Growth priority

Written By: Aninda Mitra Senior Sovereign Analyst Standish

China’s economy is unique in being both enormous, and rapidly and relentlessly growing. Like a jumbo jet with fighter plane performance, the Chinese economy can have a massive impact for good or ill far beyond the country’s borders. Standish’s senior sovereign analyst, Aninda Mitra, considers the latest developments in China

Several times in the past two years, policy shifts and missteps in China have brought volatility to what had been mostly placid markets. So is China a looming source of potential volatility or a bulwark of stability and a counterweight to destabilising forces elsewhere?

The good news for investors is that in the short term at least, we believe China is a source of both macroeconomic stability and positive global risk sentiment. A variety of factors are contributing to China’s positive contribution to the benign conditions that have characterised global markets for most of the past 12 months. State-owned enterprises and other firms alike have reduced excess production capacity, which has pushed up producer prices and shored up domestic revenues and profits. The weaker US dollar has also reduced pressure on the renminbi and boosted external liquidity. Above all, though, the greatest contributor to stability from China is the determination of its policymakers to maintain the momentum of economic growth even as they weed out pockets of excessive risk.

Achieving growth
For China’s leaders, growth remains a top priority. They view it as indispensable to domestic stability, which also contributes to stability in the global economy. The question is whether and how China can continue to sustain this growth in the longer term.

China’s policymakers have been challenged by changes in both its domestic and global economies in the past couple of years. China’s export growth has slowed, asset price bubbles have arisen and capital has flowed out. Despite these challenges, policymakers are showing they remain able to steer their country’s massive economy.

They have imposed strict capital controls to limit the liquidity drain, which has become a policy headache. They have also tightened property market regulations in some cities and price increases are slowing. Finally, stricter regulations on shadow banking and interbank borrowing are cooling risky, and leveraged, lending practices.

To be sure, the cooling of property market activity is already becoming a drag on the economy. Lower property prices may also increase investors’ interest in other asset classes such as domestic equities, commodities or foreign currency. However, we expect ongoing investment in infrastructure, technology and energy efficiency – alongside tougher regulations – to create growth multipliers, limit speculation, slow the further buildup of leverage and move China’s overall productive capacity to higher value- add areas.

The long-term efficacy of several of these reforms, regulations and investments remains to be seen but in the near term, they should lower macro and policy headwinds from elevated leverage and an eroding current account surplus.

Demographics
The government clearly possesses a variety of policy levers. However, there remain forces at work in the world that do not yield to the dictates of policymakers, no matter how much temporal power they may wield. Like King Canute who recognised that the waves and tides of the ocean rose and fell despite his ordering them not to, China’s leaders confront the fact that the country’s demographic realities do not necessarily support Beijing’s push for continued growth.

China’s growth potential is being reduced by the rapid ageing of its working age population, slowing migration to urban areas and rising debt – all of which depress domestic demand. The shrinking labour pool will undoubtedly lower China’s potential growth rate and the country faces a clear risk of getting considerably older before it becomes much richer.

However, China’s rural population is still large compared to other East Asian or other OECD economies. Continuing migration and urbanisation, albeit at a much more moderate pace, would buffer but not offset the drag from worsening demographics. Additionally, the imbalance in the sex ratio in favour of males lowers the number of child-bearing women over the medium term. The reversal of the fertility ratio resulting from the ending of the one-child policy will therefore take much longer – if it succeeds at all – to reduce the demographic drag on growth.

These secular trends do not pose an imminent threat to social stability because wages are likely to rise due to labour shortages in the near term. They do, however, highlight worsening inter-generational economic prospects, an underdeveloped social safety net, looming long-term credit risks and a halting commitment to reforms that would deepen China’s credit and equity markets.

In this less-favourable-than-it-used-to-be environment, China’s continued long-term growth will need to come from different sources than it has during previous decades. Instead of seeking to boost manufacturing of goods for export, policymakers are trying to increase domestic consumption, which is low compared to developed markets, though not significantly slower than in other fast growing emerging markets.

Government allocations
Investment-driven growth in sectors other than real estate is another important driver of potential growth. Heightened infrastructure spending and investment in high-tech sectors of the economy will remain important components of the overall thrust of investment. China’s overall share of investment in GDP has remained distinctly and persistently higher than other emerging markets and in comparison to past investment booms in Japan and other older East Asian Tigers. Even then, China’s capital stock per capita is still considerably lower than many other economies, highlighting the country’s continuing “catch- up” potential.

The incremental capital to output ratio has worsened markedly in recent years. This underscores the need for better allocation of capital. The big question facing Chinese authorities is whether a continuing investment drive in non-real estate areas should be spurred by state directives, backed by tightening macro-prudential measures or driven by market-based mechanisms.

An additional policy initiative with implications for growth involves reducing the use of leverage in investment. Earlier this year, China’s National Financial Work Conference, which meets every five years to set financial policy, committed itself to reforms intended to lower leverage. Reducing the high capital intensity of state-owned enterprises (SOE), private companies and consumers is intended to reduce the likelihood of future financial crises. It will hopefully be accompanied by not only increased capital investment in infrastructure and high technology but also changes to the underlying management and incentive structure of the SOEs – to limit arbitrary growth targets and limitless implicit backstops by the government, which, previously, have distorted perceptions of financial soundness and mis-allocated credit.

Meeting targets
We continue to believe the authorities will be largely successful in smoothing the GDP slowdown to slightly below 6.5% in coming years. Without meaningful reform and with the increasing centralisation of authority, it will remain difficult to find new wellsprings of productivity, which could otherwise keep the growth target easily within reach.

Still, the government has shown it remains committed to the growth target with a limited stimulus and accompanying supply side adjustments. These initiatives have ended producer price deflation and sparked a stronger-than-anticipated cyclical rebound. This firmer cyclical context has then become the basis for doubling down on tackling pockets of financial risk and broadening the scope of de-leveraging efforts.

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