Emerging Markets  

China’s prospects give reason for cheer

This article is part of
The Guide: Investing in emerging market equities

China’s prospects give reason for cheer
 This should be the sixth consecutive year where services and consumption growth in China will be larger than manufacturing and construction

The list of common complaints against China is long: there is a credit bubble and overinvestment, the economy is state-controlled and overheating, there is no innovation, companies have poor governance and you can’t trust the numbers. Looking at the facts, however, it becomes clear these criticisms are founded largely on misconceptions.

It is not surprising that investors worry about the health of the Chinese economy. Media coverage tends to focus on commentary from the perma-bears, who have been forecasting imminent collapse for many years. Yet the economy delivered many surprises in the first half of the year, again disappointing the pundits who predicted a hard landing.

A key part of the perma-bear thesis has been that the structure of the Chinese economy is unsustainable as it is based on investment, heavy industry and exports, rather than on consumption and services. That perspective is becoming outdated as the Chinese economy continues its rebalancing.

This year should be the sixth consecutive year where services and consumption will be larger than manufacturing and construction. In the first half of 2017, consumption accounted for 63 per cent of GDP growth, up from 42 per cent in 2006. Net exports accounted for about 2 per cent of China’s GDP last year, and were a negative contributor to GDP growth.

China’s economy is also rebalancing in another important way: it is becoming entrepreneurial. In the early 1980s there were no private companies in the country, compared with today where about 85 per cent of urban employment is in small, privately owned firms. State-owned enterprises are shrinking, and net job creation is by entrepreneurial, private companies. Prices of most goods and services are set by the market. 

The state (and the Communist Party) continues to play an outsized role in the economy – especially in the financial sector – but the rise of the private sector has been rapid and irreversible.

China’s economy faces plenty of challenges, but these should be put in context. In early 2016, many predicted China would run out of foreign exchange reserves by the end of the year, and its currency would devalue sharply against the dollar. Neither of those events took place, and reserves have since risen and the renminbi strengthened. But it is worth nothing the direction of the currency is determined primarily by the dollar, rather than the health of the Chinese economy. The renminbi was hit as the dollar strengthened in 2016, but the opposite has occurred this year.

But what about China’s debt burden? There is no denying that the nation’s debt has risen significantly. To a significant extent, every country’s banking system is shaped by its political system. And every nation’s solution to a banking system problem is based on politics. 

All Chinese banks are controlled by the Chinese government, and the potential bad loans are those extended by government-run banks to state-owned enterprises, at the direction of the government for social and political reasons. This policy is not going to cause a banking system collapse as the Chinese government will over time absorb the majority of the burden of these bad loans. The fiscal deficit to GDP ratio will rise, but there won’t be a banking crisis.