Most observers tend to fall into one of two camps on China: the diehard sceptics and the perma-bulls. The sceptics are convinced that nothing about China — from the data to the banking system to the demographics — bears close inspection. The sceptics argues that the official numbers are too unreliable to follow, and the imbalances too large to warrant detailed analysis. Sceptics envision an implosion of the Chinese economy, resulting from a bubble in the housing market, in local government debts, in the stock market — or frequently in all three. They view the collapse as impending, and has been for the last decade. The smaller group of China bulls take an extremely benign view of the country’s transformation, and expect the China growth miracle to continue, with moderation lasting temporarily.
This camp tends to dismiss concerns about imbalances, arguing that China has ample money, the right policies and an unparalleled control over its economy.
We try to take a step back and take a more nuanced and balanced view than the diehard sceptics and perma-bulls. On balance we remain optimistic about China’s outlook, but recognise that the country faces formidable policy challenges and substantial risks that bear close monitoring.
China has reached a crucial juncture in its ongoing deep economic transformation. Its three traditional engines of growth have all stalled at the same time: The real estate sector is contracting after a protracted boom; local governments needing to deleverage have scaled back their investment; and many components of the manufacturing sector have been shrinking.
However, growth in consumption driven by rising wages, growth in the service sector and new infrastructure investments work to offset the simultaneous contraction of these other three sectors. The manufacturing contraction has been triggered by the Lewis turning point: a demographics-driven deceleration in labour force growth, which has boosted wage pressures, undermining the competitiveness of traditional export-driven manufacturing.
The slowdown in labour force growth, however, means fewer jobs are needed to maintain full employment. The faster growth of the service sector (now lead leading job creator over industry), should be enough to provide them. Therefore, the contraction in manufacturing, real estate and local governments has not caused an increase in unemployment — a potential thorny social and political problem.
Rising wages and sustained employment have allowed household consumption to overtake investment as the main contributor to gross domestic product (GDP) growth, exactly the type of rebalancing needed. Sustained wage growth, however, needs faster productivity growth. Without this, a growing share of the economy will become uncompetitive, forcing China into the “middle-income trap.”
Faster productivity growth requires industry to shift toward higher technology and higher value-added sectors. The government has fostered this process through a number of key policies: bolstering the education sector, reforming state-owned enterprises (SOEs) to encourage faster private sector growth and incentivising innovation.
The middle-income trap has proven extremely difficult to escape. Nonetheless, China appears to have adopted the correct strategy, and has supported its policies with other long-term reforms, including capital account and financial market liberalisation to improve capital intermediation, thus channelling capital to the more productive parts of the economy.
Meanwhile, environmental and infrastructure spending helps support longer-term growth prospects internally and expands China’s global reach particularly through the new One Belt, One Road initiative.
Significant risks still exist. First, monetary policy needs to strike a balance: The People’s Bank of China is giving just enough support to attenuate the economic slowdown; should growth decelerate further but recent measures to allow local government debt to be swapped for municipal and provincial bonds could turn into a quantitative easing (QE)-style excessive stimulus, undermining the deleveraging and setting the stage for a hard landing.
Second, over the past decade, China has rapidly accumulated substantial debt, largely in less transparent local government and shadow banking operations. We estimate this could be as large as 250 per cent of GDP. But China has an enormous stock of assets, comprising foreign exchange reserves and the assets of its strongest SOEs. Additionally, the central government has no foreign debt. These factors help minimise the risk of a classic debt sustainability crisis.
Third, the stock market could crash — especially after equity indexes there more than doubled in the last 12 months — posing concern.
Though China’s stock market still plays a relatively minor role in its economy, a sudden crash could give a further contractionary shock to growth, and would stall the process of financial sector strengthening and diversification.
Finally, essential SOE reform needs to overcome powerful vested interests, and could face considerable pushback, increasing the chances of failure.
We believe China will remain on course, with GDP growth decelerating moderately toward the 6 per cent mark over the next few years. This could have important implications for the global economy, given the structural fragility of the European recovery and the prospective tightening of US Fed policy.
China’s rebalancing also has a differential impact on trade flows. We should see more trade with advanced economies, producing finished and industrial goods, and relatively less with commodity producers.
Finally, sustained wage growth implies that China should gradually export a more inflationary push globally, reinforcing our view that the outlook remains for higher inflation rates and higher interest rates.
— Writer is the executive vice-president, portfolio manager and chief investment officer at Templeton Global Macro.
