China: Asia’s next success story

published 15 November 2018

This article is the second in a two-part cover story. Read Jonathan Compton's counter argument here:China will get old before it gets rich

Larry Kudlow, Trump's main trade adviser, said last August that the Chinese economy "looks terrible". Stockmarket investors appear to agree. The Chinese domestic A-share market has slid by a fifth this year and the renminbi is down 7%. Foreign investors' favourites such as internet giants Alibaba and Tencent are down by at least 30% from their 2018 highs. GDP growth fell to 6.5% year-on-year in the latest quarter, compared with 6.9% in 2017 as a whole. Some analysts expect 6.1% in 2019.

China's temporary struggles may reinforce President Donald Trump's belligerence. He calculates that if the US pushes hard against the Chinese economy it will prove to be a "paper tiger" and collapse. To stave off a slump, China will be forced to sign a new Treaty of Nanking (the one-sided treaty forced on China by the UK at the end of the First Opium War in 1842, which broke open imperial China to foreign trade). Shortly before Kudlow's statement on the health of the Chinese economy, he said, "I'm not a China expert, although I'm boning up as fast as I can". But would a teacher give him a pass grade for his economic assessment? Spoiler alert: no.

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Last year saw the anointment of Xi Jinping as the paramount leader. As with most politicians he was keen for the economy to be in tip-top condition for his arrival, so the economy was pump-primed to perfection. As a result, 2018 has seen a commensurate slowdown as the stimulus has abated and the government's current dominant economic policy deleveraging has held sway. Debt within the Chinese economy has been rising faster than GDP growth since 2009 but in 2018 will come in below GDP growth. So it is embarking on the process of lowering the debt burden as a proportion of GDP. Deleveraging is crucial to China's long-term economic future, but it is negative for growth in the short run. Public sector capital investment, where much of the debt has been racked up, is now down on a year-on-year basis.

This highlights the important shift that has been made in the Chinese economy: it is no longer about size but the quality of growth. All economies that have successfully moved through the tricky middle-income problem (some countries have got stuck in a middle phase of development and never quite emerged as rich states) have done so as consumer-led economies. In 2008 China's consumption as a percentage of GDP was as low as 37% but over the following ten years that has risen to 42%-43%. The figure is set to rise much further as China gets richer and the middle class expands. Bain, a consultancy, expects household consumption to grow by 6% a year between 2016 and 2027, reaching a value of $8.2trn almost double the current figure.

China is the fourth north Asian state-driven economy to go through this process. Japan led the way, with South Korea and Taiwan then following. The period when each transitioned towards consumer-led growth saw steep slowdowns in overall GDP growth but dramatic rises in their stockmarkets as investors approved the shift towards sustainable long-term growth and new-found earnings quality. Note, too, that this is also the phase when each of the other north Asian economies created home-grown exporting champions such as Sony and Samsung. China's 2025 economic plan foresees domination of the global market for semiconductors and electric vehicles.

Consumption in China this year has been soft but this is almost entirely due to two sub-sectors vehicles and home appliances. Both these sub-sectors have connections to credit markets as consumers use finance for purchases. The government has been trying to regulate the booming online credit market more rigorously. As is the way with all new markets in China, thousands of companies crowded into the space offering super-aggressive deals.

The state has now barred some of the smaller players, but at the cost of a noticeable credit crunch for low-to-mid income citizens in the first half of this year. Credit growth rates will start to return to normal as the clampdown eases next year. Bear in mind that consumer credit levels in China are dramatically lower than Western ones, in any case. Most house purchases are still made without a mortgage.

So where is the real weakness? Well, Larry Kudlow would point to the mountains of debt still sitting in China and rising defaults as a sign that a collapse is round the corner. It is undeniable that defaults are rising, but they are still at very low levels compared with Western economies that are generally perceived to be in good nick. However, the defaults issue does highlight one of the main concerns for investors in China. The perception is that the government does not want any bad news to get out. So when it does appear, markets think the real situation must be much worse.

We will never know what is happening but all we can be sure of is that the amount of bad debt is not large enough to force a collapse, mostly because the government is both the lender and the borrower in at least 70% of bad debt situations: state-owned banks and companies are the main owners of bad debts. This is a managed process. Its speed will in turn determine how fast China moves through the middle-income problem. But as long as the process keep going, the Middle Kingdom will get there in the end.

Bears also point to the renminbi/US dollar exchange rate. Many investors think that if the currency weakens quickly, then Chinese nationals must be deserting the sinking ship, sending their cash abroad. China undeniably has a potential problem here. The $3trn of foreign exchange reserves could in principle be swamped by money leaving the country. However, the government has largely closed the capital account, so money can't leave and the renminbi is not a freely circulating currency. The central bank is utterly in control. The weakness of the renminbi this year thus reflects a managed devaluation to offset the effects of Trump's tariffs and encourage Chinese exports to other nations. This process does not look over. As US rates continue to rise and Chinese rates start falling the renminbi should breach seven to the dollar and slide into the 7.2-7.3 range. This may trigger a series of "China tailspin" headlines and market weakness. For us bulls, however, this will be the next wonderful buying opportunity.

The working population has peaked in China and is falling slowly. However, this problem will be negated by urbanisation over the next few years. At present there are still 200-300 million people too many working in agriculture. This is mostly because in China if you are a farmer you cannot sell your land. Without being able to sell your land, too many farmers stay on their very small plots in the country. Their children are also discouraged from moving to cities by the Hukou system: you can usually only consume government services in the area where you were born. These two factors mean that urbanisation is around 10% below where Japan and Korea were at this stage of their development. The urban workforce will thus keep rising for the next 10-15 years. Urbanisation spurs productivity and growth as industries and knowledge cluster in cities and economies of scale develop. The overall demographic picture won't be an issue for a decade and a half.

The upshot is that Chinese GDP will slow for the next few years. But this is a corollary of deleveraging and regulatory changes. The key is the consumption picture. As long as this remains strong, everything is fine. Indeed, this week it emerged that e-commerce group Alibaba (China's Amazon equivalent) set a new record during the 24-hour Singles Day shopping festival. Sales reached $30.8bn, up from $25bn last year.

The valuations of Alibaba (NYSE: BABA) and other top Chinese firms have collapsed along with the market this year. That spells opportunity. Alibaba recently reported overall sales growth of more than 50% in the quarter to the end of September. Its e-commerce division (one of many internet businesses) is now trading at just 15-20 times earnings. Amazon's e-commerce business is on a price-earnings ratio (p/e)of 80. Alibaba is the dominant company in the largest and fastest growing e-commerce market in the world and is now starting to expand overseas.

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Rupert is an investment strategist and adviser at J & C Foster, providing Asian, Consumer and Global Equities Strategy advice to a number of family offices and portfolio management organisations. He writes on Asia and Global Macroeconomics for a number of investment publications including MoneyWeek and HL Investment Times.