July 18th, 2012 | By Nick Sargen
For the past three decades, China’s economy has been an economic marvel, with real GDP growth averaging close to 10% per annum while an estimated 500 million people lifted out of poverty. China recently surpassed Japan to become the second largest economy, and it weathered the 2008-09 financial crisis very well, while the advanced economies suffered the worst declines since the Great Depression.
Yet, as my colleague John O’Connor has noted in a recent commentary, there have been China skeptics ever since it burst onto the world scene. This month, Barron’s contained a feature article on China entitled “Falling Star” that attracted considerable attention. The article contains the following lead: “The Chinese economy is slowing and is likely to slow a lot more. Get ready for a hard landing, with growth falling to 3% to 4%.”
The article cited the assessments of two prominent skeptics – James Chanos, a hedge fund manager, and Edward Chancellor, a global strategist with GMO – who contend China is headed for a hard landing because its financial system is shaky and its property market is about to burst. It also cited concerns of Nicholas Lardy, an Asian scholar with the Peterson Institute, who points out that residential construction accounts for more than 9% of China’s GDP compared with 6% for the U.S. at the peak of the housing bubble in 2006.
What caught my eye, however, is that the report also cited concerns by William Overholt of Harvard’s Kennedy School, who has been a long-time champion of the China growth story. Overholt’s primary concern is that the economic and political reform movement of the Jiang Zemin/Zhu Rhongji era (1993-2002) has flagged badly over the past ten years. He is quoted as saying that China’s future is in question if the blatant political favoritism is not curbed by the incoming administration of Xi Jinping.
The Barron’s report concludes with a discussion about growing income inequality in China and capital flight by party members and other affluent Chinese. It notes that the Chinese government has staked its legitimacy on the ability to deliver “unending, hyperthyroid GDP growth,” of at least 7% to accommodate the millions of citizens migrating to cities and industrial areas from rural areas. While Barron’s offers the possibility that the new administration of Xi Jingpin could make necessary reforms to rein in powerful special interest groups, it concludes that this is unlikely: “All things considered, the odds in favor of fixing China seem long indeed.”
Against this backdrop investors eagerly awaited the results of China’s GDP data for the second quarter, which showed the economy grew by 7.6% y/y down from 8.1% in Q1. While this represented the slowest growth since the first quarter of 2009, the trough during the financial crisis, most economists have interpreted it as consistent with a “soft landing.”
To be sure, these results are unlikely to convince the skeptics, who allege that the Chinese government distorts the numbers. For this reason, many China watchers place greater reliance on measures such as electricity production, rail freight, real estate construction and bank loans.
Nonetheless, while there may be valid reasons to question the official data, it is not clear how much they distort the underlying picture of the economy. For example, Capital Economics, a highly regarded research firm, created its own proxy of Chinese economic activity and has found to its own surprise that it tracks the official numbers fairly closely. In fact, the proxy for the second quarter matched the official number exactly. Furthermore, the Chinese government recently has adopted a new approach for data collection on industrial output that is intended to improve its reliability: Under the new approach, the largest businesses report data to the National Bureau of Statistics directly over the internet, rather than reporting through local prefectures.
Weighing the balance of evidence, I side with those who believe the economy is slowing, but not at an accelerating pace. In this regard, Don Staszheim of ISI summarizes the current context very well:
“China has its economic problems – structural and cyclical. But compared to the rest of the world, China compares favorably in many characteristics.”
“Those cries in recent months about credit (no demand; not available) were wrong. Both net new loans and M2 growth in June and in 2Q12 were healthy. Beijing is trying to support economic growth. Three highest priorities in lending: 1) social housing; 2) agriculture; and 3) small- and micro-sized enterprises. Relax.”
While the evidence to date does not suggest China is on the cusp of a severe slowdown, there are formidable challenges in sustaining double digit growth. Indeed, we suspect the recent slowdown is the beginning of a transition to a lower growth trajectory. In formulating its five year plans, the Chinese government has typically targeted annualized growth of about 8%, which it has consistently exceeded. More recently, the government lowered the near term target to 7 ½%. While it is too early to discern what China’s long-term growth trajectory will be, much hinges on how it tackles issues relating to demand management and structural reform.
To a large extent, the current economic slowdown represents the influence of cyclical forces – notably, the tightening of Chinese monetary policy that was undertaken to curb inflation and an export slowdown linked to weakness in Europe and other advanced economies. One of the main differences today between China and the advanced economies is that Chinese policymakers have greater room to maneuver than the advanced economies in countering the slowdown.
An encouraging development is that inflationary pressures have lessened recently. The latest readings show CPI inflation receding to 2%-3% from a peak of 6% in 2011. This has also been accompanied by a slowing in the housing sector, and it has enabled the central bank to ease reserve requirements and to lower short-term interest rates. Moreover, further interest rate cuts are anticipated in the months ahead.
In addition, the Chinese authorities can also boost aggregate demand via stepped up spending by state-owned enterprises and by increasing the availability of credit via the banking system. These mechanisms proved very powerful in offsetting the slump in export demand during the financial crisis, with the fiscal stimulus in the vicinity of 14% of GDP over a multi-year period. However, the magnitude of stimulus this time is likely to be much smaller, because the previous stimulus unleashed a bout of inflation and also left a legacy of troubled loans.
Over the long term, the biggest challenge for China is to attain more balanced economic growth. While its growth strategy consistently exceeded the stated five-year goals, it was achieved via over-reliance on exports relative to domestic demand, and on investment relative to consumption. The current five year plan and the previous one both identified the need to achieve more balanced growth as a top priority. Yet, thus far, China has been unable to achieve this objective: In fact, there has been a secular rise in the share of investments relative to GDP, which currently is about 48%, while the share of consumption has fallen to less than 35%.
A report by Barclays Capital entitled “China: Beyond the Miracle” (September 5, 2011) spells out the challenges that lie ahead. The Barclays report notes that China’s economic miracle was based on a model in which prices for factors of production – labor, capital, land and the environment – were heavily influenced by government policies that were designed to facilitate a transfer of resources from the rural sector to the export sector. In the process, China developed businesses that were highly competitive externally, but ones that were less competitive internally. Looking ahead, the report observes that the key to China’s upcoming transition lies in the anticipated reform of factor markets, including rapid wage growth, interest rate and exchange rate liberalizations, and market-based resource prices. It concludes with a positive message:
“Fortunately, we have already started to see changes in the factor markets. Wages have been rising rapidly due to emerging labour shortages. The government has begun to adjust the prices of resources, including electricity, oil, gas and water. The authorities also plan to introduce market-based interest rates and increase exchange rate flexibility during the 12th FYP. These changes should gradually remove distortions to the incentive structure for economic entities, and eventually drive the transition of the Chinese economy – from economic miracle to normal development.”
Where does that leave us? My take is that investors should not rush to judgment in forming a view on China. Considering all that has happened to the world economy and financial markets, we cannot rule out the possibility of a significant slowing of China’s economy. But when we look at the balance of evidence thus far, our take is that a “soft landing” outcome is more likely in the next year or two.
Over the long term, we believe China is transitioning to a lower, more sustainable growth trajectory. But we are unsure whether the new trend rate will be in the vicinity of 7%-8%, which policymakers are seeking, or one that is lower. Our main difference with the China skeptics is that they are convinced China’s fate has already been sealed. In my view, however, much hinges on how China’s policymakers respond to the challenges. To the extent China can follow through on its stated goals of liberalizing the economy, there is reason to be optimistic about China’s future. However, in the event the economy falters, I suspect policymakers will delay liberalization in favor of greater control of the economy. Therefore, in forming a long-term view about China I will be monitoring how its policies stack up against the stated objectives.