China’s Growth Rebalancing and Systemic Risks

More than at any time in recent history, the health and performance of the Chinese economy is front-and-centre on the minds of investors, economists, businesses, banks and world leaders. In just thirty years, China has become systemically important to the global economy, probably more so than the US has been. It’s linkages to Asian supply chains, its demand for global commodities, its increasingly globalized consumers and financial markets, are just some of the many reasons why China matters more to the world than every before. Which is why everyone is concerned about how China’s ‘great re-balancing’ pans out.


China’s Growth Rebalancing


China’s growth record has been nothing short of exemplary, albeit with a highly centralized and overbearing state. It demonstrated the fastest and most sustained economic growth performance in human history. Driven by globalization (manufacturing) and infrastructure investment, China’s economy soared. Over last 20 years, it plowed 8.5 percent of GDP each year into infrastructure – twice the level of India and more than four times of Latin America. In the past 15 years, China built 90 million new homes – enough to house the entire populations of UK, France and Germany combined. But now, this growth is slowing down. But what is driving it?


It is now widely acknowledged that the slowdown is part of an inevitable rebalancing of the Chinese economy. Rebalancing on two fronts – rebalancing of growth drivers from investment to consumption and rebalancing of growth poles from the coastal regions (mainly in the South-East like Shenzhen and Zhengzhou) to inland areas. The former is probably the most critical. Growth in China over the last decades has been driven by an aggressive investment drive – investment in factories and investment in infrastructure to support those factories. The rebalancing that needs to take place is away from an investment-led growth, to a more domestic consumption-led one. Economist and Nobel Laureate Paul Krugman suggests that the Chinese model is about to “hit it’s Great Wall” because of this rebalancing.


To understand the Chinese model, we must go back to revered economist Arthur Lewis. He suggested that countries in the early stages of development typically have a small modern sector alongside a large traditional sector containing huge amounts of surplus labour. This has two effects. The first is that the country can keep plowing in capital in to new factories, construction, and so on, without running into diminishing returns on that capital. It can also keep drawing on surplus labour from the countryside to keep fuelling growth. The second is that as there is ample rural to urban migration of workers, competition among labour is high, and so wages are low. But now, China has hit its ‘Lewis Point’, where that seemingly unlimited flow of labour at cheap wages is rapidly waning.


Krugman, explaining his viewing on ‘hitting the great wall’, has observed that, “all successful economies devote part of their current income to investment rather than consumption, so as to expand their future ability to consume. China, however, seems to invest only to expand its future ability to invest even more […] Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does”. Household consumption accounts for less than 40 percent of China’s GDP. Put differently, the Chinese consumer has not begun picking up the economy’s slack caused by the country’s investment-led model reaching its limits. Chinese household consumption as a proportion of GDP is barely half that of USA which is at around 70 percent, and significantly less than other large economies like France, Brazil, Germany and India, which are hitting around 60 percent in recent years.

Recent Signs of China’s Slowdown


Since early 2013, growth began to slowdown. Growth slowed in nine of the next ten quarters – a first for the Chinese economy. Then in the summer of 2015 some of the worst bout of crisis hit, causing many to question, ‘when China sneezes, does the world catch a cold?’. Troubles in the Chinese economy had unprecedented ripple effects in markets around the world and it became clear that the Chinese economy is more systemically important than ever before. In July that year, China’s stock market began to show the first signs of stress, with the markets in Shanghai plunging and over 1000 listed companies suspending trading. Then in a sudden move in early August, the People’s Bank of China devalued the Yuan by the sharpest amount in two decades, leading investors to believe that China was facing severe weaknesses in exports. The final sneeze was in end August 2015 when a key manufacturing factory activity indicator – the Caixin-Markin Purchasing Managers Index (PMI) fell to its most pessimistic level since the global slowdown in 2009 – a 77-month low of 47.9 (a PMI below 50 on the 100-point scale indicates a decline). All of these ‘mini-sneezes’ combined to send jitters across the global economy, and since then the entire global economy has been sniffling. The full-blown cold came on Monday 24th August – now dubbed ‘Black Monday’ – where nearly every major market saw declines not seen since the onset of the global financial crisis in 2007. The Shanghai Composite Index fell by 8.4 percent – the largest one-day drop since 2007. Meanwhile, the Hongkong HangSeng fell by 3.5 percent, Singapore Straits Times Index by 2.3 percent, Australia S&P/ASX 200 by 2.6 percent (steepest since May 2012), and the Dow Jones Index and NASDAQ in the US and the FTSE in the UK all down by more than 3 percent. The Dow fell by nearly 600 points after starting trading down over 1000 points. Many of the markets recovered in the weeks that followed, but continued to remain volatile as questions around China’s as well as broader emerging markets’ growth prospects emerged.


Systemically Important


If it wasn’t clear already, those events of July, August, through to September 2015 confirmed how China’s growth fortunes are linked to the global economy more than ever before and any weaknesses in the Chinese economy poses systemic risks. The Chinese economy now accounts for 15 percent of global GDP and around half of global growth. China’s insatiable appetite for commodities means that it now accounts for 25 percent of global steel demand and determines the prices of copper, iron, and coal. Any slowdown in China would mean a slowdown in the global commodities trade, and hurt some countries harder than others. For Australia, one fourth of its exports are to China (mainly commodities). For South Africa, 45 percent of its exports are to China, mainly in platinum group metals, gold, coal, and iron ore. Fears are that a prolonged Chinese slowdown would reduce demand for commodities like metals and oil. This is probably why, following ‘Black Monday’, commodities indices fell sharply. The major counters influencing the fall of the Dow in the days immediately after were stocks of mining, mineral and other commodities companies. In fact, the Bloomberg Commodity Index fell to its lowest level in 16 years.


Chinese Reforms – Unconvincing or Unseen?


In an era of increased systemic risk from China, it seems that the global investment community is unconvinced of, or at least unsure of, what Chinese authorities are doing to stop the rout and stimulate growth. The most obvious move, of the People’s Bank of China repeatedly cutting interest rates and reserve requirements, had the most pronounced effect. Yet, investors are yet to see the extent to which more fundamental structural reforms are being done to ensure that Chinese growth avoids a so-called ‘hard-landing’ and instead transitions into an era of rebalanced, slightly slower, growth that is sustained over a long period.


The full effect of China’s rebalancing is not yet known. The government led by Xi Jinping and Li Keqiang have embarked on a potentially tricky, but essential, rebalancing away from investment-led growth to consumption-driven growth. Part of this rebalancing is that there is a substantial slow down in the real estate industry, a strong growth driver in the past. Projects have slowed, new constructions have slowed, returns on new projects are lower, and many projects remain unfinished leaving large ‘ghost towns’ of unfinished condominium complexes.


So, a nervous Chinese state is seeing these signs and not backing away from public investment and stimulus completely. Chinese authorities have lowered the mortgage down payment for first time homebuyers in order to stimulate the property market. Local Government Financing Vehicles (LGFVs), which are economic entities established at the local government level to finance public investments, have received large amounts as stimulus. And most strikingly, China lifted the decades-long ‘One Child’ Policy and replaced it with a ‘Two Child’ Policy; recognizing that a declining working age labour force is hurting growth prospects.


Meanwhile, important progress is being made to re-orient the economy. Over the past two years the central government has either cut or streamlined over 600 items of administrative approvals processes to improve the business climate. Efforts to reform SOEs to become more professionally managed, more globally competitive and less state-dependent are already underway. Long perceived as the imitator, copier, and low-cost ‘follower’ of other countries products, China is determined to break away from that. Innovation has become a strong focus, in order to move the economy away from a low cost model to a value creation one. Chinese universities are globalizing and Chinese researchers are publishing in international journals and filing more patents in the US than the US itself (250,000 in 2012). Over 100 universities now have innovation incubators to help young Chinese students commercialise their ideas, and in the past three years alone 100 universities in the country have started departments to research on the ‘Internet of Things’. E-commerce and e-tailing (online retail) are now key tech-driven growth areas. China now has the world’s second-largest e-tail market, with estimates as high as US$ 210 billion of revenues in 2012 and a compound annual growth rate of 120 per cent since 2003. So, writing off China’s growth prospects as “weak” in light of recent volatility and turbulence might be premature.


Going Out Strategy


Amidst slowing growth at home, Chinese companies – and indeed the Chinese state – have begun expanding their interests overseas. There is a noticeable and concerted push outwards – whether it is Chinese firms independently adopting a ‘going out’ strategy, or the Chinese government promoting the ‘One Belt One Road’ (OBOR) and ‘New Silk Route’ (NSR) and ‘Maritime Silk Route’ (MSR) as new foreign policy initiatives with a substantial investment component. The country in fact has a stated ‘Go Out Policy’ (走出去战略 in Chinese) – also known as ‘Going Global Strategy’ – initiated in 1999 by the government and the China Council for the Promotion of International Trade, which actively encourages Chinese enterprises to invest overseas.


Chinese companies – both state owned and private – are making strong headway in foreign markets. For instance, it may be surprising to know that its Chinese competitor ‘9Bot’ recently bought up the famous ‘Segway’ personal electric scooter that is ubiquitous in major tourist cities; a Chinese insurance group now owns the iconic Waldorf Astoria in New York City; and Chinese tech firm Baidu has stakes in Uber and Nokia. Chinese state-owned firms, having attained scale and competency at home, are now winning contracts in abroad – whether its in power plants in the Middle East, port terminals in Belgium, Tanzania, Pakistan, Myanmar and of course Sri Lanka; and in high-speed rail in the United Kingdom.


As for the strategic foreign policy initiatives pushed by the Chinese state, I was once told by a Chinese diplomat in Tianjin that, “Even though it is called that, the Chinese authorities don’t like to necessarily see it as One Belt One Road, but rather many belts and many roads”. While there is much speculation (and indeed suspicion) around such grand foreign policy initiatives, the ‘belt and road initiative’ is clearly part of larger ‘going out strategy’ for China. A strategy to diversify away from the domestic Chinese market, a strategy to diversify away from putting all surpluses in low yielding US treasuries, and instead invest in higher yielding assets abroad. Arguably, China has large foreign exchange reserves, large current account surpluses, and a relatively closed capital account. Meanwhile, there is growing excess domestic capacity in infrastructure, as the economy rebalances. Some estimates put this at a 70-80 percent gap in cement, steel, and aluminum. So Chinese firms are looking to export this capacity, and so, are seeking opportunities in infrastructure projects in overseas markets through the NSR/MSR and OBOR initiatives. Of course, the financing from large Chinese banks like China EXIM Bank as well as the new Asian Infrastructure Investment Bank, will fit in nicely to this. China has also set up a ‘Silk Road Fund’ – with money allocated from forex reserves – to finance this going out strategy.


Future Outlook


Fundamental questions are being raised about China’s growth rebalancing and economic management. For instance, reforms in financial market liberalization have not progressed and there are questions on the central government’s bona-fides on the commitment to other market-oriented reforms. The current Chinese regime’s singular focus on combating corruption in the government and public-private dealings (some argue some of it is politically motivated, but that is a different story altogether) has been having an impact on infrastructure projects and also interactions between government and business. Overly cautious public officials are hesitant to facilitate private investment projects. There is some sense that this is affecting the real economy.


China’s medium to longer-term prospects appear bright although it may be a few years before many of us can be truly convinced of it. Are the current signs just symptoms of a transition phase as the Chinese authorities get used to managing an evolved economy? Or is there good reason for concern on longer-term prospects? The world is closely watching – is China’s recent sneezing a symptom of inner bacteria that’s weakening growth dynamism or just a short-lived allergy?


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