25 October 2018

We all know China’s economy is slowing. Indeed, markets and pundits agonise when GDP results fractionally dip below expectations, as highlighted by the spike in market volatility following the recent news  Chinese output advanced “only” 6.5% during Q2 2018 (compared to the 6.6% forecast). To be sure, such results seem disappointing, as we had come to expect China to grow 8-10% every year.

However, this misses the larger, more important message.  China has embarked on a historic transformation, which Chinese authorities (and the IMF) describe as a transition from “high-speed to high quality” economic growth. To begin with, China must deal with the excesses of their earlier rapid growth phase, e.g. reversing its recent state-directed borrowing binge, which produced overcapacity in several key industries.

In addition, China aspires to transition towards a growth-model driven by consumption and services, rather than its previous reliance on highly polluting industrial exports and investment. Chinese leaders acknowledge this rebalancing will require a greater reliance on market forces, innovation, openness, and a modernised policy framework.

Not surprisingly, the prospect and consequences of a US-China trade war now dominate the headlines. However, the implications of China’s debt deleveraging and navigating the economic rebalancing are potentially far more significant.  How is the transition progressing? Even if handled skillfully, markets should brace themselves for Chinese GDP to decelerate towards the 4-5% range during the next 18 to 24 months. Risks even to these sobering projections are to the downside,  especially if China adopts policies that impede the needed debt deleveraging.

China Falling into the Middle-Income Growth Trap?

One explanation for China’s recent growth slowdown may simply be that the economy is maturing, and is no longer capable of generating double-digit output gains. The following Chart illustrates that many countries have experienced this pattern. After a prolonged phase of rapid growth, many East Asian economies have seen GDP growth cool towards the 5-6% range, but have still enjoyed expansions well in excess of the USA (convergence continues). Meanwhile, Latin American countries have been less successful after achieving “middle-income” status. In Brazil, in particular, not only has growth slowed, but the income gap with the USA has widened!

The explanation for this pattern is straight-forward. The early growth surge relies heavily on agricultural workers migrating to urban industrial jobs and large-scale capital spending.  Eventually, surplus labour is eliminated and returns on investment decline, and GDP growth moderates. At that stage, productivity (e.g. total factor efficiency) becomes an increasingly dominant driver of GDP growth.

This is precisely what is happening in China.  China experienced an unprecedented growth phase: GDP averaged over 10% per annum for nearly 30 years — not even Korea, Taiwan, or Singapore matched that! — during which time 800 million people were lifted from poverty. The Chart above highlights the dominant role state-directed business investment played in this astonishing performance.  In the future, however, the plan is for capital spending to be a less important growth driver. The Chart illustrates this is already happening. Indeed, after expanding 25% annually during the growth phase, Fixed Asset Investment is now up only 5%.

As in other countries, therefore, productivity gains will become the key component of China’s growth. And, while the Chart above illustrates that China’s efficiency gains remain enviable, labour productivity has slowed markedly during the past decade. President Xi’s recognition of the key future role productivity will play provided the inspiration for the Made in China 2025 program. Hopefully, China will also recognise the benefits US technology can provide in sustaining healthy growth.

Since the end of the Global Financial Crisis (GFC), China’s GDP has advanced 7.5% per annum.  However, the IMF estimates the recent credit binge (to be discussed) added up to 2% per year. This suggests, and I believe, China’s growth potential has already slowed to 5.5-6%!

Deleveraging: Focus of Downside Risks

In an effort to isolate itself from the impact of the GFC, China went on a borrowing binge. The following Chart illustrates that China’s debt ratio has reached levels  experienced previously in Japan, East Asia, Spain (throw in Sweden for good measure), and well above the USA. In all these cases the inevitable process of deleveraging led to abrupt, deep recessions or extended periods of stagnation.

Is China different? Optimists suggest China’s low-level of external debt and protected capital markets will allow deleveraging to occur more smoothly over a longer period than in other cases. And, they argue, China has considerable scope to use stimulative fiscal policies to offset the inevitable drag on GDP growth.

Even though Chinese authorities recognise the problem, and have made deleveraging a priority, progress has been limited so far.  To be sure, the Chart above indicates there are tentative signs sky-high corporate debt may be peaking; meanwhile, household borrowing (particularly mortgages) has accelerated. In addition, government fiscal stimulus has added to the stockpile of public sector liabilities. Higher household debt is not overly worrisome at this stage, especially given the priority to boost consumer spending. However, while consumer debt is much higher in the USA, China’s household borrowing is now elevated compared to other Emerging nations.

Likewise, recent BIS data indicate that the stabilisation of corporate debt ratios may have been only temporary, and additional worrisome trends in this vital sector still exist.  In particular, even though private sector firms have reduced debt this year, liabilities of state-owned corporations have risen 11%, presumably as part of the fiscal stimulus package. Additional government outlays into unprofitable SOEs have kept the measure of investment efficiency well below pre-GFC levels (Chart below shows the number of RMBs of credit needed to boost GDP by 1 RMB).

To be sure, credit growth is slowing. However, the Chart below illustrates that “total social financing” (the most comprehensive, closely followed measure of credit) is still advancing  by nearly 10%.  As a result, overall debt/GDP ratios are still rising. Deleveraging is only just beginning!

ReBalancinG: Shifting Roles for Markets and Soes

The second major initiative is rebalancing the economy towards domestic consumption and services, while reducing its reliance on external demand, fixed investment, and industrial output. Success will require greater reliance on market forces and a reduced role for state-owned enterprises (SOEs).

While not without some mis-steps, there has been meaningful progress. The Chart above highlights the  out-performance of the service sector (tertiary) compared to industry, and consumption has outpaced investment spending. And, overall, the external sector’s contribution to GDP growth has declined in recent years, as planned.

In general, likewise, even though SOEs still loom large,  their role in the economy has diminished on many measures (Chart above). The following Chart illustrates why SOEs reform is so vital if China is to succeed in producing high-quality growth. Despite earlier adjustments, SOE profitability (return on assets) has not improved, and lags well behind private firms. Likewise, nearly 25% of SOEs are unprofitable (“zombies”). And, the declining share of  loss-making state firms is simply the result of mergers with the stronger SOEs.

However, despite these successes in rebalancing the economy, there are some signs that the pace of change may be slowing.  During the past year, for example, economic activity has relied again more heavily on external demand and policy support. Indeed, the earlier Chart illustrates the recent boost provided by the export sector in 2017 (even though the current account surplus remains very small). More worrisome, however, are indications that fiscal support for SOEs may have increased. The following Chart illustrates that public sector fixed asset investment is rising again, and the SOEs’ assets increased a further 12% in H1 2018.

Opening Up: Can a Showdown with the USA Be Averted

Chinese authorities recognise achieving “high quality growth” will require a liberalisation of its trade and investment regime.  Progress, however, has been inconsistent (to say the least). After initial tariff cuts following WTO membership, further reductions have not occurred unlike in Mexico and India.  While levies are lower than some Emerging nations, they remain well above the OECD average.

Likewise, the following Chart illustrates reforms in the trade of services and foreign direct investment lag well behind other regions, leaving China as one of the world’s most restrictive. Not too surprisingly, perhaps, FDI inflows have slowed in recent years: from 3% of GDP in 2013 to 1.4% last year.

At this stage, it appears unlikely that the proposed hike in US tariffs on Chinese imports will be averted. America’s export/import ratio with China is the lowest amongst its key trading partners (Chart). And, the bilateral deficit continues to swell: $260bn so far this year compared to $240bn.

Measuring the impact on China’s economy is difficult.  Nevertheless, I estimate the proposed tariffs could reduce growth by roughly 1% over the next two years. As painful as that sounds, however, it pales in comparison to a mishandled deleveraging effort.

China’s Policy Mix: Walking a Fine Line

In setting monetary and fiscal programs, China must walk of fine line.  On the one hand, policymakers want to provide support while the economy deals with both domestic and external challenges.  However, they need to avoid policies that either impede deleveraging or curtail the desired economic rebalancing.  Chinese officials assume that low levels of government debt provides time to proceed cautiously.

The Charts above illustrate the signficant fiscal stimulus in recent years. With debt/GDP still below 40%,  China believes it can continue to provide similar support.  Using “augmented” definitions (which includes local governments and off-balance sheet activities), however, the IMF estimates China has far more limited room to manuever. They estimate the overall deficit at nearly 11% of GDP (govt targets 4%), and public sector debt at over 70% and rising quickly. The government suggests that investors, not the public sector, are responsible for off-balance sheets liabilities. However, it is worth noting the 2013 jump in government debt, as the public sector absorbed  sizeable off-balance sheet liabilities.

In addition, the following Chart indicates that Chinese interest rates remain below “neutral” settings, suggesting that monetary policy remains accommodative (the RMB’s recent weakness supports this view).

Of course, it makes perfect sense for China to use macro-economic policies to support economic activity. However, the Chart above illustrates that  overly accommodative monetary conditions played a key role in the earlier borrowing binge, and provides a disincentive to reduce leverage. In addition, the current RMB weakness (and a now undervalued currency) would appear to work against the objective of reallocating resources away from exports. Meanwhile, fiscal expansion aimed at boosting incomes and consumption is sensible.  As we have seen, however, public sector expenditures appear also to be supporting state-owned enterprises, which again works against SOE reform and deleveraging.

Deleveraging is inevitable. The current mix of stimulative monetary, fiscal, and FX programs may cushion the pain in the near term. However, if these policies impede the adjustment, they run the risk of making the problem larger, and the inevitable adjustment potentially more disruptive and painful.

Strategic Implications

• China’s growth potential has already slowed to 6%.  GDP gains will decelerate gradually further to below  5% over the next 18 to 24 months.
• Macro-economic policy support remains sensible. But, programs impeding deleveraging and rebalancing could potentially, inadvertently result in a more abrupt, deeper slowdown.
• Stock market support may be tempting, as much household wealth lies in equities. However, overly relaxed policy also may be a disincentive to deleveraging.
• Chinese authorities appear to prefer to maintain relaxed monetary conditions (e.g. note the recent reduction in bank reserve requirements), and to accept a weaker undervalued RMB for now. This may change if US-China trade tensions abate.
• Tariff hikes in January now seem unavoidable.  Eventually, however, there are many concessions China could make which  would be both in their own self-interest and assuage American concerns. Eventually, I expect common sense to prevail, but not soon enough.
• Concerns about slowing Chinese growth will remain a risk for global and EM markets, at least until the Fed halts interest rate hikes and trade talks progress considerably further.