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China – “the outlook is more nuanced than the pessimists argue”

11th May 2015

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Some segments of the Chinese economy could see exceptional growth in a global context for some years to come and it can continue its transition to sustainable economic development argues Invesco Perpetual’s global equities fund manager, Andy Hall…

Many investors are worried about the Chinese economy; some investors think we are approaching a ‘sub-prime’ moment for China. We see many challenges facing the world’s second largest economy but we think the outlook for China is more nuanced than the pessimists argue.

The key detractors from the China story are excessive credit growth in the past five years, the emergence of systemic risk, risk inherent in the entire market or in a segment of the market, in the form of its shadow banking sector, slow progress on structural reforms, an ageing population and simply the law of large numbers.

China’s current growth rate of 7% is the equivalent to creating an economy the size of Indonesia every single year. It is inevitable that China’s growth trajectory will continue to moderate. However this doesn’t necessarily equate to a pending crisis for China. In fact some segments of the Chinese economy could still see exceptional growth in a global context for some years to come.

It may sound obvious but China is a not a country. It is a vast continent made up of 34 distinct provinces and 660 cities (120 of them have more than 1m people), each with different economic drivers and each at vastly differing stages of economic and social development. To look at China as one country is to generalise greatly. It is probably akin to thinking of Europe as one country, itself made up of 58 countries and 850m people. Europe is not homogenous and neither is China.

Premier Xi Jinping came to power in November 2012. He has set about cementing his power base with an aggressive anti-corruption campaign which has had the benefit of seeing off his key political threats and potentially given him the power to implement challenging reforms. Xi Jinping will serve another eight years as Premier. He has the time, and capacity, to implement necessary structural reforms that should put China on a stronger footing for sustainable economic development. We believe investors are under-estimating the potential for positive developments on reform.

Transitioning the economy from one driven by fixed asset investment to one driven by consumption is the key economic priority of the government. This doesn’t mean that infrastructure development will stop overnight. Fixed asset investment still makes up half of China’s GDP and by extension it can’t just stop without serious consequences for the overall economy. There are many huge investment projects (high-speed rail and airports for example) which will make China better connected and more productive. Even in Tier One cities there are major investment requirements such as the need to modernise the housing stock. In Chengdu there are only two metro lines for a population of 12m people. I believe infrastructure development will remain an important element of Chinese economic development for some years yet.

Transitioning the economy from fixed asset investment to consumption is the key economic priority of the government. This doesn’t mean that infrastructure development will stop overnight.

However the economy is gradually re-balancing towards consumption. Wage inflation is rapid in the ‘working-class’ segment. The government are effectively enforcing wage inflation of 10% – 15% p.a. over the next five years as a means of driving consumption’s share of the economy. While this is a potential problem for China’s competitiveness, wage inflation is an important element of the transition of the economy.

The bearish commentators tend to focus on the level of debt in the corporate and local government sectors of China but they tend to neglect to mention the strength of the household sector in China. Increasingly the younger generations are being forced to take on debt to get onto the housing ladder but mortgage restrictions are quite tight, and at this stage, the Chinese household savings rate is still very high in a global context. The older generations tend to have a deep savings pool which is used to help support their children and grand-children. China’s overall debt burden is not as high as many developed economies and it has the capacity to grow nominal GDP more quickly than most developed nations.

The government are effectively enforcing wage inflation of 10% – 15% p.a. over the next five years as a means of driving consumption’s share of the economy.

China is suffering from a hang-over of over-investment (especially in property) driven by the previous administrations US$4 trillion reflation policy. Arguably there has been a serious mis-allocation of resources (a bloated property stock) and a huge build-up of credit as a result of very stimulatory monetary policy. The shadow banking system does present a systemic threat to the financial system of China and there is likely to be a large bad debt problem which the government must manage. However, we believe the Chinese administration are more than aware and have the tools to deal with it.

While we agree there is potentially a sizeable bad debt problem in China, we believe the government has the capacity to repeat what they did in 1998 and clean-up the bad debts with so-called ‘asset management companies’. This is one of the benefits of a centrally planned economy. China also has a closed capital account and is keeping a tight grip on cross-border liquidity flow. This is a typical area of vulnerability for other emerging markets. When you visit China it is quite apparent that the people of China have a genuine belief that they can succeed. These elements give us a degree of confidence that China can avert a crisis and continue to manage the transition of its economy to a more sustainable path of economic development.

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