Special Report: On the march to China 3.0
It has become commonplace to blame China’s recent financial volatility on its economic slowdown but this view is open to question, says Daniel Ben-Ami
There are numerous categories and sub-categories of Chinese asset classes but they include:
• A-shares. Shares listed on the Shanghai or Shenzhen stock exchanges and denominated in renminbi.
• H-shares. Shares in mainland Chinese companies that are listed on the Hong Kong Stock Exchange.
• Dim Sum bonds. Bonds issued outside of China but denominated in renminbi.
• Panda bonds. Renminbi-denominated bonds issued by foreign companies in China.
Are some of the world’s largest financial markets destined for several years of high volatility? That is at least the implication of what many high-profile commentators have said on China and some have stated explicitly.
The most popular form of the argument is that the dramatic slowdown of China’s economic growth is a sign of trouble. Its growth rate has dropped from double digits to about 7% – and the official statistics could well understate the scale of the problem (see figure 1).
China’s attempt to tackle the challenges it faces itself creates more uncertainty. Its economic miracle was, so the argument goes, centred on manufacturing and exports. But the slowdown is forcing it to shift to an economy that is focused more on services and domestic consumers. The growing internationalisation of the renminbi adds to the complexity.
Such an enormous economic shift inevitably creates a challenging environment for Chinese companies. As a result, the stock market and possibly the bond market too could be set for considerable volatility. Under such circumstances it is not surprising that many investors and potential investors are becoming anxious.
Those who know China best tend to be more sanguine than those viewing it from afar. It has become commonplace for external observers to directly link the economy’s slowdownw to the stock market turmoil. In other words they assume a straightforward causal relationship running from poor economic performance to a falling stock market.
China specialists are more prone to distinguishing between the two. Typically, they argue that there is no simple connection between the slowing economy and the stock market’s recent woes. In this view, the Chinese economy is generally seen as handling its transition relatively well. From this perspective, factors that are not directly economic, such as excessive margin lending, are often a key part of the explanation.
But the distinction between different views on China is not always clear-cut. There are specialists who know China well but still hold that high volatility lies ahead. In any case, it should not be simply assumed that the best-informed are always right. The world is littered with examples, in China and elsewhere, of experts making the wrong calls on important questions.
This article will examine the link between China’s economic transition and the prospects for financial volatility. It will start by examining China’s remarkable economic transformation since the start of the reform process in the late 1970s. From this account alone, it is possible to dismiss some of the more popular misconceptions about the financial impact of China’s economic slowdown. It will then go on to consider in more detail the likely investment impact of China’s current economic shift.
A remarkable shift
Before considering developments in contemporary China it is important to recognise the enormous scale of China’s economic transformation since the late 1970s. Back in 1980 it only accounted for about 2.3% of global output measured at purchasing power parity (taking into account different international price levels). This year the figure looks set to reach about 17%, according to IMF figures (see figure 2).
Think about what this means in more practical terms. In the 1970s China was still dirt-poor. GDP per head was well below the levels in sub-Saharan Africa. It was also largely rural and it had little external trade. When people discussed China at the time it was typically in relation to Chairman Mao and his peasant-based version of Marxism.
Today the Communist Party remains politically dominant but much else has changed. China has become, by some measures at least, the world’s largest economy. It is also the biggest manufacturer and the biggest exporter. Another milestone was reached in September when the chair of the US Federal Reserve, Janet Yellen, explicitly referred to China in her official statement on interest rates.
China has advanced so rapidly that it would be easy for anyone below the age of about 35 to be unaware of its earlier predicament. The younger generation of adults are probably mostly unaware of how, only a short time ago, the country played a relatively marginal role in the global economy. It is only since about 2000 that China has taken on a high international profile.
But although China has made a remarkable shift, it is arguably incomplete. It is wealthy in absolute terms but that is partly because of its huge population. China’s GDP per head is about one quarter of that of the US – putting the Asian giant on a par with countries such as South Africa and Serbia.
To put it another way, China is facing the prospect of what some call a middle-income trap. It is no longer poor but it is not yet rich either. To make the successful transition to an advanced economy it needs to increase its productivity considerably. For most commentators this means putting less emphasis on traditional manufacturing and developing the service sector. It means less wasteful investment, more consumption and a reduction in the emphasis on saving.
This transition, from what could be called China 2.0 to China 3.0, which is at the heart of the current debate. It is broadly what President Xi Jinping means when he refers to the emergence of a “new normal” in China. For him, the key factors are slower GDP growth, an improved economic structure and increased emphasis on innovation, rather than input or investment.
Some argue that China’s drive to renew itself looks set for failure with an economic hard landing probably imminent. But even the country’s most ardent admirers recognise that it is facing substantial challenges. The transition will mean ditching some of the ways of doing things that have proved so successful in the past.
A moment’s thought at this stage should be enough to dismiss some of the crasser criticisms of China. To observe that China’s GDP growth has slowed from double digits to perhaps 7%, or even 5% is to say less than first appears. The key point is that 5% of a large number can be more than 10% of a small number.
China’s rapid growth of recent years was at least partly premised on the fact that it was starting from a low base. Although its growth rate has slowed relative to the size of its economy it is still adding a huge amount in terms of dollars (or renminbi) of extra output. It is almost inconceivable that China could have continued its double-digit growth for decades into the future.
It should also be remembered that high volatility has long been a feature of the Chinese stock market. The Shanghai Composite’s fall from its recent peak of just over 5,100 in mid-June to below 3,000 at the end of August only brought it back to about where it had been in December 2014. It is also worth noting that the recent peak was still well below the market’s all-time in October 2007 (see figure 3).
Debating the transition
Leaving aside these more basic misunderstandings there is still scope for substantial debate on China’s transition. The most prevalent view of those close to China’s equity markets is that their excesses should be separated from the country’s economic transition process.
Ken Wong, an Asia equity portfolio specialist at Eastspring Investments in Hong Kong, points out that China’s economic slowdown was already well-known. For that reason, it would have come as no surprise to the markets. “It’s not the fundamental issue,” he says.
In his view, like that of many others, margin lending played a big role in pushing up asset prices. He points out that the extent of such lending was substantially larger than the official figures suggest. “When you got to a point when so much of the market was being fuelled by steroids, things were really getting out of hand,” he says.
In his view, the unexpected devaluation of the renminbi in August added to the market jitters: “Markets overreacted because they’ve never seen the RMB depreciate.”
However, in Wong’s view, the market fundamentals are better than such volatility suggests. “Things are not quite as bad as everyone thinks, especially if you look at companies more closely.”
Sandra Crowl, a portfolio adviser at Carmignac Gestion, agrees partly with Wong. Like him, she places a great emphasis on excessive leverage pushing the market up to artificially high levels. But, in her view, the slowdown in the manufacturing sector should also take a share of the blame.
“The sell-off was caused by an excessive amount of leverage into a market where the growth rate could not sustain further valuation extension,” she says. “Excessive leverage with lower growth potential. That was a very dangerous cocktail”.
Specialist China economists tend to recognise the economic challenges while arguing that, if these are managed well, the economy could continue to grow strongly. Economic reform, such as the planned changes in relation to state-owned enterprises (SOEs), will, in their view, be key to success.
Aidan Yao, an emerging Asia economist at AXA Investment Managers, says that “Chinese consumers have a huge potential to increase their consumption”. An important part of the reform process will therefore involve decreasing the country’s dependence on exports and bolstering the domestic economy.
He also points out that many of the measures that the pessimists focus on tend to give a one-sided view of economic performance. “Indicators such as electricity use and freight volumes capture the old part of the economy that is clearly struggling,” he says. But, as many other experts agree, the service sector is doing much better.
Although experts are generally more upbeat about China’s service sector rather than manufacturing this is not universally the case. It is possible that China will continue to modernise its manufacturing and shift towards more advanced technology.
That is certainly the view of a leading expert in this area. Professor Tomoo Marukawa, an economist at Tokyo University, sees great scope for China to develop in this way. “I see many Chinese enterprises that are shifting from manual labour in their production line to using robots or automation machinery, he says. “I don’t think there is any obstacle to Chinese companies moving on in this way.”
He is also positive about the government’s role in this area. “The government is very eager to promote technological development,” he says.
Marukawa does not deny there are challenges ahead but he sees them in other areas. In his view, the problem is more on the demand side. China might struggle to find customers for all the goods that it is producing. He also argues China is facing environmental challenges in relation to tackling pollution.
But even if it is accepted that China will ultimately make a successful transition to an advanced economy – and this is still open for debate – it is not the end of the story. It is possible that there could be many stumbles along the way.
Chi Lo, a senior economist specialising in Greater China at BNP Paribas, says the Chinese markets face years of volatility ahead. The key reason, in his view, is that China’s economic shift will inevitably involve a high degree of uncertainty.
“There is no way you can pin down how the uncertainty will be offset or play out,” he says. “You cannot price a company during this transitional period. The structural parameters are unstable.”
Alicia Garcia Herrero, the chief economist, Asia Pacific, at Natixis in Hong Kong, also places a great deal of emphasis on uncertainty but her take on it is different from the mainstream. She points out that developments in the West have played a central role in stoking up equity volatility worldwide. These include concerns about the monetary policy being executed by the Fed and the European Central Bank.
That is not to say China is blameless – she acknowledges its economy is weakening – but she argues that it is getting an unfair share of the flak for the world’s equity market woes. “China is having it hard because the Fed is increasing volatility,” she says. “China has its own problem but it is not determining the financial condition in the world.”
This is a point Western investors would do well to remember. China has received much blame for equity volatility and slower growth but it could equally be argued that causality runs in the opposite direction. The challenges it is facing in making its economic transition are no doubt intensified by the lethargic state of much of the rest of the world economy.
Is China about to follow Japan into the doldrums?
One of the most negative takes on China is to assume it is on the verge of replicating Japan’s experience from the late 1980s onwards.
For those who do not remember the Japanese economy’s experience until a quarter of a century ago it is a salutary tale. Back then, the economy was performing strongly and asset prices were surging. There was even serious talk that the Japanese economy would overtake that of the US by the turn of the millennium. Then things started to go horribly wrong.
The economy moved from being one of the fastest growing of the large developed economies to being one of the slowest. For example, GDP growth reached 7% in 1988 but by 1993 had fallen to about 0.2%. There was a cyclical element to this slowdown but the average rate of growth was far slower after 1990 than before (see figure).
At the same time the stock market fell precipitously. The Nikkei 225 peaked at just below 40,000 at the end of December 1989 before falling to about 16,000 before the middle of 1992. At the time of writing it was only at 18,000.
Japanese property prices also slumped over roughly the same period. For example, Japan’s Urban Land Price index, compiled by the official Statistics Bureau, fell from 147.8 in 1991 to 51.9 in 2014.
This clearly lends itself to pessimistic parallels with China. There are those who argue that the recent falls in the Chinese stock market could also herald a similar period of economic stagnation.
Gillian Tett, the US managing editor of the Financial Times and its former Tokyo bureau chief, is one of the most high profile proponents of this parallel. She does not argue that China will inevitably follow Japan’s path but suggests it is a strong possibility. Tett points out that: “In the past two decades China has delivered impressively high economic growth by investing heavily to build an industrial export machine. This was supported by a bank-centred, state-controlled financial system that channelled cheap funding to favoured industries at the expense of consumers. The price of money, in other words, was set by autocratic fiat.”
However, others have argued that such parallels are misleading. Among them is Professor Tomoo Marukawa of Tokyo University, one of the foremost Japanese experts on the Chinese economy. “There is a big difference between the two,” he says. “Japan was already a well-developed country in 1990, whereas China today is still a middle-income country.”
Axa’s Aidan Yao takes a similar view. He points out that, at the end of the 1980s, Japan’s GDP per head was at about 90% of US levels. In contrast, China is currently at about 25% of US levels.
Marukawa does see some parallels between China and Japan but they relate to an earlier phase in Japan’s development. In the early 1970s the Japanese economy also experienced a sudden slowdown after more than two decades of double-digit growth. “By saying that China today is Japan in 1974-75, I am implying that China can still grow at a medium speed, like 6%, for another decade,” he says. “I don’t think that China in the next 25 years will grow by 1-2% per year, like Japan did after 1990.”
Any comparisons between the Chinese and Japanese experience should be handled with care. Although it is easy to find superficial similarities the differences between the two are also substantial.