A central question for investors today is the outlook for China. As the country’s importance has increased in the global economy, so has its impact on client portfolios. Getting China “right” has become increasingly crucial. Yet, wide-ranging perspectives are generating confusion, adding a new dimension of risk to the “China factor” on a still-fragile world.
The consensus views on China
Two main opposing views frame the debate. The first is that the era of China’s blockbuster growth is over. In the past decade, the country built its economy through massive infrastructure and export promotion, becoming the world’s largest trading nation and second largest economy. From 2002 to 2011 China grew at an average GDP rate of 11%. That is an enormous number. Unsurprisingly, many commodity-oriented countries and sectors profited handsomely during that period.
But growth is now dramatically slowing to less than 7%. Further moderation is likely ahead. Debt also continues to rise and a necessary deleveraging phase will only contribute to even more tepid growth. Under this view, the boom times are over and related investments will suffer.
Looking past the cyclical outlook
The above is the dominant market view. However, that perspective very likely represents both a failure to think outside the Western box and to read Beijing’s policy signals. Looking past the cyclical outlook, several positives emerge. Consider that much of China’s slowdown has been coordinated by policy. Many starry-eyed China watchers predicted GDP growth of 10% plus indefinitely. But there are limits to linear thinking. While trends can stay in place for some time, lines often bend, or even break and shoot off in unexpected directions.
China’s new path is driven by broad recognition that the growth model of the last 30 years is neither balanced nor sustainable. The new model must rebalance away from export and investment-led production toward private consumption. “Made in China” and Western consumerism can no longer be intimately linked. This is a necessary shift if China is to avoid the so-called middle income trap, which ensnares most emerging economies that are dependent on cheap labour for growth.
GDP per head in China is now approaching $10,000. To move beyond this level, productivity must dramatically improve. That requires a litany of change – reduced corruption, middle class rights, and an improved operating environment for the private sector. A campaign against corruption has already begun in earnest.
A critical next step is to establish a robust social safety net and thereby reduce fear-driven high household savings rates. This will lead to a virtuous cycle of consumption, job growth and, ultimately, higher real wages and corporate profits.
The debt-reduction problem
Turning to the debt issue, no one disputes that China must deleverage. Debt has grown rapidly, especially in the corporate sector since the global financial crisis. However, the path of debt reduction is now the central question. Most are superimposing recent deleveraging experiences – the Asian crisis in the late 1990s or the eurozone’s austerity drive since 2008 – onto China. Neither of these scenarios is likely.
At less than 10% of GDP, China has very low foreign debt. Most debt creation is financed by China’s massive domestic savings. A loss of confidence by its foreign creditors would not suddenly force China into a downturn similar to the previous Asian crisis, which China essentially sat out.
A prolonged austerity-driven path is just as unlikely. The market’s main concern is overinvestment in housing in underpopulated cities and worthless public works projects. But these excesses are the result of targeted policy-driven efforts to steady growth. There is little risk that policymakers will suddenly turn and tighten credit.
China’s global financial objectives
Even more important than the above is China’s strategic objective of increasing its global significance as a financial power (in addition to having major economic and trade influence). A better financial system is crucial if China wants to move away from the rapid industrialization phase where the aim was to build up as much infrastructure as possible to a higher quality growth phase with a focus on maximizing the return on investing.
Two outward thrusts are noteworthy here. One is the “Belt and Road” Initiative; an infrastructure program with the goal of creating China-financed transport links across Central Asia to Europe via a “Silk Road Economic Belt,” and across Southeast Asia to the Middle East and Africa via a “Maritime Silk Road.”
If executed properly, the new infrastructure would greatly enlarge the economic ecosystem within which China operates, creating investment and trade opportunities far beyond the initial infrastructure projects. Efficient transport and communications infrastructure effectively lowers the cost of moving goods, people, and ideas around. Economic activity is boosted and smaller countries become clients of the central power that built it.
The second, longer-running, initiative is the promotion of the Chinese renminbi as a major global currency. Clearly, if China is to become a serious financial power, it must have stable and open capital markets. A strong renminbi is key here, not least to finance its trade and outward investments in its own currency. This is already happening. The renminbi has stealthily been one of the world’s strongest currencies in the last decade and now accounts for about 35% of China’s total trade (a tripling from three years ago). The next stage is to achieve “reserve currency” status. The first milestone will be inclusion in the International Monetary Fund’s Special Drawing Rights basket – perhaps as early as November of this year.
Adapting to the new China paradigm is essential
Looking ahead, there is much work if China is to fulfill these ambitions. Financial reform and opening China’s capital account will be a volatile process. Cyclical headwinds are indeed present. And, prophecies of doom will continue to plague China.
Yet, despite a large gap in values between an authoritarian state and capitalist democracies, China has proven extraordinarily resilient. There is evidence of widespread improvement – less corruption, reduced debt, and shrinking overcapacity in heavy industry.
Investors have incredible difficulty making the leap that the paradigm is changing. Views of the future tend to rely heavily on the recent past. Yet, change is indeed afoot. In the coming decade, the world will have to reckon with China not as a rapidly growing export nation, but as a burgeoning geopolitical and financial power. The practical challenge will be to identify a broader range of both Chinese and non-Chinese assets that will be re-rated due to China’s global objectives. Our Investment Committee will be closely tracking these trends and positioning client portfolios accordingly.
Courtesy Fundata Canada Inc. © 2015. Tyler Mordy, CFA, is President and Co-CIO of Forstrong Global Asset Management Inc. Securities mentioned are not guaranteed and carry risk of loss. This article is not intended as personalized investment advice.
