GLOBAL MACRO SHIFTS

CHINA: SEARCHING FOR A NEW EQUILIBRIUM

"The days when China could leverage low cost manufacturing are clearly over"

MICHAEL HASENSTAB, PH.D.
Chief Investment Officer, Templeton Global Macro

Nobody interested in the global investment landscape today can afford to look past China. Now firmly established as the world's second largest economy it is expected to take the top spot in little more than a decade. But how much do investors really know about this enormous and diverse country, the factors driving its growth and the challenges that it faces. Contradictory headlines abound, but here the Templeton Global Macro team, led by Chief Investment Officer Michael Hasenstab, cuts through the noise to examine the real story.

We find that most observers tend to fall into one of two camps on China: the die-hard skeptics and the perma-bulls. The skeptics are convinced that nothing about China— from the data to the banking system to the demographics—bears close inspection. This school of thought argues that the official numbers are too unreliable to follow, and the imbalances too large to warrant detailed analysis. Skeptics envision an implosion of the Chinese economy, resulting from a bubble in the housing market, in local government debts, in the stock market—or frequently in all three. In their view, the collapse is impending, and has been for the last 10 years. The smaller group of China bulls takes an extremely benign view of the country's transformation. This group expects the China growth miracle to continue smoothly, with any moderation lasting only temporarily. This camp tends to shrug off concerns about imbalances, arguing that China has more than enough money, the right policies in place and an unparalleled control over its economy.

We take a more nuanced and balanced view than either the die-hard skeptics or the perma-bulls. On balance we remain optimistic about China's outlook, but we recognize that the country faces formidable policy challenges and substantial risks that bear close monitoring.

China today has reached a crucial juncture in its ongoing deep economic transformation. Its three traditional engines of growth have all stalled at the same time: The real estate sector is contracting after a protracted boom; local governments needing to deleverage have scaled back their investment; and many components of the manufacturing sector have been shrinking.

However, growth in consumption driven by rising wages, growth in the service sector and new infrastructure investments work to offset the simultaneous contraction of these other three sectors. The manufacturing contraction has been triggered by the Lewis turning point: a demographics-driven deceleration in labor force growth, which has boosted wage pressures, undermining the competitiveness of traditional export-driven manufacturing. The slowdown in labor force growth, however, means fewer jobs are needed to maintain full employment: an estimated 3 million per year compared to a previous peak of 12 million. The faster growth of the service sector, which has taken over from industry as the leading job creator, is enough to provide them. Therefore, the contraction in manufacturing, real estate and local governments has not caused an increase in unemployment—which would pose a thorny social and political problem.

Rising wages and sustained employment have allowed household consumption to overtake investment as the main contributor to GDP growth, exactly the type of rebalancing that China needs. Sustained wage growth, however, needs faster productivity growth. Without this, a growing share of the economy will become uncompetitive, forcing China into the "middle-income trap." Faster productivity growth requires industry to shift toward higher technology and higher value-added sectors. The government has fostered this process through a number of key policies: bolstering the education sector, reforming state owned enterprises (SOEs) to encourage faster private sector growth and incentivizing innovation. The middle-income trap has proven extremely difficult to escape, as proven by the few countries that have successfully accomplished this—certainly none as large as China. Nonetheless, China appears to have adopted the correct strategy, and has supported its policies with other long-term reforms, such as capital account and financial market liberalization aimed to improve capital intermediation and thus channel capital to the more productive parts of the economy. Meanwhile, environmental and infrastructure spending will help support longer-term growth prospects internally as well as expand China's global reach, most notably through the new One Belt, One Road initiative.

Significant risks still exist. First, monetary policy needs to strike a delicate balance: So far the People's Bank of China (PBOC) is giving just enough support to attenuate the economic slowdown; should growth decelerate further, however, the recent measures to allow local government debt to be swapped for municipal and provincial bonds could turn into a quantitative easing (QE)-style excessive stimulus, undermining the deleveraging and setting the stage for a hard landing. Second, over the past decade, China has rapidly accumulated a substantial debt stock, largely in less transparent local government and shadow banking operations. In our estimates, this stock could be as large as 250% of GDP including all the different sources of on- and off-balance sheet debt (i.e., central and local governments, households, and corporates). But, unlike many other countries, China's state has an enormous stock of assets, comprising foreign exchange (FX) reserves and importantly the assets of its strongest SOEs. Additionally, the central government has no foreign debt. These factors help minimize the risk of a classic debt sustainability crisis. However, the deleveraging process might not be smooth, which could trigger problems in the banking or corporate sector, disrupting growth. On the other hand, the deleveraging might be reversed, which could lead to a continued build-up of debt, still a source of risk. Third, the stock market could crash—especially after China's equity indexes have more than doubled in the last 12 months—posing concern. Though China's stock market still plays a relatively minor role in its economy, both as a source of capital for companies and as an asset for households, its importance on both sides has increased somewhat. A sudden crash could give a further contractionary shock to growth, and would stall the process of financial sector strengthening and diversification. Finally, essential SOE reform needs to overcome powerful vested interests, and could face considerable pushback, increasing the chances of failure.

China currently faces recessions in three major sectors of the economy.

Overall, based on our detailed analysis, we believe China will remain on course, with GDP growth decelerating moderately toward the 6% mark over the next few years while the economy shifts toward consumption, services and higher value-added manufacturing. This has important implications for the global economy:

  • 6%+ growth in China will support global growth, an important factor given the structural fragility of the European recovery and the prospective tightening of US Federal Reserve (Fed) policy.
  • Together with the new round of infrastructure investment, this will provide some support to commodity markets. Note, however, that China's rebalancing from investment to consumption will also reduce demand for most industrial metals. On balance, therefore, our China outlook should be consistent with stable commodity prices in the next few years.
  • China's rebalancing also has a differential impact on trade flows: We should see more trade with advanced economies producing finished and industrial goods, and relatively less with commodity producers. Moreover, the One Belt, One Road initiative and the actions of the newly launched Asia Infrastructure Investment Bank also bear close monitoring because of their potential impact on trade flows over the long term.
  • Finally, sustained wage growth implies that China should gradually export a more inflationary push to the rest of the world, reinforcing our view that, starting with the US, the outlook remains for higher inflation rates and higher interest rates.

Overall, based on our detailed analysis we believe China's search for a new equilibrium will succeed. We reaffirm our baseline view that China remain on course, with GDP growth soft-landing to about 6% as the economy rebalances. This would give important support to global growth and put a floor under commodity markets—though China's absorption of industrial metals will likely diminish further. China's trade will gradually reorient from commodity producers to advanced economies providing finished and industrial goods; and sustained wage growth implies that China should gradually export a more inflationary push to the rest of the world, reinforcing our view that, starting with the US, the outlook remains for higher inflation rates and higher interest rates.