Has there ever been a country with an expected economic growth rate of 7.5% that has caused so much angst among investors worldwide? Then again, has there ever been an economy like China’s?
In the three decades-plus since Deng Xiaoping launched reforms that gradually reintroduced China to the global economy, China has experienced unprecedented growth that has averaged 9% annually as it zoomed up the charts to rank as the world’s second-largest economy behind the U.S. And conventional wisdom holds that it’s on pace to someday supplant the U.S. as top dog.
But China’s growth story has slowed (a relative term given its still-robust prospects), partly because its sheer size means it can’t possibly maintain past growth trends and partly because of the government’s stated goal to slow down the train and create more sustainable economic growth by emphasizing domestic consumption fueled by the consumer and service sectors rather than its prior reliance on exports and fixed investment assets such as infrastructure, buildings and machinery.
Of late, the Chinese economy’s aura of inevitable supremacy has been replaced by an air of doubt as the increasing number of red flags associated with the country have nothing to do with its national flag. The laundry list of concerns over the Chinese economy can fill a paragraph such as this one: slower growth highlighted by declining industrial output and exports; enormous private-sector debt, a bloated banking system and a growing, nebulous shadow banking system; opaque accounting practices; fears of a possible real estate bubble; endemic corruption and, recently, bank runs and its first-ever domestic bond default.
And for good measure, there’s also rampant pollution and bubbling social unrest that play into the economic picture. Given China’s importance to the global economy as the straw that stirs the drink, particularly for the commodities trade, what happens in China doesn’t necessarily stay in China.
So for investors accustomed to viewing the country as a modern-day El Dorado, the issue boils down to three questions: Is China a ticking time bomb capable of taking down the global economy? Can the central government’s strong hand continue to deftly guide the economy through its many challenges and safely engineer the soft landing of slower, more sustainable growth? And despite the headwinds, how can one make money in this vast market?
If you’re expecting easy black-or-white answers, you’ve come to the wrong country. “It’s a pretty complicated place,” says John Rutledge, chief investment strategist at Safanad, a global private investment firm. “But you can’t ignore China because it’s the number two economy and eventually will be number one.”
Leveraged Growth
In recent years, China has been a paradox where economic growth and stock market returns haven’t jibed. The Chinese stock market, as measured by the Shanghai Composite Index, has slumped more than 40% since August 2009. That was after the Chinese government launched a roughly $650 billion stimulus package to prop up its domestic economy and ultimately helped boost the global economy following the financial crisis.
Although China’s stock market has been a loser in recent years, the country’s economy doubled from a $4.5 trillion annual gross domestic product to one that was roughly $9.2 trillion in the five years since the global financial crisis thanks to a credit boom focused mainly on real estate and infrastructure projects. Much of that leverage has been in the private sector, mainly via bank loans and credit trusts (i.e., non-bank financing through shadow banking channels). According to Newedge, a global multi-asset brokerage business, China’s total private and public debt as a percentage of GDP in 2012 was 189%.
Robbert van Batenburg, Newedge’s director of market strategy, believes China has created a no-win situation for itself by leveraging the country to the hilt to grow the economy. And as the government tries to wring the speculative excesses out of the markets by tightening credit and allowing defaults to occur, van Batenburg asserts that it risks causing a domino effect that could significantly harm the economy.
Indeed, manufacturing in this year’s first quarter slowed to the point where Chinese officials this spring undertook stimulus measures––including spending on railways, low-income housing and tax breaks for small businesses––to help revive flagging growth and keep the economy on course to reach the government’s forecasted growth rate this year of 7.5%.
But the stimulus measures highlight the government’s tightrope act of trying to create a more market-based, sustainable economy even as it intervenes to keep the economy from slowing too quickly. “China has done everything to manufacture growth and has doubled the economy through enormous leverage, including foreign inflows,” van Batenburg says, adding that China could be facing “a day of reckoning because credit cycles this large aren’t easy to stop once they’re set in motion.”
Changing Tires
China has more moving parts than a Swiss watch, and up to now the single-party leadership of the Communist Party has managed to keep things running relatively smoothly. As spelled out in a white paper from Matthews Asia Funds, the new leadership of President Xi Jinping and Premier Li Keqiang realize the country needs to open up its capital markets, encourage private enterprise and decrease its reliance on state-run entities to achieve its long-term goals of growth and prosperity.
And they also realize they can’t afford to let the natives get restless.
“China has a history of peasant revolts,” says Rutledge, an old China hand whose résumé includes being an advisor to Chinese officials. “When you talk to Chinese leaders privately about policy, they always talk about what policies would be good for stability, and the Chinese government wants stability because it wants to be king and because China needs to compound its growth over a long time period to lift people out of poverty.”