Strategy Bulletin  

21/01/2014

LOWER CHINESE GROWTH AND OPPORTUNITIES

One major investor concern as we start 2014 is declining Chinese growth. We do fully acknowledge that headline growth will trend lower going forward, but we consider this as a welcome and long-awaited development. The fundamental question in our opinion is rather whether the country will successfully transition to better quality growth, and the answer boils down to two questions: Does China really want a shift from investment-led to consumption-based growth? What are the obstacles, and will they prevent this transition from happening?

To the first question, recently observed evidence seems to support a positive answer. While the country’s growth did rely heavily on investment, exports and increasing current account surpluses until 2007 – and in turn financed US deficits, the trend has reversed, with Chinese external surplus having been more than quartered in 5 years, from 10.1% in 2007 to 2.4% in 2012 (upper chart). To follow on from these external adjustments, we now logically expect internal adjustments. Indeed, Chinese private consumption accounts for just 37% of GDP, 31% less than in the US. Yet, this could be the start of a new, albeit slowly evolving, trend. While last year’s reform agenda has lent more importance to domestic consumption (e.g. the administration’s desire to increase urbanization and improve property rights), the nature of fixed investment, although still very high at 47% of GDP in 2012, also appears to be evolving: in 2012, investment growth in the tertiary industry (services) overtook that of the secondary industry (manufacturing), and the trend appears intact for 2013 so far. In addition, the Chinese central bank (PBoC) has significantly reduced the size of its balance sheet, from a peak at 68% of GDP in 2009 to 56% today, effectively tightening its monetary policy and allowing the Chinese yuan (CNY) to appreciate (middle chart) – despite declining growth, moderate inflation and large losses of competitiveness. Resisting the “old” habit of boosting growth through currency devaluation is probably the best proof of China’s willingness to be a team player in the global rebalancing game.

So – what could stand in the way of a successful transition? The first obstacle is debt. Whilst China’s government gross debt, at just 26% of GDP in 2012 according to the IMF, appears very low, this measure does not account for massive local-government debt, which – as revealed by the audit published last month – had reached RMB 17.9 trn (34% of 2012 GDP) in June 2013. In addition, while state-owned enterprises (SOEs) have been kept afloat so far by artificially (and unfairly?) low interest rates, fundamentals are weak. SOEs’ liabilities-to-assets ratio has grown from 56% to 62% since 2007, and banks’ non-performing loans could therefore rise quickly when interest-rates liberalization unfolds. The second burning issue lies in the housing sector. House prices in the 4 main cities1 brushed a record high last November and are growing at an annual pace of 19%. In addition, consumers’ savings rates remain extremely high, at 42% of disposable income, and the unemployed population in urban areas is still expanding, which does not help consumption – not to mention the very thin social safety net. Finally, the opening of Chinese markets could lead to outflows. Any loss of control on that front could prompt Chinese authorities to again resort to currency devaluation.

In that context, one interesting development in 2013 was the further opening of the offshore bond market, with currency swap agreements signed between the PBoC and BoE/ECB2. Indeed, the above analysis suggests that the CNY should pursue its strengthening trend. In addition, the newly investable Chinese bond market (Dim Sum) offers attractive yields compared to the developed world (lower chart). As such, the combination of elevated yields and a rising currency represents an interesting opportunity, even if monetary tightening and interest-rate liberalization could create volatility in the near term. For those not able (or willing) to invest in the bond market, we would recommend at least taking advantage of the appreciating currency.

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