likely to grow at a significantly slower rate this year than the official target of 7%. Manufacturing surveys have been soft – both the official and Caixin PMI (a gauge of nationwide manufacturing activity) have fallen to new post 2012 lows. Although official GDP growth beat analyst expectations in the second quarter of the year - at 7% year-on-year - many analysts remain sceptical about the official numbers.
The Li Keqiang index (which uses three indicators to measure the Chinese economy) is currently growing at only 2.5% year-on-year. This index focuses on rail freight, bank lending and electricity consumption and is attributed to Premier Li Keqiang. He allegedly once told a United States diplomat this was how he estimated growth when in charge of Liaoning - a province in northern China. However, while the Li Keqiang index may have provided a reasonable set of indicators for Liaoning in the mid-2000s it is perhaps less relevant to a China trying to shift away from heavy industry and transform into a consumer-driven economy. Chinese retail sales are growing at 10.8% and surveys of service activity and consumer confidence suggest an economy that is still expanding.
“In recent years China’s reputation for good macro-management has been tested.”
Secondly, in recent years China’s reputation for good macro-management has been tested. After freeing up capital flows into Chinese equities and cheerleading a bubble in domestic equities, the authorities panicked and spent US$200 billion in a bungled attempt to shore up the market. Similarly, a modest depreciation and supposed move to a market-determined rate has been followed by significant intervention and reversal of capital account reforms by the central bank to stop the currency falling precipitously. While China has US$3.5 trillion of foreign exchange (FX) reserves, those reserves are largely funded by base money issued by the central bank. Spending reserves to support the currency will therefore lead to a contraction in the monetary base. We don’t know if China will chose to close off the capital account or allow the currency to slide, however, we believe it is unlikely that they will continue to spend FX reserves at the current rate at the expense of dramatically tightening domestic financial conditions.
It is still unclear what will take over from investment as China’s growth engine. Consumption has only contributed around 3.7% to 4.4% to growth in recent years. A bigger contribution than this will be tricky. China’s aging population combined with a weak social safety net and public healthcare coverage, drives high precautionary savings as well as the need to build up a nest-egg for retirement. Even if China decides to devalue the currency aggressively net export demand can no longer help significantly; China is now the world’s biggest exporter and big increases in market share are no longer possible.
The poor capital allocation of the past will eventually generate bad debts for the banks. However, the banking system is still controlled and largely owned by the government who will continue to underwrite and, if necessary, recapitalise it. The chances of a systemic financial crisis are slim. Poor investment allocation also has a silver lining: there are still many good investment opportunities that have been missed. In provinces such as Guizhou - which has a population similar to that of Canada (35 million), although it is 1/60th of the size - GDP per capita remains lower than in India. The amount of infrastructure investment needed is evident to any visitor to the province, but so too is the potential for tourism and hydropower. Indeed Guizhou is seen as the future centre for data-warehousing in China, and according to the ChinaDaily newspaper, will be the location for Apple’s new Asia-Pacific data centre. While investment expenditure will no longer be China’s growth engine, it shouldn’t collapse either. China will continue to grow albeit far slower than before.
