By Richard Carlyle
The past year has been challenging for China. Slowing economic growth, a sharp sell-off in the stock market and a surprise currency devaluation have raised doubts about the dynamism of the world’s second-largest economy.
China today: Where are the risks?
We have seen more evidence recently that China’s manufacturing sector is contracting. Inevitably, there have been concerns about what the transmission of any cyclical weakness in China might have elsewhere. Nevertheless, it’s important to differentiate between what is really happening on the ground and what has been happening on the markets.
The equity markets on the mainland are going through a volatile period; the bull market started in 2014 but really accelerated in November last year, supported by explicit and implicit government measures. The Chinese government gave explicit support through statements emphasising the importance of equity markets, while cutting interest rates and lowering the banks’ reserve requirements gave implicit support.
As a result, investors started borrowed heavily from brokers to buy shares – buying on margin. Some estimates suggest that margin lending accounted for 8%-10% of trades at the peak, much higher than the 2%-3% level typically seen in developed markets. That helped the Shanghai Composite Index rise by more than 150% from mid-2014 to early June 2015, while the Shenzhen Composite Index more than doubled. Both then lost around a third in value after the government acted to curb borrowing this year.
Since the recent stock market crash, regulators have continued to try to address the leverage in the system. Of course, the Chinese government wants a healthy equity market, partly because it recognises the problem of corporate debt. We believe that the authorities can help ameliorate the situation by making it easier for companies to swap debt into equity and raise money on stock markets.
What’s next?
Our view is that the Chinese government’s recent currency devaluation is not significant enough to substantially affect the economy. Again – we need to see the recent events in context; the Chinese currency has in fact appreciated by some 50% over the past seven years. We expect Beijing to continue rolling out moderate stimulus to prevent further deceleration. Policies might include lowering interest rates, investing further in infrastructure, continuing with China’s own form of quantitative easing, and perhaps cutting tax.
Opportunities for further growth in China
If you fly into Beijing or Shanghai, you see new infrastructure everywhere; it looks as if China has already built itself. But about half the population – around 600 million people – is still living in poor rural areas. We are coming to the end of the rapid-growth phase of investment, but there is still a lot more action that is needed away from the coastal areas. The focus will have to move away from building roads and airports to building schools and hospitals, cleaning up the environment and solving problems with water quality.
Meanwhile, wages in China continue to grow by around 5%-7% each year, but are growing in some regions and sectors by closer to 10%-15%, even in the slower growth environment. This puts money in the pockets of the masses. Consumption of luxury goods has fallen but mass-market consumption is still quite healthy – we can see this in the volume of online shopping and spending on healthcare. In fact, independent surveys suggest that consumption is higher than the official statistics suggest.
Looking to the future
Many people say that China can only grow at a 2%-3% rate over the next 10 years, but we think that is overly bearish. Over the next 10 years, it would be reasonable to expect growth to average around 4%-5%, up from a current rate of 3%-4%, but still below the reported current growth rates. Future economic growth will be driven more by consumption, services and technology, areas that intrinsically grow a little bit slower.
Overall, China remains a relatively low-income economy compared with more developed countries – there is still a lot of catch-up growth that should be relatively easy to achieve.
Richard Carlyle is an investment specialist at Capital Group
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