Why the pace of growth in China matters for investors everywhere
Over the past few years, the largest stock market falls have been caused by concerns that China’s fast-paced economic growth could suffer a sharp slowdown. This matters for investors everywhere, given widespread predictions that China will overtake the US as the world’s most important economy. Fortunately, we do not see a slowdown in China as a significant threat for 2018.
To get some clues on the direction of the economy, investors were closely watching the Communist Party’s recent National Congress. It approved the line-up that will govern the country for the following five years, with President Xi firmly at the helm. But hopes for clarity on how the government would balance the trade-off between reducing debt and upholding growth were largely unfulfilled.
President Xi repeated his commitment to reforms already announced in 2015, including reducing excessive lending to state-owned enterprises, improving efficiency and ensuring financial stability. Yet progress has been lacklustre and only a few struggling firms have been allowed to fail.
We believe China’s growth rate is more likely to slow than reaccelerate over the coming year, but a significant policy-induced slowdown seems unlikely in the wake of the 19th Congress.
A change in tone
One notable shift over the past 18 months is the government has begun to acknowledge that high levels of debt pose a risk for future growth. It realises that the days of high-speed growth are over and short-term policies must be abandoned to avoid a financial crisis.
If President Xi is serious about reform and financial stability, then he is in a strong position. He has used an anti-corruption campaign to consolidate his grip on power by removing rivals. Only two members of the newly announced seven-member Politburo Standing Committee are outside his inner circle.
How much of a threat is China’s debt? There is certainly a lot of it. According to the Bank for International Settlements, total debt excluding the financial sector is 258% of GDP (although the figure is 268% across advanced economies). The nonfinancial corporate sector is particularly indebted at 165% of GDP, while the household sector is relatively light on debt.
Yet the size of an economy’s debt mountain has little bearing on the likelihood that it will trigger a debt crisis. It is the speed at which the debt is accumulated that matters. A more reliable measure is the debt-to-GDP gap – how far the debt-to-GDP ratio has moved above the long-run trend.
In 2010, China breached the threshold that has triggered 70% of the world’s debt crises over the past 50 years. Since then the debt-to-GDP gap has fallen. Debt has continued to accumulate but at a much slower pace. Annual growth in bank loans has stabilised at around 15%. Meanwhile, growth in non-bank loans (the shadow banking sector) has fallen precipitously due to government policies.
Time to worry?
Why has there not been a debt crisis already? In the first instance, most of China’s debt is funded with domestic capital. Questions over debt sustainability do not translate into a balance of payments crisis, like Asia in the late 1990s. China is still a net creditor to the rest of the world, with a gross national saving rate of about 45%.
Second, loans from domestic banks are largely funded with deposits. Indeed, in 2017 the regulator banned banks from obtaining more than a third of their funding from interbank lending (which was one of the main causes of the global financial crisis).
Third, most of China’s debt has been issued by state-owned banks to state-owned firms and local government entities. Defaults can be averted by shifting money around. In our 2015 report, Taming the dragon, we showed that even if default rates rose to extreme levels and the government bailed out the system, its debt-to-GDP ratio would still be lower than in most G7 countries.
This assessment does not mean there is nothing to worry about. Excess debt has the potential to dramatically reduce growth and lending to productive projects. Investors should take note because China has accounted for 30% of global growth since 2010.
We estimate that more than 40% of all credit outstanding in China has failed to generate a sufficient economic return to render it viable. Unsurprisingly China’s productivity growth has plunged. That is why reform is so important for the country’s ability to deliver long-term returns.
Figure 1: What's really going on?
Our 'nowcast' estimate of China's underlying rate of growth uses a range of measures of economic activity
We use ‘nowcast’ estimates for Chinese growth to gauge what’s really going on in the Chinese economy (figure 1). According to our calculations, underlying growth accelerated from the fourth quarter of 2015 before peaking in the third quarter of 2017. This measure is closely correlated with the performance of mining stocks in the FTSE 350 (figure 2) as well as Asian equities.
Where will it go from here? China’s central bank has allowed interest rates to rise over the past year, which should cool the economy. The authorities have used regulations to curtail lending, particularly in shadow banking. However, the central bank has also announced it wants to ensure ample liquidity by cutting the reserve requirement ratio for banks able and willing to make new loans. Monetary and credit growth have slowed as a result.
Residential property investment is also set to soften. Some 100 cities have introduced policy measures to soften house prices. Yet the property market is unlikely to suffer a deep downturn. Housing stock is at a multi-year low and the government is investing in affordable properties as part of a programme to tackle wealth inequality.
President Xi reaffirmed the commitment to doubling GDP per capita by 2020. However, Beijing is hamstrung on the amount of reform and deleveraging it can undertake, while maintaining annual growth at the 6.3% rate required to achieve this objective. Any restrictions on manufacturing as part of a new anti-pollution scheme may also impede growth.
Notably, at last year’s Congress, the government said it would not set a similar target after 2020, pointing to the importance of quality of growth over speed. Perhaps this underreported statement was the most important thing to come out of the Congress, indicating that growth will slow significantly and decidedly after 2020. We estimate that GDP growth is likely to be between 4% and 5.5% over the next decade.
What does this mean for investors? Neither China’s domestic stock market (A-shares) nor the Hong Kong market (H-shares) has shown any relationship with economic fundamentals. Many bullish fund managers often argue that A-shares could benefit from market reforms that would make them more shareholder-oriented. Yet the emphasis on state control at the 19th Congress is at odds with this idea. President Xi even reaffirmed the intention to take small but influential stakes in China’s privately owned technology giants.
For global investors, events in China may not have a substantial impact on global equity returns over the long term. Although any concerns about a slowdown or negative headlines about debt levels could result in short-term periods of volatility, they are unlikely to be a significant drag.
Figure 2: China matters
The pace of Chinese economic growth is closely correlated with the performance of the UK resource stocks.