The influence of the United States on the global economy is captured by the old adage that when America sneezes, the rest of the world catches a cold. Yet this historical causality appears to have reversed of late, as a minor devaluation of the Chinese currency in August sent global financial markets into a tailspin, and was subsequently cited by Federal Reserve Chairwoman Janet Yellen as a reason to delay an interest rate hike in September. Fluctuations in capital markets, interest rates, currencies and commodities are routinely credited to (or blamed on) economic developments in China. Should investors worry that a slowdown in the Chinese economy will spell an end to the domestic economic cycle and pose a threat to stock and bond markets? Is this 21st century version of a Red Scare warranted?
Lest we be accused of burying the lede, our answer is no. Economies, like trees, don’t grow to the sky, and as the Chinese economy matures, the pace of activity naturally slows. In the commentary that follows, we discuss the evolving role of China on the world stage and how the combination of central planning, a crackdown on corruption, the exigencies of population growth and the desire to be a bigger player in global affairs adds up to a more modest, but more sustainable, pace of Chinese growth.
The State of the Chinese Economy
China’s importance became overwhelmingly evident during the global financial crisis. Although gross domestic product (GDP) growth slowed to 6.2% in the first quarter of 2009, that rate stood out in an environment in which every other major economy shifted into reverse. The world economy has improved from those dark days, but economic growth remains modest, and China’s contribution to that growth therefore remains meaningful – hence the rising anxiety about the deceleration of Chinese activity to 7.0% in the first half of 2015 and a further drop to 6.9% in the third-quarter report recently released.
Exacerbating that general concern is the suspicion that Chinese economic growth is overstated – even at the reduced pace of 6.9%. One need not be a conspiracy theorist to draw this conclusion. The sheer size and breadth of the population, the informal nature of much economic activity and the lingering reliance on agriculture all combine to make accurate statistics elusive. We therefore analyze a variety of secondary measures of Chinese activity to arrive at a partially objective, but still fairly subjective, reality check on the health of the economy. None of these alternative measures of activity provides a clear answer to the question of real Chinese growth, but in aggregate they point to slowing, but not contracting, economic activity. Comparing current conditions with those experienced in the global financial crisis is particularly instructive.
The clearest indication of economic deceleration is seen in the import and export statistics, which, although volatile from month to month, have both shown year-over-year declines. Imports have been decreasing for 11 consecutive months, while exports have fallen for seven of the past nine months. This is by no means as dire as the 2008 to 2009 period, during which imports contracted by 54% from peak to trough, but it does speak to a slowdown in Chinese demand for imported goods (whether for personal or business use). Yet this could also be a reflection of the desire on behalf of central planners to reorient the engine of economic activity away from export markets and more toward meeting demand domestically. We discuss this policy shift in further detail as follows, but on the surface, the trade data indicate a slowdown in economic activity, but not a contraction.
Data on domestic trade in goods show a similar pattern. Rail freight loadings, which capture domestic demand more so than air or sea cargo destined for foreign shores, declined 15.3% year over year as of the latest data point (August 2015). That figure is markedly weaker than the drop of almost 10% experienced during the global financial crisis, but once again, changes in trade patterns may explain some of this weakness. Highway freight continues to grow (up 5.7% year over year in August) even while rail freight shrinks, signaling a shift in preference away from rail and toward roads. Whereas aggregate rail cargo was four times the size of road cargo in the mid-1990s, that relationship reversed by the end of the decade, and trucks now transport 11 times the amount of freight carried by rail.
That change carries environmental implications, and Western readers are aware of the air pollution challenges that face Chinese cities, not to mention the occasional epic traffic jam that lingers for days. Taken as a whole, these two measures of domestic transportation argue for more modest economic growth, but continued growth nonetheless.
Other measures of economic activity lead to similar conclusions. Domestic construction has slowed from a torrid annual growth rate between 30% and 40% in the early days of the recovery from the financial crisis to an average of 5% so far in 2015. Local bank loan growth remains quite healthy at 15.7% year over year, but this too has halved over the past few years. Taken in aggregate, these secondary measures of economic activity argue that, whereas the economy is likely still growing, it is certainly not expanding at the pace of the last few decades.
The ‘Devaluation’ of the Renminbi
Anxiety about the deceleration of Chinese economic activity is not a new development. The proximate cause of the most recent spike in concern was the action taken by the People’s Bank of China (PBOC) on August 11 to devalue the renminbi (RMB) by about 2%. Exacerbated by typically thin trading days in late summer, the U.S. equity market dropped 10% over the subsequent fortnight. The market interpreted the devaluation as a sign of panic at a sharp slowdown in economic activity and an effort on behalf of the PBOC to boost export competitiveness through a cheaper currency. Market analysts who see a currency war around every corner labeled this evidence that the Chinese, whose exports have been punished by the linkage of the RMB to a strengthening U.S. dollar, were themselves joining the fray.
We couldn’t disagree more with this analysis.
The RMB is loosely pegged to the U.S. dollar in a managed float, in which the central bank of China sets a reference rate each morning, and then allows the currency to trade within a 2% range above and below that target. As the nearby graph shows, the RMB has been trading near the low end of the 2% trading band since the beginning of the year. The PBOC move in August was essentially an acknowledgment of reality and an adjustment of the reference rate so that it better reflected the spot rate. Since the devaluation, the spot rate has adhered tightly to the reference rate. Order is restored, and the RMB has actually strengthened a little bit since the PBOC’s initial action.
If the intent was to restore competitiveness of Chinese export markets, a devaluation of 2% isn’t enough to do the trick. That variation is equivalent to the occasional daily move of other, more freely traded currencies, and, although it seems counterintuitive, the export sector is not a large part of the Chinese economy. As we discuss in greater detail later in this commentary, investment in infrastructure and capital formation are the largest part of the economy, accounting for 46% of GDP, whereas net exports only add 2.7% to the total economy. Gross capital formation does not benefit markedly from a weaker currency.
We believe that the August currency adjustment is part of an ongoing effort to enhance China’s profile and influence in the global economy. A milestone in that effort would be the inclusion of the RMB in the basket of currencies that determines the Special Drawing Rights (SDRs) managed by the International Monetary Fund (IMF). SDRs act as a form of global reserve currency and are based on the four most important currencies in global export and financial markets. Importantly, these currencies must be “freely usable.” The composition of the basket is reviewed and adjusted every five years, and since the 2010 review the SDR comprises the U.S. dollar, euro, Japanese yen and British pound sterling. The RMB is clearly an important global currency, and the Chinese would like for it to be considered for inclusion in the 2015 review.
In an interview conducted on August 4, 2015, IMF Director Siddharth Tiwari noted that “[t]he Chinese RMB is the only currency not currently in the SDR basket that meets the export criterion. Therefore, a key focus of the current review will be whether the RMB also meets the freely usable criterion in order to be included in the SDR basket.” We interpret the adjustment that took place one week later to be a direct response to this observation – and a show of good faith, if nothing else – to enhance the free usability of the RMB. This is, in other words, continued evidence of China’s desire to integrate more fully into the global economy, and not the panicked response to economic weakness that some analysts believed.
The Future of the Chinese Economy
China is an old country, and any consideration of the future must rely on the past. Events taking place now are just the latest steps in an ongoing effort to reorient the composition of the Chinese economy and enhance China’s role on the global stage. In 2007, just before the onset of the global financial crisis, then-premier Wen Jiabao characterized the country’s economy as “unsustainable, unbalanced, uncoordinated and unstable,” a remarkably candid assessment from a Chinese premier. He found rising income equality to be socially unstable, while the variation in growth between urban and rural areas led to unbalanced economic progress. An emphasis on the export sector and capital investment in industry was uncoordinated with the desire to make personal consumption more of an economic activity driver. Proof of this overreliance on exports and industry would come shortly as China suffered from the collapse of economies elsewhere during the global financial crisis. Finally, the focus on economic growth at the cost of environment degradation was unsustainable, and evident in the pollution of air and waterways throughout China.
Premier Wen concluded that all of these challenges could be addressed by an economy more reliant on domestic personal consumption than capital spending and exports. The solution to these “Four Uns” took the form of a Five-Year Guideline for economic development.
The Chinese government has used a series of Five-Year Plans (re-christened “guidelines” in 2006 to better reflect a transition away from Soviet-era planning to a more market-driven socialism) since 1953 to establish economic and social priorities for the intermediate future. In liberal democracies of the West, citizens are accustomed to treating economic promises as no more than that – well-intended aims that often founder when confronted with political realities. In the centrally planned economy of China, however, officials have implemented each and every one of these Five-Year Plans, and their history is the history of post-World War II China.
The 12th Five-Year Guideline was enacted by the National People’s Congress in March 2011 and, among other goals, committed to address the Four Uns identified by Premier Wen several years earlier. In particular, the guideline called for a rebalancing of economic activity away from capital formation and more toward personal consumption. As noted earlier, China’s reliance on personal consumption has declined steadily over the past 50 years as investment in infrastructure, industry and manufacturing took the lead. Personal consumption accounts for only 38% of Chinese GDP, vs. 68% in the United States. Gross capital formation, on the other hand, is 46% of Chinese GDP, vs. 17% in the United States. This leads to an overreliance on foreign demand, booms and busts as capital is not always allocated efficiently, vast disparities in wealth and income, and environmental degradation as growth takes priority over air and water quality – hence the desire to re-establish domestic demand as a more robust engine of economic activity.
Part of this plan already seems to be working, as Chinese household consumption doubled between 2009 and 2014. After decades of growing at mid-single-digit rates, consumption during the period of the current Five-Year Guideline has accelerated to an annual pace of almost 14%. This doesn’t address the challenges of income inequality or environmental pollution, but it is evidence that a pivot toward a more domestic source of economic growth is succeeding. The overall economy has fallen slightly short of a targeted growth rate of 8%, but the dynamism of personal consumption argues that the transition toward a more sustainable source of economic activity is taking place.
The Role of Corruption
An aspect of the 11th Five-Year Guideline that was carried over into the 12th was a desire to create a more transparent society by cracking down on the corruption that naturally proliferates in a planned economy. Transparency International issues an annual Corruption Perceptions Index, surveying the perceived amount of corruption in every country worldwide. In the 2014 survey, China ranked 100th out of 174 countries, behind Hong Kong (17), South Korea (43), Brazil (69) and India (85), but ahead of Russia (136).
Improving that ranking involves a tradeoff, as routine corruption in an economy usually evolves as a way of getting things done. Deals done in smoky back rooms, bribes and tacit guarantees all grease the gears of economic activity in the short run but make it harder to compete on a global and level playing field in the longer run. That is as much a statement about human nature as it is about Chinese society. Anti-corruption campaigns have been waged before in China, but the current iteration has reached the highest echelons of government and business, and signals that this time is different.
Upon his election as General Secretary of the Communist Party in November 2012, Xi Jinping promised to crack down on “tigers and flies” – that is, senior leaders as well as lower-level officials. The record since then is impressive. In the past few years, high-profile members of the party such as General Xu Caihou (former member of the Politburo and Vice Chairman of the Central Military Commission) and Zhou Yongkang (former Politburo member and national security chief) have been expelled from the party. Xu died before trial, and Zhou was sentenced to life in prison. Most recently, Guo Boxiong, former Vice Chairman of the Central Military Commission and Politburo member, was arrested on July 31 for taking bribes in exchange for officer promotion. He is in jail, awaiting court martial. In all, over a hundred senior party officials, a dozen senior military officers and several senior executives of state-owned companies have been indicted and convicted of corruption crimes, usually involving some form of bribery.
The audience for this crackdown on corruption is not just the global community, which should welcome a cleaner and more transparent Chinese economy and government. The rank-and-file members of the party, as well as the man and woman on the street, have likewise cheered a move away from a system characterized by patronage, entitlement, conflicts of interest, bribery and inefficiency. This popular approval strengthens Xi’s hand in carrying on with the campaign, while burnishing the credibility of the Communist Party in the eyes of the masses. For a government still informed by the events of Tiananmen Square in 1989, anything that fosters social tranquility is desirable.
Chinese history is rife with political purges disguised as a crackdown on corruption, and it is possible that this latest round is no different. Arrests have clearly broken down factions within the party and diluted a system of client-patron privileges that drove political and business success within the provinces. However, when understood in the context of China’s desire to have more influence in global affairs, the political implications of these actions become a convenient collateral benefit of an effort otherwise intended to enhance the country’s standing in the world community.
This marks, however, a literal change in “business as usual.” The Chinese word is often used to describe the Chinese way of doing business, in which the exchange of favors and the development of personal relationships are regarded as more important than laws, regulations and written agreements. But when does an innocent exchange of gifts during the holiday season become a bribe? When does the effort to build relationships with party officials or business leaders become unwarranted patronage? Activities that were not considered illegal or even problematic a few years ago are now being called into question, and that has a naturally depressing effect on economic activity. It is easy to identify outright bribes as criminal offenses, but as an economy tries to figure out where the line of acceptability falls, uncertainty reigns.
Demographics Is Destiny
China has been able to generate such impressive economic performance over the past several decades because of the rapid growth and rising productivity of its population. Ironically, it is precisely because of the size and growth of the population that China needs to grow so quickly. A growing labor force is a powerful input to economic activity, but as populations age, the labor force at some point begins to decline. An aging population is a call on economic vitality, not a contributor to it.
Although we usually associate the challenges of stagnant and aging populations with Western (and particularly European) countries, China faces these same challenges in the near future, largely as a result of its policy to manage population growth by allowing families to have just one child. (At the end of October, the Communist Party decided to end the decades-long policy, boosting the limit to two.) According to the United Nations Population Division, China’s population will rise from the current level of 1.376 billion to peak at 1.415 billion in 2030. That seems like a long time from now, but 15 years is not that much time in demographic terms. From that high, the population is likely to shrink, ending the 21st century at just over 1 billion people. Economic growth is hard to maintain when populations and labor forces are in retreat.
Developments in gerontology and the application of those advances in China means that the population will age dramatically as the percentage of the 65-and-older population balloons from 9.6% in 2015 to 33.8% in 2100. The combination of decelerating population growth and lengthening life spans will act as a scissors effect, dramatically increasing the portion of the population that is not in the labor force but reliant on external support for food, shelter and clothing. To put that into context, China will become an older society than the United States by the year 2040.
These demographic trends pose several challenges. Unlike the developed economies of the West, China does not have the social infrastructure to handle an aging population. There is no Chinese version of Social Security, Medicare or Medicaid. As is common in Asian societies, family ties play the support role that government programs often play in the West, but those ties are fraying as younger generations move farther away from home. Furthermore, the ripple effect of the one-child policy implies that younger couples will increasingly be called upon to support as many as four aging parents. This does not bode well for a party intent on maintaining control and social stability.
The solution to this seemingly existential challenge is to generate enough economic growth to build a social safety net before these demographic trends pose the threats outlined. This is the real reason that China needs to sustain economic growth, enhance its role on the global stage and complete the transition from emerging to emerged economy. China needs to get rich before it gets old, and, as the prior graph illustrates, it has about one generation to do so.
China is an economy in transition, and the prospect of an aging population implies that the country needs to accelerate that progress to a mature economy characterized by robust and domestic sources of economic activity, a transparent business and political environment, and enough wealth to sustain a population that will increasingly call on government support. Other economies have made similar transitions throughout history, but not at the scale and under the time pressure that China faces. That poses risks, and as China plays a bigger and bigger role on the world stage, those risks redound not just to China alone.
A chief risk is the tricky shift from true communism to some hybrid form of market socialism. This transition has been underway since Deng Xiaoping in 1978 first introduced the concept of private land ownership, allowed for more free market pricing of goods and created special economic zones to encourage exports. Top-down management by the state was replaced by bottom-up initiative and even entrepreneurialism, which helped to drive per capita GDP from $195 in 1978 to $3,866 today. The economy remains centrally guided, if not strictly planned, but the ability to enact central control over the economy can be fragile when the population sees the benefits (and, admittedly, the detriments) of capitalism in their own lives. The Tiananmen Square protests of 1989 stand as an example of what could happen if economic growth slows too much or the party tries to rein in social and economic freedoms too tightly. That transition is tricky, and there is no guarantee that the party will get it right, although the historical record since reforms were first introduced in 1978 is generally encouraging.
There are multiple challenges to economic development that fall outside the scope of this article but that China will need to address if the economy is to successfully transition to a developed model. How will the country and the ruling party balance market liberation with social control, and how will they respond when those policies collide? How will the government establish a truly independent banking system, which today exists largely as a policy arm of the government? How will the central bank fully float the RMB, and is it willing to cede control to the market, as a full float implies? Only time will tell if these (and other) dynamics evolve smoothly, but it is clear that the Chinese government wishes to play a more influential role on the world stage and appreciates that this objective requires it to embrace these developments.
The rapid transitions outlined in this article make China a particularly tricky place to invest. In addition to the fundamental and valuation risks that normally accompany any investment, Chinese equities require investors to assume added political, regulatory and economic risk, the analysis of which can be daunting. Our direct investments in China are therefore limited at present, largely as a function of this opacity. We anticipate that as the evolution of the Chinese economy proceeds, it will become easier to identify true company value and invest with greater conviction. Of course, many of our investments in domestic and international multinational companies depend on Chinese demand to drive their bottom line, so our indirect investments in China carry a diluted version of some of these risks. In those cases, we rely on the insight of corporate and local management to assess and manage the extraordinary risks discussed in these pages.
None of the forgoing is intended to diminish the risks that China poses to the global economy, but simply to place those risks into the context of an economy in transition. We believe that China will continue to be an engine of global economic activity, but that the dynamic growth of the past will give way to more modest, but durable, growth in the future. This is the natural maturation of an economy seeking to become a more prominent player on the global stage while creating enough economic wealth to build out the social infrastructure that an aging population will increasingly need. We’re watching an emerging market emerge in real time, and at an accelerated pace, and we conclude that, whereas that certainly poses risks to the global economy, those risks are outweighed by the opportunities.
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