Wednesday, 17 July 2013

How slow will China grow?

The market received China’s latest economic news with an audible sigh of relief.  Growth has slowed but remains in line with expectations.  Those expectations, however, have been difficult to gauge due to a number of factors.

Most obviously the state media agency, Xinhua, reported last Friday that Finance Minister Lou Jiwei had suggested 7% growth remained a viable target, but not a “bottom line”, for 2013.  With market consensus still hovering around 7.6% (down from 8.1% as recently as April) this was something of a bombshell. Xinhua, however, later corrected the article to show a target of 7.5% and removed the reference to downside risks.

On Monday morning the National Bureau of Statistics reported second quarter growth of 7.5%.  That’s the second slowest rate of growth the People’s Republic has reported since the global financial crisis (it slowed to 7.4% in the third quarter of last year). However, the more important point is whether this growth is unbalanced, and whether it is driven by debt accumulation, monetary distortion and excess investment. 

The data accompanying the GDP release have suggested that there is modest room for optimism.  Retail sales growth has been picking up lately but remains slower than recent years.  Industrial production growth has slowed.  China has always been the shining example of a gradualist approach to economic development, but it has also been moving in a fairly straight line thus far.  Like all large and fast moving vessels, it will be difficult to change the Chinese economy’s direction quickly.

As the economy develops it becomes increasingly difficult to credibly change the message.  Urbanisation and industrial expansion have been the mantra for two decades but with the average Chinese crowded out of urban property markets by speculators, and pollution exposing the downside of rapid economic investment, evidence suggests there is a degree of disillusionment amongst the people.

Examples of the weakening ability of Chinese policymakers to impose direction on the economy are easy to find.  Last week, public protests led to a uranium processing plant being cancelled.  Paradoxically, nuclear energy would be one way of assuaging Chinese concerns over pollution (although China is only targeting 6% of total electricity production from this source by 2020).  But, if such ‘not-in-my-back-yard’ protests were to become common, China’s potential struggle to replace polluting coal-fired electricity production with cleaner energy may be just one headwind to growth.

There are plenty more.  The strength of public feeling building on environmental factors may reflect the fact that pollution is a greater headwind for growth than had been assumed. 

The Chinese authorities want to shift industrial capacity to commercial activities but hopes of a seamless transition seem very optimistic to us. Trying to expand consumption, or services, at a time when the People’s Bank of China is already attempting to restrict the growth of the Chinese shadow banking system, and the rampant Chinese property market, also looks like a tall order.

Chinese property speculation is one of the explanations put forward for the first quarter rise in fake invoicing. Fake invoicing is a fraudulent practice which occurs when an exporter sells a bogus invoice to a speculator who is looking to circumvent China’s fixed capital account.

The fake invoice gives the exporter the opportunity to reclaim value added tax (VAT).  The net result is that speculative inflows are reclassified as export revenues.  An economy with robust exports should generally prompt a strengthening currency, whereas an economy attracting net capital flow hints at a depreciation waiting to happen.  Fake invoicing is clearly just one factor contributing to China’s current account surplus and rapid growth, but it is one more factor which hints at a third quarter growth slowdown.

In July’s Bank of America/Merrill Lynch Fund Manager Survey a hard landing in China is the factor which most investors (56%) identified as the greatest tail-risk (a small probability, high impact event) facing the global economy.  But we do not expect to see Chinese growth collapse.  Rather, we see the Chinese economy reaching its industrial capacity.  Capacity, in this sense, is measured not just by inflation (although wage inflation continues to erode Chinese competitiveness), but also by environmental factors.

China’s slowdown provides an opportunity for market share gains by other populous emerging Asian nations, but will also be met through the on-shoring of manufacturing – particularly in the US.  The crucial distinction to make is between Chinese final demand growth, which ought to continue as the economy matures, and Chinese supply growth, which ought to slow.  The global economy has ample supply, which is why inflation and employment have shown such a muted response to the extreme monetary stimulus of recent years.  A Chinese slowdown is therefore a useful step on the road to normalisation.

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