“Whoever wishes to foresee the future must consult the past; for human events ever resemble those of preceding times.” Machiavelli
Some new and old threats to the Chinese economy warrant a deeper look. Again, our conclusion is to keep an open mind, but a moderate slowdown is still, by some way, the most likely outcome versus the more apocalyptic scenarios still being entertained by some.
Residents of the United States, please read this important information before proceeding
It has been more than a year since the People’s Bank of China (PBoC) triggered a global investor stampede with its surprise devaluation of the yuan. At the time, the move was interpreted by many as a desperate attempt to prop up exports in the face of an imploding Chinese economy. Chaos in global capital markets briefly ensued. For our part, we saw the devaluation as more likely a poorly communicated move to better align the yuan’s movements with market forces1.
We have repeatedly stressed that the slowdown in traditional output indicators, such as manufacturing purchasing managers’ index (PMI) and industrial output, must be viewed in the context of China’s rebalancing away from heavy industry and towards services and consumption. So far, this more sanguine take on the various risks facing the Chinese economy has been proved right. Here, we take a fresh look at some of these potential pitfalls, examining whether it remains appropriate to tune out much of the hysteria that always seems to accompany commentary on the Chinese economy.
Dog days of August
China jitters are not a new phenomenon of course - the resemblances between the Chinese economy and the pre-credit crunch US economy have been striking, if often superficial and lacking in appropriate context. Meanwhile, the widespread lack of trust in official statistics has forced many to less conventional methods of trying to read the economy, creating space for the conspiracy theorists among others.
Nonetheless, by the second quarter of 2015, it became clear that China was experiencing a slowdown. Long-term structural factors, such as demographics - diminished but still with considerable catch-up potential - and the rebalancing from an investment-led economy to a service-based one has caused GDP growth to slow to its lowest level since the Great Recession (Figure 1). To complicate matters, this structural slowdown was compounded by cyclical headwinds, mainly the unwinding of excess capacity in the industrial sector. Traditional high frequency indicators such as the manufacturing PMIs were falling into contraction territory (Figure 2), suggesting weak demand conditions and low business confidence. At the same time, both industrial production and fixed asset investment (FAI) growth continued to soften (Figures 3 and 4), with the latter’s downward trajectory led by real estate and manufacturing investment, traditionally the two largest drivers of growth.
Meanwhile, China’s service sector has continued to surge ahead, providing some solace to those looking for progress in the long-promised economic rebalancing. Non-manufacturing PMIs have remained comfortably above the threshold consistent with expansion (Figure 5), while retail sales growth has even managed to outpace last year’s already impressive growth rate (Figure 6). Online sales, in particular, have grown at a staggering rate of 36.5% year-on-year in August. Nevertheless, China’s booming service sector remains insufficiently large, as yet, to boost aggregate output growth back to pre-crisis levels, leaving many to worry that weakness within the industrial sector would eventually envelop the economy.
Part of the reason that the doom-mongers have been denied is government related. By late 2015, analysts had begun to notice a shift - the fourth quarter of 2015 saw a surge in public FAI growth on a scale not seen since the government launched a CNY4trn (USD$600bn) stimulus package to counter the Great Recession (Figure 7). Meanwhile, measures taken throughout the year to loosen property restrictions catalysed a rebound in property sales growth and real estate investment (Figures 8 and 9). The PBoC itself eased monetary conditions further, leading to a sizeable jump in credit growth (Figure 10).
At the time, we viewed these developments as a deliberate attempt by the authorities to stabilise growth in the short term, therefore buying time to carry out the difficult supplyside structural reforms necessary to safeguard China’s long-term economic growth. These short-term measures were indeed effective in bringing about some stabilisation - by the first quarter of 2016, GDP growth had picked up, while manufacturing PMIs and FAI growth have remained stable since.
The fact that the authorities managed to buy time is certainly true, but whether that time has been well spent is more questionable. So far, visible progress on reform has been mixed at best. While there have been some positive developments, such as the opening up of the domestic bond market in June, as well as official announcements in February for plans to lay off excess workers and reduce excess capacity within the coal and steel industry, those investors hoping for more far-reaching reforms have been left disappointed.
One prominent disappointment has been state-owned enterprise (SOE) reform. Original plans to reform China’s SOEs suggested a vision in which government control of SOEs shifted to a kind of wealth management approach, where state-led investment funds operated at something like arm’s length, trying to maximise the market value of their SOE holdings. This approach, referred to by many as the ‘Temasek Model’ - named after Singapore’s much vaunted approach of running its own SOEs – requires the state to distance itself from the management of its enterprises, leaving key decision-making to professional managers employed at market rates. In theory, this would ensure that SOEs are run in accordance with profit-maximising objectives and aligned to market forces.
Unfortunately, such initiatives were ultimately lost among the various stakeholders and inevitable politicking within China’s vast bureaucracy. By the time the final document was released in September 2015, these reform guidelines have become vague and contradictory. Gone were the organising principles of the ‘Temasek Model’. What emerged instead was a mandate for the creation of multiple investment funds with multiple developmental objectives rather than a narrow focus on maximising shareholder wealth. That is, these funds are expected to foster the creation of big, competitive firms, develop emerging industries and to intervene in markets precisely in order to shape specific developments. To make matters worse, it contained harmful provisions, such as those calling for a strengthening of Communist Party influence and control over boards of directors2.
As we’ve often stressed, we should be wary of spurious precision with regards to growth forecasts. However, the latest data may provide some clues as to the likely medium-term trajectory for the economy. Over the past months, the effects of last year’s stimulus have started to taper off, with FAI growth and property construction growth peaking (Figures 11 and 12). All things constant, this should lead to a continued moderation in growth over the coming quarters, but still not the hard landing talked about by many.
“Our base outlook is for the Chinese economy to undergo an orderly deceleration balanced by a lumpy pace of long-term reforms and occasional spurts of short-term stimulus”
As with all countries, the Chinese economy does contain its own unique set of tail risks. A continued depreciation of the yuan may once again spark capital outflows should investor focus turn to slowing domestic indicators once again, and potential risks within China’s vast finance sector are still worth monitoring. At the same time however, we believe these risks to be manageable3. To us the main long-term risk is the inability to implement necessary reforms to boost potential output growth. For now, our base outlook is for the Chinese economy to undergo an orderly deceleration balanced by a lumpy pace of long-term reforms and occasional spurts of short-term stimulus.
This is part of the argument that keeps us favouring Asia within our emerging markets equity allocation. China, South Korea and Taiwan, remain our preferred markets. For those of sufficient risk appetite, the above may also argue for Chinese banks being undervalued, given the dramatic rise in non-performing loans already priced in.
1 The devaluation of the yuan: The battle of midpoint – The Economist
2 Supply-Side Structural Reform: Policy-makers Look For a Way Out - Barry Naughton [PDF, 206KB]
3 In Focus – China’s capital flight, 12 February 2016, and In Focus – China update, 8 August 2014