Key Questions For China Investors In 2015 [Part II] by Andy Rothman, Matthews Asia
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