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Economic Insights

Despite geopolitical tensions, recent data out of China bode well in general for global economic growth. Will a new regime in November dampen prospects?

 

In Brief

  • With growing optimism about further modernization of the Chinese economy and liberalization of the financial system, including greater flexibility of the exchange rate, risks of a financial shock there appear low.
  • The world’s second largest economy should be able to achieve high-income status by 2027.
  • Recent reports suggest that a northeast Asia-led recovery in global trade is gathering strength, led by Japan, Taiwan, and Korea. This has very strong positive implications for global capital spending.
  • Recent support for rationing of credit to banks, along with ongoing tightening, suggests an increased focus on reining in credit growth after the party congress in November. If credit expansion is limited, it would signal a bias for reform at the expense of growth.


As Lord Abbett Director of Strategic Allocation, Giulio Martini pores through all kinds of economic and financial data, especially on China, the world’s second largest economy, which is undergoing a profound transformation, while pumping astronomical sums into infrastructure, technology, and restructuring an opaque financial system.

While many investors a year ago worried that China was letting its currency fall because there were serious problems in the domestic economy, Martini began to think such pessimism might be overblown.  By September 2016, he alerted colleagues that improvement in GDP growth in China was not just due to fiscal stimulus, although infrastructure spending had increased, but also to trade. He posited that if, as it seemed, Chinese mainland production was becoming more competitive globally, it would constitute a more fundamental and long-lasting source of strength, especially given the trade linkages between China and the other economies in North Asia.

Data since then have supported his thesis.  Stocks in China have risen sharply, and Martini remains optimistic about further modernization of the economy and liberalization of the financial system, including greater flexibility of the exchange rate.

“What you’re seeing now is stable strong growth, in part because the government has a huge interest in maintaining stability ahead of the party congress in November,” he said. “That’s when the first five-year term of President Xi Jinping ends, and investors will be paying close attention to any significant changes in leadership or policy.”

Adding to Martini’s positive outlook are recent reports which suggest that a northeast Asia-led recovery in global trade is gathering strength, led by Japan, Taiwan, and Korea. This has very strong positive implications for global capital spending, Martini said.

“While the U.S. data have not been inconsistent with a strong recovery in global trade, it’s important to realize that China’s economy is large enough to get this party started all by itself,” he added.  “Industrial output growth picked up in the first quarter, as production at state-owned enterprises began to recover after a very weak 2016.”  

Fixed asset investment in China also picked up, and more than expected, led by private companies. Moreover, trade data suggest that import and export volumes are accelerating. China’s imports from trading partners in northeast Asia are large enough to deliver significant stimulus to those economies, even if U.S. demand isn’t picking up as strongly.

“While hard data in the United States and in the eurozone are lagging behind the surge in surveys, the two sets of indicators are aligned more harmoniously in Asia,” Martini said. “That’s a very good signal for the global economy.”

Let’s Get Cyclical
One big question that looms is how much short-term pain China’s policymakers are willing to endure in terms of cutting off the credit flow to some companies and industries with overcapacity and industries where returns on capital are low in order to redirect them to other parts of the economy.  Ahead of any kind of significant political transition, the desire for taking on that kind of pain is fairly low, but afterwards the tolerance level might be much higher.

Martini summarized China’s economic cycle as follows: The government tightens monetary policies to induce structural change, which creates a crisis; so, Beijing reverts to stimulating the economy a little, thereby spurring some stabilization; and this, eventually, fosters a period of complacency, setting the stage for a recurrence of tightening and crisis.

“What’s important about China going forward is that its growth could be a little more cyclical,” said Martini. “But because it’s an economy with a closed capital account [i.e., money can’t flow freely] and because access to credit is much more important for growth than the cost of credit, the government has some really powerful tools to manage growth and has proven that over and over again during the last 15 years.”

Martini would, however, worry about China if policymakers somehow were unable to deploy monetary and fiscal policy efficiently enough to achieve what they wanted in the first place, which is to offset downturns that typically follow periods of restructuring.  But considering all the economic levers at Beijing’s disposal, Martini instead envisions cyclical growth that doesn’t fall much lower than central planners want it to.   

According to Martini, key policymakers’ recent support for rationing of credit to banks, along with ongoing prudential tightening, suggests that there will be an increased focus on reining in credit growth after the party congress in November. If credit expansion is limited, it would signal a bias for reform at the expense of growth.

As a result, Martini is relatively optimistic that China will, on average, maintain at least 5% growth through to 2025.  A significant part of that growth may come from the ongoing shift from an export-driven economy to one powered by domestic consumers and higher value-added sectors, such as technology, energy, health care, and education.1  As such, according to the McKinsey Global Institute, research and development spending in China has experienced double-digit growth since 2007 (see Chart 1), all of which helps drive forecasts of significantly higher income. (See Chart 2.) 

“A decline in migrant workers shows decisively that the era of rapid productivity growth from shifting workers from agriculture into industry is over,” said Martini. “The fulcrums for productivity gains are now found in the industrial sector and services. Chinese companies have become major investors in industrial robots and various AI technologies in response to the end of the era of abundant labor.”

 

Chart 1. China Is Playing a Bigger Role in Global R&D and Product Development
R&D spending in China has seen double-digit growth since 2007 


Source: McKinsey Global Institute. 1R&D refers to research and development. 2CAGR refers to the compound annual growth rate.

Chart 2. China Is Expected to Reach High-Income Status by 2027


Source: World Bank and Morgan Stanley Research.
Note: E=Morgan Stanley Research estimates. GNI= gross national income.

 

Growing “New China”
For all the concerns about overleveraged companies and fragile financial institutions, Martini took comfort from a recent Goldman Sachs research report on how China’s successful drive to cut excess capacity in the old economy is spreading across sectors such as steel, coal, cement, property, and telecommunications, and should continue over the next few years.  

“The rationalization of capacity also has stimulated companies to invest in other parts of their businesses,” the report said.  “Chinese companies are increasingly investing in automation and artificial intelligence to combat an ageing work force and growing labor costs, and to remain relevant and competitive.  Moreover, this investment has been driven by the ‘Made in China 2015’ plan, which aims at transforming China into a ‘manufacturing superpower,’ and by companies’ natural movement along the maturity spectrum.” 2

While the aggregate leverage levels of Chinese companies has more than doubled since 2010, China policymakers have imposed tightening measures on property purchases, property companies issuing domestic bonds, and domestic liquidity. As for China’s banks, a report from Goldman Sachs described how asset-quality pressures have been reduced due to improving corporate earnings. 3

“If even half of this is true, it’s revolutionary,” Martini said. “It also shows that China can grow robustly without adding to excess capacity or increasing the associated bad debt problems.”

Another dynamic worth watching is China’s increased focus on quality of life issues, particularly pollution (as evidenced by the fraying “green belt” around Beijing), poor medical care, poor education, and sustainable cities.   

“Even if the United States steps back from clean energy, China will continue to pursue it, because pollution has become so bad that people are extremely upset about it,” Martini said. “And considering how many new engineers are graduating each year, it’s entirely possible that China could become a global leader in battery technology, lightweight materials, and disposal technologies.”

Against that backdrop, a recent report by Morgan Stanley noted how China’s improving economy factors in the first synchronous recovery in developed markets and emerging markets since 2010.  

Banks for the Memories
On April 26, Martini alerted colleagues that financial regulators in China are forcing banks to reduce their outsourced funds. In his opinion, the intention of the new guidance is to limit the growth of leverage by curbing banks’ use of off-balance-sheet assets to channel funds to higher-return, riskier borrowers. The change, to the extent it is actually being implemented, would force banks to bring assets bank onto their own balance sheets, requiring increased funding. It would also, presumably, reduce the profitability of banks by redirecting business to independent asset management companies.

Martini also noted recent signs that funding pressure in the interbank market is increasing, consistent with a need to accommodate new assets. For example, the short-term repo rate has been spiking up again, following the recent bout of volatility during the normal end-of-quarter window-dressing period associated with meeting regulatory requirements.

“With the upcoming party congress in November, it would be extremely costly to provoke a downturn in economic activity significant enough to call the regime’s growth targets into question,” Martini said. “If regulators are pressing ahead with measures to rein in off-balance-sheet funding by banks now, it reflects confidence that the economy has a large enough cushion to withstand the potential short-term negative effects on economic activity. It may also reflect an endorsement by Xi himself for an early start to measures that limit increases in financial leverage.”

Martini went on to say that tightening regulation of banks off-balance-sheet activities has positive implications for corporate governance and transparency of the financial system. In the medium-term, reducing the influence of banks and state-owned enterprises over the allocation of capital in the economy is critical to managing rising financial leverage and avoiding economic stagnation.

One economist who met with the Beijing delegation at recent International Monetary Fund-World Bank events said there seems to be a high level of comfort that reaching the Chinese government’s growth target this year will be relatively straightforward, as the economy has decent momentum.  

The Road Ahead
In a speech to the World Economic Forum last January, President Xi recounted how rapid growth in China has been a sustained, powerful engine for global economic stability and expansion. “The interconnected development of China and a large number of other countries has made the world economy more balanced, and China’s remarkable achievement in poverty reduction has contributed to more inclusive global growth.”

Of course, there has been ample criticism of China’s trade policies and disrespect for intellectual property, but according to Xi, domestic consumption contributed to 71% of economic growth in the first three quarters of 2016.

While such data are open to question, one thing economists generally agree on is the explosive growth of China’s middle class, already the world’s largest, which some analysts expect to grow as large as 870 million by 2030.

At any rate, demand for goods and services by China’s middle class should continue to expand, which should, theoretically, help neighboring countries, and possibly even Europe, if Xi’s massive infrastructure initiative known as “one belt, one road” gains traction, notwithstanding massive debt and questionable returns. (See Map 1.) That project aims to connect emerging centers of growth around the world through infrastructure, trade, and investment.

Such globalist ambition undoubtedly will face considerable hurdles as investors weigh the costs and benefits amid increasing uncertainty about U.S. trade and national security policies, not to mention China’s attempts to tighten capital controls in an effort to stem huge capital flight.4

Regardless of how those dynamics play out, Martini believes China’s westward push is important, because inequality in China is as big an issue as it is in the United States. “All the rapid growth in China has been in the east, especially in the southeast, and the northeast, in the big heavy industrial regions,” he said.  “The western part of the country is still very poor, so a new ‘Silk Road’ and other infrastructure development in that part of the country is a good strategic move, because it would open up markets by lowering transport costs, and create new business opportunities in precisely the areas where they are needed most.”  

 

Map 1. China Is Investing Enormous Sums in New Land and Sea Trade Routes 

 

1”The Next Decade of China’s Transformation,” Morgan Stanley Research, February 15, 2017.
2 Joy Nguyen, Ambarish Jajodia, Chris Pan, “The China Capacity Question,” Goldman Sachs Global Investment Research, April 18, 2017.
3 Ibid.
4 Patrick McCabe, “The Folly of Investing in China’s ‘One Belt, One Road,’” The Wall Street Journal, April 24, 2017.

 

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