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Will China’s leaders hold steady on economic reform?

by Michael Collins, Investment Commentator at Fidelity

China’s Finance Minister Lou Jiwei enjoys the same privilege with China’s media as Australian politicians do with Hansard – if you misspeak you can adjust the official record.

Lou’s error was to imply in July at a media briefing in Washington that China’s economic growth for 2013 could fall below the government’s target of 7.5%, for it fuelled concerns about the challenges facing China’s economy. “We don't think 6.5% or 7% will be a big problem,” he told reporters, a level that would mark China’s slowest growth since 1990.

To placate concerns that China’s government might fall short of a growth target for the first time since 1998, the government-run Xinhua News Agency quickly corrected its English-language story containing Lou’s remark to say, “There’s no doubt that China can achieve this year’s growth target”.2

As Beijing obviously fears, investors may well be disappointed if China’s economic growth for 2013 undershoots the government’s goal.3 They have become accustomed to the world’s second-biggest economy reporting double-digit growth rates – the statistics show China’s economy expanded at an average pace of 10.5% a year over the past eight years, a period when it overshot growth goals, even if growth cooled to 7.8% in 2012.

But there could well be a bigger risk for investors than China fluffing its growth target for this year and maintaining at least a 7% pace of growth in coming years. This risk is that China’s government might try too hard to prop up economic growth. For that will only add to the imbalances and inefficiencies in China’s economy and make any delayed readjustment more abrupt. Political pressure is sure to mount on China’s policymakers to do just that, though.

It’s almost a cliché to say that China needs to move on from its investment-spiced, export-led, government-directed and peasant-dependent (low-wage) economic model because the old paradigm is spluttering. China faces diminishing growth returns from investment as the misallocation of capital has led to waste and overcapacity. The country confronts a slow-burning credit crisis and an overvalued property sector. Thanks to the one-child policy, China is heading into a labour shortage that is already boosting wages, thus making exports less competitive (a decline made worse right now because its currency is linked to a rising US dollar). At the same time, the gains from China’s ascent have failed to spread much beyond the political and managerial coastal elite, which is why consumption is so retarded as a percentage of output – about 35% compared with 70% in developed economies such as Australia and the US. China needs to adopt a model driven by consumption, one where market mechanisms trump central planning and one that promotes competition rather than enshrines market strangleholds, while being more environmentally friendly.

Lots of advice

Officials have talked about this switch for over a decade. But the latest report on China’s output shows the country’s economy is failing to shift, mainly because of Beijing’s investment-led stimulus to protect China from the global financial crisis. While China’s economy expanded at an annual pace of 7.5% in the June quarter, investment by local governments and state companies in buildings, roads, airports and other infrastructure contributed twice as much to growth as did consumption. This is an extension of trends through 2012 when investment rose as a percentage of output, but consumption stayed flat. (Net exports haven’t boosted China’s growth since 2008.) Such results explain why the IMF warned in July that it’s “increasingly urgent” for China to update a growth model that is “raising vulnerabilities”.5

The leadership installed in March is signalling it is serious about weaning China off investment, which would require an unrealistic leap in consumption to make up for the required drop in activity. Policymakers in recent months have reined in lending, by inducing a credit squeeze on the money market. They have taken steps to control soaring property prices, ordered a ban on new government buildings for five years and told companies across 19 industries to cut production. They have refused to loosen reserve requirements or cut interest rates even though the economic outlook is cloudier. In July, the People’s Bank of China ended a floor on borrowing costs, a token reform to be sure but one that could herald bolder changes.

The significant reforms that China’s policymakers are willing to take may become clearer later in the year at the Central Economic Works Conference, the annual gathering that sets China’s economic priorities. Among other advice, these rulers have been told to accelerate steps towards a market-based financial system, revamp local government governance and finances, widen and make more progressive the tax system, loosen internal immigration controls on 250 million migrant workers, enhance the social-welfare system and better direct fiscal policy. More radical counsel on reform is to let the credit bubble burst now to avoid larger write-offs in coming years.

Whatever course China’s leaders pursue in the short term, investment is likely to drop enough to make achieving this year’s growth target a challenge, and make a similar target harder to achieve in coming years.

Local trouble

Whenever a one-party dictatorship tried to liberalise its economy, it would face the conundrum that the associated political reforms challenge its unbridled power. While it's commendable to encourage private enterprise, free-market reforms can’t proceed too far under China’s political system. Secure property rights are lacking because the judiciary is controlled by the Communist Party. A fettered media restricts the spread of information that a capitalist system assumes, while peoples’ freedom of movement and gathering is restricted.

While China’s Communist leaders will grapple with these issues for years to come, they are not necessarily the origins of the political stress they will face in the immediate future. They are under pressure to succumb to more investment-led stimulus right now from two local sources.

The first is their 1.3 billion compatriots, who mostly rank among the world’s poorest. Shorn of Marxist ideology, China’s Communist rulers have an almost declared pact with their subjects; trust us, the able elite, with power and you will get wealthier. An economic slump will strip these leaders of the legitimacy that accompanies an image of competence, already damaged by the environmental damage that China’s industrialisation has inflicted and allegations of corruption. China’s rulers won’t want an economic slowdown to add to the social disquiet across China that is behind – by the government’s count – about 150,000 “mass incidents” of undefined unrest a year. (In one such incident on July 20, a man detonated a bomb at Beijing Capital International Airport in an apparent protest at police brutality.)6  Beijing’s options are more stimulus directed at the masses or harsher policing.

The other pressure is more venal. The vested interests and gravy trainers that rely on investment for their wealth and power will use their political muscle to exert pressure on Beijing for more of their drip feed. Pleas for stimulus from state companies and local governments facing bankruptcies and debt defaults are bound to be forthcoming. State companies are employment agencies for Communist Party members and their managements will use their connections all the way up to the Standing Committee (China’s cabinet) to influence policy. Local governments are run by party officials whose careers will be ruined if their province’s economy stumbles and unrest rises.

This political pressure and the slowing economic outlook prompted Beijing to announce some stimulus measures in recent months. The State Council in July approved plans to build railways away from the coast, scrapped some taxes on small businesses and cancelled inspection fees for some exports while the central Bank of China ensured the money market was well supplied with money.

A better target

While no one expected Chinese leaders to do nothing to help their economy, these officials will be erring if they yield to large stimulus for two reasons, besides adding to China’s debt, inefficiencies and other imbalances that will only worsen the eventual reckoning.

The first is that GDP growth is the wrong goal for them to pursue anyway. As many point out, the Chinese, like people everywhere, are focused on the growth in their household income, not the share of consumption in GDP. Michael Pettis, a finance professor at Peking University in Beijing, estimates that for consumer spending to reach half of China’s output within the next decade, consumption growth would need to exceed GDP growth by 4 percentage points a year.7 Thus, say, a 7% annual economic growth target over the next five years would require household income to soar by 11% a year. As the world’s economy is only hobbling along (China’s old economic model failed to allow for drops in global demand), that won’t happen without more debt-laden stimulus from Beijing.

A more sustainable rate of economic growth for China could be as low as 4% per year over the coming years, many (including Pettis) say. At a 4% rate of GDP growth, household income only need expand about 7% a year for the economy to become noticeably more dependent on consumer spending within a decade. With the right market-orientated reforms, enhancements to productivity and well-timed counter-cyclical measures, China could easily achieve 7% annual growth in household income and keep much social unrest at bay and the coastal elite dependent on investment happy enough.

The other reason is that, amid doubts about China’s economy (including talk that it’s entered a deflationary spiral where the economy is only eking out 2% growth), many will only scoff at the integrity of China’s economic statistics if GDP growth stays on target. After all, as revealed by the WikiLeaks cables, China’s new Prime Minister Li Keqiang once told a previous US ambassador to China that the country’s economic data is “man-made” and for “reference only”  – as in just as flexible as quotes from ministers in the official media.8

Financial information comes from the IMF, the Financial Times and Bloomberg unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

Investments in small and emerging markets can be more volatile than investments in developed markets.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment.

1 Bloomberg News. “China can endure growth slowdown to 6.5%, finance chief says.” 12 July 2013. 
2 Reuters. “Xinhua corrects China finance minster’s growth target comment.” 13 July 2013. http://www.reuters.com/article/2013/07/13/us-china-economy-loujiwei-idUSBRE96C04X20130713
3 China sets an annual average GDP goal in its five-year plans and the government each March reveals a target the year that may be different.
4 IMF. World Economic Outlook. April 2003. Table A4, page 153.
5 IMF. “People Republic of China. 2013 Article IV consultation.” July 2013. Page 5. http://www.imf.org/external/pubs/ft/scr/2013/cr13211.pdf
6 Agence France-Presse. “China sympathy for airport blast protest.” Run in The Australian on page 9. 22 July 2013.
7 Bloomberg News. “Analysts obsess over the wrong target in China: Michael Pettis.” 22 July 2013.
8 Reuters. “China’s GDP is ‘man-made,’ unreliable: top leader.” 6 December 2010. http://www.reuters.com/article/2010/12/06/us-china-economy-wikileaks-idUSTRE6B527D20101206

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