Key Questions for China Investors in 2015—Part II
China is complicated and raises many questions for investors. On the one hand, China’s economy is growing more slowly at 7.4% last year, compared to 7.7% for the two prior years. On the other hand, because the base was far larger last year, the incremental increase to the size of the economy was 100% greater than the increase a decade ago, when GDP rose 10%. This is why the International Monetary Fund estimates that China accounted for almost one-third of global growth last year. With inflation-adjusted income up about 7% in China, compared to 2% in the U.S., consumer spending is booming, up 11% vs. 2% here. Media headlines, however, continue to tell us that China’s economy is doomed.
This is the second installment of a three-part Sinology series designed to answer some of the most important questions about China’s economy. We explore the reasons why the Communist Party is comfortable with slower growth, and just how slow a pace might be tolerable. This segment will also answer questions about the health of what has been the world’s best consumer story, and about prospects for further economic reforms.
The final installment will answer the question: Is China’s property market heading for a crash? And it will discuss what we feel are the biggest long-term risks to growth and stability—an absence of the rule of law and trusted institutions.
The first part of this series, published in early February, addressed the impact of falling oil prices and the risks for deflation. We also considered the prospects of certain policy moves—cuts to interest rates and bank required reserve ratios—that have led to a booming domestic Chinese stock market, and concluded that many domestic investors are likely to be disappointed.
Why Do I Keep Saying China Won’t “Ease” this Year?
Because we are witnessing the odd scene of Communist Party leaders being comfortable with a gradual deceleration of economic growth that is making most foreigners very nervous.
China won’t—and doesn’t need to—ease significantly because current conditions are not “tight”; because the macro deceleration is largely the inevitable result of structural changes; and because the slower pace of growth is still fast enough. Let’s look at each of those three points.
Current conditions are not “tight.” The growth rate of total social financing (TSF, or aggregate credit) has continued to cool, from 19.1% year-over-year (YoY) at the end of 2012, to 14.3% at the end of last year, but that was still considerably higher than nominal GDP growth of 8.3%. Broad money (M2) rose 12.2% YoY last year, compared to 13.8% in 2012. Hardly tight, in my view.
Deceleration is largely the inevitable result of structural changes. After two decades of 10% annual GDP growth, it is inevitable that the growth rate is slowing. Many factors contribute to this slowdown. Demographics, for example, plays a big role: in past years, the workforce grew rapidly, making a significant contribution to GDP growth. Now, the working age population is beginning to shrink, eliminating the “demographic dividend.” Similarly, so much public infrastructure has already been built that the growth rate of new construction is significantly lower. Commercially built, privately owned housing boomed during its first decade of existence in modern China, and is now growing more slowly as that sector matures.
This slower growth is, however, still pretty fast. GDP growth averaged 8.6% between 2010 and 2014, and 7.4% last year (compare this to 2.4% GDP growth in the U.S. for 2014). And the absence of a significant stimulus last year is strong evidence that the Party is comfortable with this gradual deceleration. The Party controls the financial system, and did not reaccelerate credit growth last year. TSF outstanding rose 14.3% last year, down from 17.5% in 2013.
Contrast this with the sharp rise in outstanding credit growth engineered by the Party in response to the 2009 Global Financial Crisis: from 19.7% in November 2008 to 33.4% a year later.
There was also no sign last year of stimulus in the growth rate of fiscal spending, which averaged 1.4% YoY during the September-November 2014 period, compared to 12% during the same period in 2013.
China’s leaders took no significant steps to reverse last year’s gradual deceleration, signaling that they are comfortable with this trend.
How Much of a Slowdown will Xi Jinping Tolerate this Year?
A starting point to answer this question is to understand that the GDP growth rate is not the Party’s main economic indicator. Chinese citizens pay no more attention to GDP than do Americans. As in other countries, the important factors are employment and people’s sense that their standard of living is improving.
China’s official unemployment statistics are (as their economists readily admit) useless, but there are no signs that slower growth has led to rising joblessness. A study of privately-owned, small- and medium-sized (SME) manufacturers by the research brokerage firm CLSA found that in 4Q14, 7% of firms reported it was easier to find new unskilled labor, compared to a year earlier. This compares to an 8% response by SMEs in 2Q08, which then jumped to 76% in 4Q08 as the global financial crisis set in. Similarly, 3% of SMEs reported it was easier to find new skilled workers in 3Q14, while the rates were 2% in 2Q08 and then 61% in 4Q08.
The same CLSA study found that SME wages rose by more than 6% YoY for unskilled factory workers and by almost 8% for skilled workers in 4Q14, growth rates that have remained fairly stable over the past few years after bottoming in early 2009 at -1% for unskilled and 1% for skilled workers.
The independent data from CLSA is in line with official numbers showing continued strong income growth. Inflation-adjusted (real) urban household disposable income rose 6.8% YoY last year, compared to 7% in 2013. Real rural cash income was up 9.2% last year, compared to 9.3% in 2013. (As a reference point, U.S. real disposable personal income rose 2.2% YoY last November.)
Wages for migrant workers, who move from China’s countryside to staff the nation’s urban factories and construction sites, rose by almost 10% last year. The country’s overall labor market remained stable despite slower macro growth.
In my view, as long as there is no spike in unemployment and real income growth remains strong, the Party is unlikely to deploy a significant stimulus. This holds even though I expect GDP growth to slow to the 6.5% to 7% range this year, and then to 5% to 6% by 2020.
Another important factor in understanding why gradually slower growth does not constitute a crisis is the base effect.
At 7.4%, last year’s GDP growth was significantly slower than the 10.1% pace of 2004. But because the size of the economy (the base to which the 7.4% increase was applied) was three times larger than the 2004 base, the incremental increase in the size of China’s GDP at last year’s slower growth rate was 100% larger than the increase at the faster growth rate a decade earlier.
Similarly, if we look ahead to the bottom range of my GDP growth forecast for 2020, 5% growth, that will be applied to a base which will likely be over 60% bigger than the base in 2014 and about 600% bigger than the 2004 base. Therefore, at 5% growth in 2020, the incremental increase in the size of China’s economy will be 39% larger than the increase at 7.4% in 2014, and more than 180% larger than the increase at 10.1% in 2004.
In other words, the slower growth rate will generate a much bigger addition to the size of China’s economy—and a much bigger opportunity for the companies we invest in.
Will China’s Consumer Story Hold Up this Year?
Yes, but—as with almost everything else in the Chinese economy—the growth rate will be slightly slower.
As noted earlier, income growth has been decelerating, and that process will continue. I also expect the Party’s anti-corruption campaign—that has had a modest negative impact on retail sales—to continue. Both of these factors have led to slightly slower growth in consumer spending, with real (inflation-adjusted) retail sales growth going from 11.5% in 2103 to 10.9% last year. With income growth expected to continue to slow, this year will likely deliver “only” about 10% real retail sales growth. Slower, but still the world’s best consumer story. (For reference, in the U.S., retail sales were up about 2% last year.)
Will there be More Reform Progress?
Yes, for several reasons I’m confident that more economic reform is coming.
First, because the Communist Party has no choice. With previous reforms the Party has already bet its future on China’s entrepreneurs, so it must continue down the path of creating a more market-based economy in order to generate the growth necessary to remain in power.
When I first worked in China 30 years ago, the economy was dominated by stagnant state-owned enterprises (SOEs). Today, however, small, privately owned companies account for 80% of urban employment and more than 70% of investment and industrial sales. In a relatively brief period of time, China has become very entrepreneurial, and the Party must continue to improve the economic infrastructure—everything from the tax code to access to bank loans—so that it better supports the private companies that create all of China’s new jobs.
Second, I expect continued reforms because the Party has a track record of delivering significant economic restructuring. For example, although China still has a “fake” banking system, where all of the banks are closely controlled by the Party, the Party has succeeded in giving its fake bankers the incentives (bonuses and promotions) and tools (greater flexibility to price risk) to steer an increasingly larger share of lending to private sector. The following chart illustrates that the companies that drive China’s growth are now getting most of the loans.
Only 29% of loans outstanding were to SOEs as of 2013, down from 41% in 2006, while the share of loans outstanding to private firms rose to 43% last year from 36%. Add in the 18% share for consumers, and last year the private sector and households accounted for 61% of loans outstanding, up from 47%.
This is also consistent with central bank data showing that today more than 70% of new loans are priced above the benchmark lending rate, up from 48% in 2006. This reflects more lending to (riskier) small private firms, as it is unlikely that a significant share of loans priced above the benchmark rate are made to SOEs or government agencies.
This data is consistent with the conclusions of Nick Lardy’s recent book, Markets Over Mao: The Rise of Private Business in China. Nick, an economist who has written presciently about China since the 1970s, concludes that “the access of private firms to bank credit has improved so much that on average new bank lending to private firms in 2010–12 was two-thirds more than to state firms.”
Another example of reform is that last year, for the second consecutive year, the tertiary* part of the economy (services, retail and wholesale trade in addition to finance and real estate) accounted for a larger share of GDP than the secondary* part (manufacturing and construction).
Last year the Party began reform of the hukou, or household registration system. Launching this complex and expensive reform program is a sign that the new Party leadership is willing to take on big challenges. Hukou reform should also reduce the risk of social instability for some of the 230 million people living in cities who face de jure discrimination on a daily basis, particularly due to their ineligibility for social services and subsidized housing. Over time, hukou reform should also boost consumption and raise manufacturing productivity. (See the August 2014 issue of Sinology for more on reform of the hukou system.)
But we need to maintain realistic expectations for the pace and scope of reform. The days of dramatic, big-bang changes are over, in large part because Chinese society would not accept the mass state-sector layoffs that were tolerated 20 years ago. This is one reason why I have low expectations for further SOE reform in the near future. Closure of many money-losing and indebted steel and cement plants isn’t likely for a few more years, while the Party wrestles with the problem of how to deal the unemployment consequences of shutting the largest employer in small cities. I recognize that more modest reforms designed to boost the efficiency and productivity of SOEs are likely to only generate modest results. For me, however, this is acceptable, as I prefer the Party continue to focus on improving the operating environment for the private firms that drive China’s growth.
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