21st August 2012
There is little doubt that the economic growth rate in China is slowing. The question now is whether this will have a broader impact both domestically and internationally.
News earlier this month that the Chinese economy grew at its slowest rate in three years between April and June has worried analysts. While concern has focused on the impact that slowing growth could have on the nascent global economic recovery, some commentators have voiced fears over what it could mean for the social compact between the ruling Communist Party and the people of China.
The rapid rate of growth in the country over the past decade has pushed China onto the top table of global politics but it has also created a sense of expectation among the citizenry. Under the one party system the trade off between social freedoms and prosperity has always been a delicate balancing act, and there are now signs that growing affluence is altering the dynamics. As Mark Leonard, co-founder and director of the European Council on Foreign Relations, writes:
"The number of government-recorded "mass incidents" (defined as a violent demonstration involving more than 500 people) has risen from 8,700 in 1993 to 87,000 in 2005, and 180,000 in 2011 according to several state-backed studies."
Yet the situation is not as clear cut as these statistics paint them. Although China is undoubtedly still experiencing some fundamental economic and cultural shifts, there remains little indication of a broad, coherent challenge to the Communist Party.
Meeting the demands of a growing population
James Weir, Asia Investment specialist at Guinness Asset Management, says the task of meeting the various needs of the population are growing.
"China is currently seeing about 13 million new urban dwellers each year on average. You've got underemployment in rural areas and a huge shift of people moving into cities looking for work. The government needs to provide urban jobs as well as supporting the wages for those in the countryside."
In Europe, Weir suggests, politicians sought to address this issue by bringing in farming subsidies that help to cushion the income gap between urban and rural communities. Chinese policymakers may be tempted to go down a similar route; yet as with most large scale government policy moves, the challenge is how to achieve efficient implementation.
This, according to Weir, is where many of the difficulties in the Chinese economy have been created:
"Part of the problem comes down to a dysfunctional relationship between the centre and the regions," he says. "Sometimes in implementing central policy the regions get the balance wrong. This is a system where the instinct is to control. What they haven't been able to do, therefore, is to release control of the supply side in a timely way."
One way in which this has manifested itself is in the construction industry. After the house building boom of recent years many commentators were warning of a bubble in property prices that was primed to burst. In recent months, however, prices have started to recover.
The problem is that China's rigid vertical structure means that construction companies, which have been dropping projects over the past year, may struggle to respond quickly to a pick-up in demand. Here, then, there is room for significant improvement.
The Middle-Income Trap
Just as significant to maintaining the social compact, however, is the longer term need for the country to break out of the middle-income trap. The recent history of the region contains a number of worrying examples of states that have made significant economic strides only to fail to move up the value chain in their industrial production.
The situation occurs when rapid economic growth caused by industrialisation begins to drive wages high enough that a country can no longer derive large profits from low-value industries. At that inflection point the economy must either shift towards higher value goods that can sustain wage levels or else stagnate. It is this latter circumstance that has come to be described as the middle-income trap.
China's rapid growth has also seen a degree of wage inflation, although to date it has grown fast enough to absorb the additional costs. The worry is that if the country were to grow at a significantly slower rate for a sustained period this dynamic could quickly go into reverse.
"Clearly there are concerns around China but on a per capita basis they still have a lot of ground to make up yet," Weir says. "It's easier to transition from agriculture to industry than it is to move from industry to services. When Malaysia's productivity growth started to fall it struggled to maintain per capita income growth, yet Korea managed to continue raising income levels by moving up the value chain."
Which example China is likely to follow remains hard to identify, and as the migration into cities is ongoing it may be some time yet before it becomes clear. Of course, one way to help avoid the trap is to encourage broad participation by citizens in financial markets rather than ploughing savings into physical assets such as houses.
In most developed markets investors have long held a – sometimes irrational – bias to investing in domestic companies. Were this to occur in China it could provide both a boost to share values but also the foundations of demand for a range of financial services industries.
Weir says he has already seen signs of improvement in this regard:
"The natural buyers of Chinese equities are Chinese people. In the past the A share market has been treated like playing roulette, but I think that situation is improving."
Investing in China
For outside investors even a slower growing China offers a compelling opportunity if they can access the right companies at the right price. A limited range of investment products offering access to the region and volatile performance meant that traditionally only the most adventurous individuals put a sizeable portion of their portfolios into this market. Yet in the post-financial crisis climate this already appears to be changing.
To ensure long term success, the Chinese government needs not only growth targets but an understanding of where central policy can help and where it hinders progress. Whether the country will ultimately avoid the middle-income trap will likely depend on the degree to which the Communist hierarchy cedes its control over economic levers. This, however, could be as much a cultural as a structural transition.
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