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China Update

30 October 2014

China – should investors be concerned?

Over the course of 2014, we’ve seen increased commentary on the direction of the Chinese economy and the potential for China to enter into a sustained down cycle. Some are even calling for a ‘bursting’ of the China bubble.

Much of this commentary has come about due to concerns around the possibility of a housing bubble and risk in the shadow banking system. The rapid rate of growth seen over the past ten years has manifested in a burgeoning middle class coupled with massive internal urban migration, many of whom have entered into the Chinese property market for the first time. This has led to a massive construction boom, with a corresponding increase in the level of debt taken on by Chinese consumers, developers and local government agencies. It’s this increased level of debt that has the pundits worried.

It is true that the China of today is different to the China of 10 years ago. China is now dealing with structural problems in its economy, which are compounded by the lack of global economic growth.

Our base view is that China is likely to continue at lower levels of growth over the next few years – without suffering the hard landing that some of the pundits suggest.

The volatility around property values and the associated credit boom is certainly not without risk. However, we believe this will be dealt with responsive central bank and government initiatives.

Here we outline our views on China in further detail:

The economy will continue to slow – but there’s still growth

Our base view is that the Chinese economy is slowing and will continue to slow. We are expecting GDP growth in the region of 7% to 7.3% over the forthcoming year.

The chart below shows the slowing level of growth in Chinese GDP, positioned against the money supply/circulation in the economy (M1)¹ going back to 2008. This slower growth is not a recent phenomenon. China is a much larger economy than it was 10 years ago. It is growing off a much larger base. In addition, Chinese exports have also been impacted by the global downturn since the GFC. These are unlikely to pick up until 2015 – on the back of a growing US economy. Notwithstanding this, we see the Chinese government adjusting the economy away from the heavy reliance on export income to an economy which is led by internal consumption. This is a journey for China which will take some time.

china1

Property sales and investment are likely to be lower

Property is the sector of the economy which poses the biggest risk to economic growth. Property prices have fallen across China in 2014, with most of the larger falls centred around the coastal provinces. Prices in these regions fell 18% in the first 18 months of 2014 (after a gain of 33% in 2013²).

Property investment has also slowed to 12.5% in September from 19.8% at the start of the year. The expectation is that this rate of growth will slow further. Property sales growth has slowed due to tighter monetary policy by the People’s Bank of China (PBoC) and tighter lending restrictions. The chart below shows the weaker level of construction activity and the wide fluctuation in house prices.

china2

Monetary policy likely to be loosened

It is likely that the central bank will respond to some of the concerns around asset deflation/falling house prices by easing monetary policy (interest rates) over the next year. The central bank understands the risks associated with credit markets and would prefer a slow landing to the economy. It has responded in this way in the past – cutting rates in 2012. Interest rates remain an effective tool to manage falling investment.

Inflation under control

The chart below shows the average level of inflation in China, split between food and non-food related items. This highlights the lower levels of inflation in 2014 (on a month on month basis) compared to the 2001 to 2013 period.

Chinese wages are rising, but the inflationary impact of this is offset by improvements in productivity growth. Inflation currently sits around 2% and has been on a slowing trend over recent months. This provides further room for interest rate cuts as highlighted above.

china3

Credit and debt concerns

Another risk to China remains the rapid increase in debt over the past few years. The Chinese government had been aware of the shadow banking system (non-regulated banking system) and largely left these unregulated. Some defaults or near defaults associated with wealth management products have recently raised concerns.

What’s important to remember is that household debt is very low at 30% of GDP, average deposits are around 40% of values, 20% of buyers pay in cash and 90% of new home buyers are owner occupiers³. Aggregate debt as a percentage of GDP is also lower than many other countries around the world.

Pollution controls

China has a pollution problem. It poses massive health risks to the population and will potentially impact economic growth in the future. Government controls have been put in place such as alternating days in which vehicles can travel into cities, as well as limiting imports of dirty coal and the closure of polluting factories. China has a target to cut its 2005 Carbon Dioxide emission levels by 45% by 2020. These measures will have an impact on economic growth. This is an ongoing issue and represents a major political challenge.

Summary

Whilst there are pockets of the economy that have over extended and do pose some risk, we don’t see these risks as being large enough to bring down the Chinese economy. China is a much larger economy and the rate of growth in the economy will naturally slow over the next few decades. However, we remain conscious that the property sector and credit related issues are not a small problem for the Chinese government and central bank. A focus on slowly deflating this sector, whilst at the same time maintaining current levels of economic growth will be a challenge. We continue to watch this space with interest.

 

¹ M1 can be defined as the most liquid form of money –ie: the sum of total money held by the public and transaction deposits at banks, credit unions. It helps track the amount of liquidity in the financial system.
² Deutsche Bank – Revamping our China macro outlook
³ AMP Capital Investors – Feb 2014