China’s record economic growth clearly appears to have slowed sharply down from the double digit rates seen for most of the past decade, with GDP growth during the first half of 2012 falling to 7.8%. A closer look at the underlying drivers of growth reveals that the slowdown is closely linked to the ongoing rebalancing of the Chinese economy. With government investment, formerly a key driver of expansion, being reigned in and weak demand for global exports, China’s growth has to rely more on private enterprise and consumption. China’s leadership appears to have accepted the ensuing slow-down as a necessary cost of rebalancing while shifting its focus from GDP to per capita income growth, a key driver of social stability. Interestingly, a comparison to other countries that transitioned from an investment driven growth miracle shows that China’s economy still has plenty of steam for high growth left, particularly in sectors relating to domestic demand. While China’s “Miracle” of 10% sustained annual growth may be over, the China Story clearly still has a long way to go.
China’s Growth Prospects: Rebalancing for Stability?
China’s second quarter GDP growth dropped to 7.6%, down from first quarter growth of 8.1% and barely above the 7.6% growth forecast by the central government for the entire year. Commentators in both the West and China have already called China’s current slump the End of the Chinese Miracle, following 30 years of 10% plus GDP growth. While it is clear that the weak global macro-environment, the ongoing Euro-crisis and the fragility of the US recovery is impacting China’s growth outlook, the country’s policy and structural issues are also significant. China’s overdependence on investment and exports, widespread participation in the economy and a repressive financial system are among others well known issues facing China’s economy today. However, a closer look the latest data, the government’s recent reactions and a comparison to other “economic miracles” tells a more nuanced story about China’s growth prospects.
Looking more closely at China’s recent economic data, there are signs that the economy is undergoing a much needed and long awaited rebalancing. China’s economic rebalancing needs to take place along three critical dimensions:
- From Investment to Consumer Led Growth: China’s growth model has long been driven by fixed asset investments, which for the past decade have grown between 25% and 30% annually. Moreover, China’s consumption as a percentage of GDP is among the lowest in the world. Recent data however suggests that the rate of investment growth is flattening out while consumption is on the rise. Fixed asset infrastructure growth has slowed to 20.4% (down from 25.0% y-o-y), while retail sales growth, a key indicator of consumption has risen to 13.1% from 8.8%, well above the current GDP growth rate of 7.6%. As a result of these trends, consumption as a percentage of GDP is on the rise again (partially enabled by lower overall GDP growth rates) for the first time in over a decade, and hit 40% in 2011. As the OECD average is over 60%, China will be able to sustain high consumption growth for some time before its consumer markets matures and economic growth levels off again.
- From Government Investment to Private Investment: The second shift is a difficult long term one for a country with a massive embedded state sector. In China, government investment has traditionally been one of the largest drivers of growth, either through direct government investment in infrastructure or through large scale investments by state owned enterprises (SOEs). Although the state share of employment has fallen steadily from 60% to under 20% over the past 20 years, SOEs in 2011 still accounted for 36% of fixed asset investments. The current slowdown in fixed asset investment is being led by a significantly slower rise in government spending. In 2011, while overall spending is still increasing at 20.4%, public spending has risen by only 12.5%, less than half the rate of private investment. This trend reflects the fact that the government is scaling back expensive but employment generating infrastructure projects like railroad construction (down 36.9% vs. the previous year) while encouraging increased amounts of private investment in key sectors. To further this objective, the central government has issued guidelines to allow private investment more heavily state-controlled and monopolized sectors such as oil and gas exploration, education and health sectors and private investment in the sectors during the first half of 2012 is up by 89.2%, 40.2% and 43.1% respectively. This move to private vs government led investment can bring China closer into line with other developed economies, where government investment (and participation) in industries is the exception rather than the rule.
- From External Demand to Internal Demand: China will need to (further) wean itself off a dependency on foreign exports to drive growth, particularly given the weak global demand outlook for its products. During the past decade, China’s foreign trade grew in excess of 20% annually, with the country amassing the largest current account surplus in history. More recent data however shows that both imports and exports have ground to a halt, with import growth in June actually negative, at (2.6%) year on year. Although this sharper fall in imports has seen the monthly trade balance increase to US$26.7bn, vs. US$17.8 one year ago, the long term trend is driving a decline in China’s current account surplus, as slower export demand and a growing domestic market push up import over export growth. China’s trade surplus in 2011, US$155bn, was barely half the amount achieved in 2008 and the lowest level since 2005. Accordingly, exports’ share of China’s GDP is falling, from 8.8% in 2007 to less than 4% today. This decrease actually results in exports having a negative impact on GDP growth, with net exports providing a (9.4%) contribution to China’s growth in the first quarter of 2012, down from a positive contribution of 18% in 2007 pre the global financial crisis. Seen in this light, the relative drop in external demand is already well underway and is expected to continue in the face of a weak global economy. China’s challenge, as outlined above, will lie in replacing the ensuing shortfall with domestic demand.
China’s Government Focused on Income Growth
In the West, we are used to politicians saying things that we are not meant to take very seriously. On matters of policy, Chinese politicians still have that quaint habit of saying what they really do intend to do, although often in an oblique way. Signalling value is still important in China. So, the fact that the Chinese government’s response to its slowdown has been mellow by its own standards indicates an acceptance or even an endorsement of slowing growth. In reaction to August manufacturing PMI falling below 50, (to 49.2), for the first time since November 2011, National Development and Reform Commission chairman Zhang Peng commented: “Economic growth is slow but stabilising”, while Premier Wen Jiabao stated: “It is under considerable downward pressure, but we have the ability to keep our economy in good shape.” Comments of this nature, along with the reduced growth forecast for the year (down from the traditional 8.0% from previous years) indicate that China’s government is not panicking over the growth slowdown and may well not implement an aggressive stimulus plan like the one enacted in 2008. The conclusion appears to be that China’s leaders are comfortable with a slower pace of growth moving forward. The government appears to have recognised that China’s headline GDP slowdown need not endanger social stability, the Communist Party’s overarching and long-term goal. In fact, China’s investment led model had previously driven record rates of growth without corresponding changes in household wealth and income, one of the most important factors in social stability. Households don’t care what GDP growth is, they care about the growth in their spending power.
Income growth in China has lagged GDP growth considerably in the past decades averaging 5% since the mid 1990s, and the government had set an annual target of 7% for the 2011-2015 period. Despite the slowdown in overall economic growth, household income growth has actually accelerated, with H1 2012 per capita disposable income growth for urban households at 9.7% in real terms (up from 8.4%) and per capita cash income growth for rural households at 12.4% (up from 11.4). However, in order to continue to ensure stability and income growth, China’s leaders will need to do more than just raise per capita incomes, including strengthening the social safety net to gradually reduce the relatively high savings rate and continuing to create employment as well as adequate housing for China’s urbanising workforce. In 2011, government spending on education increased 28%, healthcare spending increased by 33%, social security spending by 22% and spending on low-income housing increased 61%. With the current unemployment rate at 4.1%, trending just below the ten year average, it appears that China is making some progress with regards to continued employment, income growth and social stability.
It is worth pointing out that, should GDP growth fall below a critical margin, China’s leaders have a comfortable buffer within which to provide job creation and economic stimulus without overheating the economy. At the recent World Economic Forum meeting in Tianjin outgoing Chinese Premier Wen Jiabao stated that “Be it monetary or fiscal, we still have ample strength” further noting that the government had reserved US$15bn in a fiscal stabilisation fund to “appropriately use that [sic] for pre-emptive policy and fine-tuning to propel stable economic growth.” Inflation is currently running at 2.0% p.a., well below the annual inflation target for the year of 4.0%. Further, year-on-year house price growth has been negative since March of this year and is currently running at (1.2)%, providing some comfort around a possible deflation of the housing bubble. To date China’s efforts have focused on reducing interest rates to drive credit growth, with some effect, although over the short term, these measures work against rebalancing by further increasing investment.
The End of the Miracle?
Neither China’s development path nor its current economic challenges are unique. The investment/export driven growth model was adopted by a number of countries, including Japan and the Asian Tigers, which witnessed rapid growth followed by a period of economic rebalancing. Looking at the transitions experienced by these countries provides an interesting comparison for China’s current performance and outlook, despite massive difference in scale between China and these other countries. China is not only 10 times larger than say Japan in terms of population, it also invested more on a relative basis than Japan or Korea, and subsequently depressed consumption more than they did. The table below shows the difference in investment and consumption levels during their respective periods of rapid growth. Japan in the 1970s and South Korea in the 1990s (and Taiwan in the 1980s) all slowed from about 9% GDP growth to around 5%, at a time when their GDP per capita levels reached levels considered middle income, or about US$5000. China today, with a GDP per capita of US$5400, has clearly reached the same state of development and now faces a number of the same pressures that slowed growth in the other “Asian Miracles”. This slowdown is partially a function of size: the larger an economy is, the more difficult it is to grow at an accelerated rate. By this definition China’s economy, the second largest in the world, should slow down from its double digit levels. However there are two critical factors at play in China that differ markedly from the experiences of the other Asian growth economies.
Firstly, development in China to date has been less than uniform with a significant development gap between the industrialised eastern coast provinces and the poorer, less developed central and western provinces. Although the average GDP per capita as of 2011 was US$5400, there were a total of 14 (out of 31) administrative divisions/provinces in China with GDPs per capita of less than US$5000 (“Developing China”) and six with GDP’s per capita of less than US$4000. The total population of the 14 provinces is nearly 600m (200m of which reside in the bottom six provinces), which on a standalone basis would make Developing China the third most populous nation on earth. In these regions the investment led growth model still has some headway to make and their sheer size will ensure that their growth has an impact on China’s overall GDP development, at least over the near to medium term, when these provinces hit middle income levels. The second factor is relating to the size and development of China’s domestic market, which is both significantly larger as well as relatively underdeveloped vs. other Asian miracles at the time of their slowdowns. Private consumption in China is at 35% of GDP, vs. approximately 55% in Japan and Taiwan. As stated above, Chinese consumption has significant room and a sufficiently large domestic market to grow to pick up the slack left by flagging exports and a decade of high investment rates, unlike other Asian countries which saw a sharp drop in growth.
Finally, it is worth pointing out that GDP growth does not equal sector growth: even in a 6-8% growth scenario for China there will still be multiple sectors expanding at two to three times that rate. Retail and consumer related sectors should continue to grow at income growth levels or above, in the double digit levels, and could continue to do so until the economy effectively rebalances. Related sectors such as education and healthcare should also continue to see sustained growth levels in excess of GDP. Moreover, China’s government has identified seven strategic sectors for China’s continued growth, including (i) energy saving and environmental protection, (ii) new-generation information technology, (iii) biotechnology, (iv) high-end equipment manufacturing, (v) new energy, (vi) new materials, and (vii) new-energy vehicles. These strategic emerging industries are each targeted to achieve an average annual growth rate of more than 20% and the government has committed to provide favourable fiscal and financial policies to boost their development, rather than participating directly. China in other words still represents one of the most attractive growth stories available to investors and corporations globally. And even though the “China Miracle” may be coming to an end, the China Growth Story that is taking its place promises to contain some highest potential value creation opportunities at a regional and industry-specific level.
Conclusion: Implications for Investors
From the perspective of international investors an 8% or even a 6% growth China is still expanding at three or four times the rate as the best case scenarios for the US or Europe. However, the systemic and specific risks of investing in China can be expected to to require a highly selective approach to investment strategy. Given the changing shape of China’s profile as an investment destination, there are three emerging strategies for investors to participate in the China Growth Story, investing in
- High growth sectors like healthcare, consumer goods and personal financial services, where increasingly scaled investments will be required to compete effectively;
- High specialisation sectors like biotech, new energy, high tech and IT, that require significant technical expertise and capital, and
- High quality companies and industries that are transparent and well run with high corporate governance standards where companies and industry specific risks risk is lower and well understood.
In world of increasing volatility and uncertainty, and weak growth in Europe and the United States, China continues to be an important engine of global GDP growth. And while the China Growth Story may not be good as the China Miracle was, it has the potential to be significantly more sustainable, which in today’s world might be just what investors are looking for. Next month we will look at India’s current slowdown and its recovery and growth prospects.
1. See appendix for definitions and sources
Creating Prosperity for a Billion People: Re-architecting the System of Wealth Creation