- Although the debt challenges in Europe and the U.S. have dominated the headlines recently, China holds the key to global economic growth for the next several months and years.
- Heightened concerns about trade, a potential housing bubble, and inflation have fueled misplaced fears that China could be in for a hard economic landing.
- We believe the most likely scenario for China will be a soft landing/ deceleration in economic activity. Real GDP growth in China will likely oscillate between 7.5 and 8.5 percent in 2012 and early 2013. This moderation in growth will help to temper inflation in China from a recent peak around 6.5 percent towards 5.5 percent early next year and 5 percent or less by late 2012 to early 2013.
- The combination of moderating growth and inflation in China will bring an end to the tightening actions there and should open the door for a more flexible monetary policy stance, including an easing in monetary policy conditions, beginning with a lowering in reserve requirements in late 2011 or early 2012.
Economic activity in China has decelerated modestly as real GDP tempered from 9.7 percent in 2011:Q1 to 9.5 percent in 2011:Q2 and then to 9.1 percent in 2011:Q3. However, China remains a growth engine for many economies around the world. This process is likely to continue even as China transitions from a low cost producer of goods to a more balanced economy that includes an active global consumer of both middle class and luxury goods.
Despite the fears about a hard landing (defined as sequential quarters of less than five percent real growth), a closer review of the data shows that China has weathered the challenging global events extremely well, and continues to have mechanisms allowing it to selectively target problem areas in its economy without resorting to outright changes in broad macro policy. We believe the most likely scenario is for China to navigate a soft landing to a still solid 7.5 to 8.5 percent real growth pace next year and into early 2013 as well. Unlike the developed world, China has tremendous flexibility on both fiscal and monetary policy, as well as extremely strong productivity growth to offset many of the input cost challenges from inflation.
Retail sales increased at a 17.7 percent yearly pace in September. Vehicle sales in China are projected to rise to 18.7 million units in 2011, up from 9.4 million units in 2008 and a meager 2.4 million units in 2001. Interestingly, the strength in vehicle sales this year is occurring despite the removal of China’s own “cash for clunkers” program and the incentives for buying small-engine vehicles. Even with this surge in vehicle sales, private consumption has declined from 46 percent of real GDP in 2000 to 33 percent of GDP in 2010, driven by the 10-year boom in production and in investment which have far exceeded the gains on the consumer spending front. In the years ahead, we should see more balance between consumption spending and the investment and production sectors. Moreover, stronger imports may fill a portion of this gap. Strong income growth and population demographics are likely to boost vehicle sales in China to 25 to 30 million units later this decade. Although domestic producers will dominate the small and mid-sized market, the explosion in luxury vehicle sales will be driven by imports. Net, the auto sector will be one of several industries that will likely continue to narrow China’s overall trade surplus.
Further helping the Chinese consumer, wages in China are accelerating sharply, as witnessed by the recent 22 percent rise in the minimum wage. This is not a major inflation concern since wages still represent a small component of overall unit labor costs (inflation of manufactured goods is still running at a relatively modest 2 to 3 percent). Moreover, the government has made it a priority to boost incomes and thus welcomed this development. With productivity gains exceeding the rise in unit labor costs, the development of a middle class in China will continue, profit margins for China’s companies should remain solid, and consumer spending should become a bigger portion of GDP growth.
Fixed asset investment in China continued to accelerate at close to a 25 percent year-over-year pace in September, while industrial value-added (China’s version of industrial production) expanded at a 13.8 percent in September, with industrial revenues accelerating at close to a 30 percent pace.
China’s trade surplus fell in September and was down 13 percent on a year-over-year basis. However, a portion of this weakness was due to dislocations associated with the effects of the earthquake in Japan and the recession in Europe. Likewise, imports of several raw materials softened after strong stockpiling earlier this year. Many economists and market participants believe that a sharp narrowing of China’s trade surplus will be a forward-looking constraint on economic activity, but a closer look at the data suggests that this may have already occurred. China’s trade surplus has dropped from $297 billion in 2008 to about $145 billion in 2011, a decline of more than 50 percent. Exports are currently about 30 percent of GDP, down from a recent peak of 37 percent in 2007. On a year-over-year basis, exports from China are up a respectable 17 percent; however, this has been more than offset by a 20.9 percent rise in imports.
Net, the trade data shows it is no longer only about what China produces, but rather it is about what China consumes from the rest of the world.
Despite this narrowing trade surplus and a solid reevaluation in the Yuan, trade friction remains a top concern. Given the bi-partisan bandwagon for China bashing that is unfolding on the political front, the greatest risk for a trade policy mistake resides in Washington, not Beijing. On October 11th, the Senate passed legislation (65-35) that would impose duties on imports from countries that manipulate their currencies (aka China), with 16 Republicans joining all but five Democrats in supporting the bill. This bill probably won’t become law; however the threat of passage, along with other China bashing measures, could become an issue as we approach the elections next year and bring back fears of the Smoot-Hawley tariff actions 80 years ago.
Interestingly, China’s currency has increased about 30 percent relative to the U.S. dollar in recent years. Moreover, during the better part of the last 15 months, Chinese officials have implemented stronger currency adjustments, possibly due to the fact that a stronger Yuan helped to temper the cost of higher dollar-based raw material, food, and energy items. The real questions that should be evaluated in Washington are: What does the managed float mean for the U.S., and what should be done about it? The managed float by China has helped to temper inflation in the U.S. Moreover, the challenge of keeping the Chinese currency from rallying too strongly against the greenback has pushed China to keep its growing dollar assets in U.S. financial assets, mainly U.S. Treasuries. This in turn has placed downward pressure on U.S. market interest rates.
The unintended consequences of the Currency Exchange Rate Oversight Reform Act could be extremely dangerous. The U.S. would place significant tariffs on goods from China, while China would likely retaliate with similar actions on our goods. The net result would weaken economic activity and raise consumer inflation in both countries. Moreover, China could go on a buying strike or opt to unwind a portion of its $1.5 trillion or so assets, the bulk of which are held in U.S. Treasuries. The House may very well pass its version of a new trade (China bashing) bill but the two bills are not likely to be reconciled, and cooler heads should ultimately prevail in Washington to table the legislation.
The latest moderation in inflation, along with signs that food prices are softening, suggest that inflation in China has peaked and that the tightening process in China could be complete. Consumer prices in China surged to a 6.5 percent year-over-year pace in July, but have tempered to 6.1 percent in September. The bulk of the price pressures have been centered in a 13.4 percent rise in food costs, which represents 31 percent of consumer inflation in China. Although Premier Wen recently stressed that China must continue to control food costs, the 6.9 percent drop in wholesale food prices the past four weeks suggests that food prices should decelerate later this year. In contrast, non-food inflation has increased at a moderate 2.9 percent pace in 2011. If this tempered pace for non-food inflation can be maintained, headline CPI should moderate to 5.5 percent early next year and 5 percent or less by late 2012 or early 2013.
A deceleration in inflation could open the door for a modest easing beginning with a cut in reserve requirements in late 2011 or early 2012. In fact, we are already beginning to see signs that the tide might be turning. Premier Wen has stated that the industry ministry is studying “stimulative policies” for smaller companies and he has already started to urge banks to loosen credit conditions to support small and mid-sized enterprises. This may be part of a crack down on the expensive costs and lending practices of the “shadow banking” market in China.
Despite fears of a housing bubble in the high-end of the housing market, a U.S. style collapse in the Chinese housing market is unlikely. First leverage is extremely limited in China. Second, in aggregate China still has an overall housing shortage. Private developers in China have been the main source of new housing in China for the last 12 years. Unfortunately, they have largely served higher-income households and their property is unaffordable for most mid-to-lower income households. The supply that is available is at the wrong price, but that can and probably will be corrected.
China’s government has been cracking down on speculation in the housing market and high prices since early 2010. Credit actions have been implemented to limit leverage, which, in turn has reduced speculation in this sector. Sales volume at the high end has been weakening and developers will be removed from certain projects. However, favorable demographics and the fact that the Chinese are not heavily leveraged (the average home has more than 70 percent equity) should act as stabilizers for this sector. The Chinese government will still need to aggressively support public housing at the right price, so deals are likely to be cut to get developers to construct lower priced homes.
The government has set an ambitious target of constructing 10 million housing units in 2011 and 2012. Although local government incentives and funding for these lower-income projects has been limited, social housing starts have increased since mid-2011, courtesy of pressure from the central government. Net, homebuilding will continue to increase in the coming years and remain a driver of overall economic activity, with the bulk of the activity shifting to more affordable dwellings.
Many investors remain cautious about the Chinese banking system. Despite generally solid profits, loan growth is slowing and it is anticipated that margins will get squeezed if interest rate liberalization moves forward. However, at mid-year, Chinese banks had an average non-performing loan ratio of just one percent and a capital adequacy ratio of 12.2 percent. This is a significant improvement from 10 years ago when the ratio of non-performing loans for many banks was more than 25 percent. Likewise, Chinese banks have solid liquidity as loan-to-deposit ratios are barely above 65 percent. The country has a consumer savings rate that is about 30 percent, which also provides deposit support to the banking system. Finally, it is important to remember that banks are either still outright owned or a majority-owned by the government, which implicitly guarantees deposits. The government has significant capacity to use its reserves to shore up the banks if necessary.
Informal lending (Shadow Banking) has become a relatively new worry in China, with off-balance sheet financing, the shadow banking system, and a variety of forms of “social financing” at the center of these concerns. Off-balance sheet lending surged in recent years as banks saw strong demand for credit but were forced to deal with both credit quotas and rising reserve requirements. The government has recently tightened liquidity, clamped down on trust products, and required banks to pay higher reserves on margin deposits, which, in turn, has slowed the growth in off-balance sheet lending. Overall shadow banking exposure and activity is still less than 10 percent of GDP. The possibility of defaults in the shadow banking sector won’t result in systemic risk, as its size is too small and the government has strong financial resources to provide support for the sector.
Although demographic conditions will still support growth in China for the next 8 to 10 years, we look for the pace of activity to temper. Real economic activity in China will likely decelerate towards the 6 to 7 percent area by the end of this decade as China continues to transition from the world’s largest low-cost producer of goods to the world’s largest global economy that also includes a powerful consumer base. As businesses and investors look to the future, the focus will not be centered on production that can be outsourced to China to lower costs, but rather on the resources, products, and services that can be delivered into China to meet its needs and the needs of its 1.3 billion consumers.
Statements concerning Commonfund Group's views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group's policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.