Sinology by Andy Rothman February 19, 2015 a In the second of a threepart series, Sinology answers some of the key questions investors should be asking about China in 2015. a We are witnessing the odd scene of Communist Party leaders being comfortable with a gradual deceleration of economic growth that is making most foreigners very nervous. a I do not expect significant stimulus or monetary policy easing this year, but continued economic reforms are coming, and China will remain the world s best consumer story. ANDY ROTHMAN lived and worked in China for more than 20 years, analyzing the country s economic and political environment, before joining Matthews Asia in 2014. As Investment Strategist, he has a leading role in shaping and presenting the firm s thoughts on how China should be viewed at the country, regional and global level. KEY QUESTIONS FOR CHINA INVESTORS IN 2015 PART II China is complicated and raises many questions for investors. On the one hand, China s economy is growing more slowly at 7.4% last year, compared to 7.7% for the two prior years. On the other hand, because the base was far larger last year, the incremental increase to the size of the economy was 10 greater than the increase a decade ago, when GDP rose 1. This is why the International Monetary Fund estimates that China accounted for almost one-third of global growth last year. With inflation-adjusted income up about 7% in China, compared to 2% in the U.S., consumer spending is booming, up 11% vs. 2% here. Media headlines, however, continue to tell us that China s economy is doomed. This is the second installment of a three-part Sinology series designed to answer some of the most important questions about China s economy. We explore the reasons why the Communist Party is comfortable with slower growth, and just how slow a pace might be tolerable. This segment will also answer questions about the health of what has been the world s best consumer story, and about prospects for further economic reforms. The final installment will answer the question: Is China s property market heading for a crash? And it will discuss what we feel are the biggest long-term risks to growth and stability an absence of the rule of law and trusted institutions. The first part of this series, published in early February, addressed the impact of falling oil prices and the risks for deflation. We also considered the prospects of certain policy moves cuts to interest rates and bank required reserve ratios that have led to a booming domestic Chinese stock market, and concluded that many domestic investors are likely to be disappointed. Why Do I Keep Saying China Won t Ease this Year? Because we are witnessing the odd scene of Communist Party leaders being comfortable with a gradual deceleration of economic growth that is making most foreigners very nervous. China won t and doesn t need to ease significantly because current conditions are not tight ; because the macro deceleration is largely the inevitable result of structural changes; and because the slower pace of growth is still fast enough. Let s look at each of those three points. Current conditions are not tight. The growth rate of total social financing (TSF, or aggregate credit) has continued to cool, from 19.1% year-over-year () at the end of 2012, to 14.3% at the end of last year, but that was still considerably higher than nominal GDP growth of 8.3%. Broad money (M2) rose 12.2% last year, compared to 13.8% in 2012. Hardly tight, in my view.
Figure 1. TOTAL SOCIAL FINANCING (TSF), LOANS, GDP AND M2 4 3 2 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Outstanding TSF RMB loans outstanding Nominal GDP M2 (a measure of broad money supply) Sources: CEIC, People s Bank of China Deceleration is largely the inevitable result of structural changes. After two decades of 1 annual GDP growth, it is inevitable that the growth rate is slowing. Many factors contribute to this slowdown. Demographics, for example, plays a big role: in past years, the workforce grew rapidly, making a significant contribution to GDP growth. Now, the working age population is beginning to shrink, eliminating the demographic dividend. Similarly, so much public infrastructure has already been built that the growth rate of new construction is significantly lower. Commercially built, privately owned housing boomed during its first decade of existence in modern China, and is now growing more slowly as that sector matures. This slower growth is, however, still pretty fast. GDP growth averaged 8.6% between 2010 and 2014, and 7.4% last year (compare this to 2.4% GDP growth in the U.S. for 2014). And the absence of a significant stimulus last year is strong evidence that the Party is comfortable with this gradual deceleration. The Party controls the financial system, and did not reaccelerate credit growth last year. TSF outstanding rose 14.3% last year, down from 17. in 2013. Contrast this with the sharp rise in outstanding credit growth engineered by the Party in response to the 2009 Global Financial Crisis: from 19.7% in November 2008 to 33.4% a year later. Figure 2. GROWTH RATE OF TOTAL SOCIAL FINANCING (TSF) OUTSTANDING RMB billions 3,000 2 2,500 2 2,000 1 1,500 1,000 1 500 0 Jan-12 Monthly new TSF Sources: CEIC, MICM estimates Growth rate of TSF outstanding (right axis) 2
There was also no sign last year of stimulus in the growth rate of fiscal spending, which averaged 1.4% during the September November 2014 period, compared to 12% during the same period in 2013. Figure 3. FISCAL EXPENDITURE GROWTH, FISCAL DEFICIT AS SHARE OF GDP 3 2 2 1 3% 2% 1% 1 2003 2004 2005 2006 2007 2008 2009 Fiscal expenditure Fiscal deficit as a share of GDP (right axis) 2014 Fiscal deficit as a share of GDP is based on estimates 2010 2011 2012 2013 YTD Nov-14-1% Sources: CEIC, MICM estimates China s leaders took no significant steps to reverse last year s gradual deceleration, signaling that they are comfortable with this trend. How Much of a Slowdown will Xi Jinping Tolerate this Year? A starting point to answer this question is to understand that the GDP growth rate is not the Party s main economic indicator. Chinese citizens pay no more attention to GDP than do Americans. As in other countries, the important factors are employment and people s sense that their standard of living is improving. China s official unemployment statistics are (as their economists readily admit) useless, but there are no signs that slower growth has led to rising joblessness. A study of privately-owned, small- and medium-sized (SME) manufacturers by the research brokerage firm CLSA found that in 4Q14, 7% of firms reported it was easier to find new unskilled labor, compared to a year earlier. This compares to an 8% response by SMEs in 2Q08, which then jumped to 76% in 4Q08 as the global financial crisis set in. Similarly, 3% of SMEs reported it was easier to find new skilled workers in 3Q14, while the rates were 2% in 2Q08 and then 61% in 4Q08. The same CLSA study found that SME wages rose by more than 6% for unskilled factory workers and by almost 8% for skilled workers in 4Q14, growth rates that have remained fairly stable over the past few years after bottoming in early 2009 at -1% for unskilled and 1% for skilled workers. Figure 4. STEADY GROWTH IN MANUFACTURING WAGES 2 1 1-2Q07 4Q07 4Q08 4Q09 4Q10 4Q11 4Q12 4Q13 4Q14 Skilled/managerial workers Unskilled factory workers Source: CLSA 3
The independent data from CLSA is in line with official numbers showing continued strong income growth. Inflation-adjusted (real) urban household disposable income rose 6.8% last year, compared to 7% in 2013. Real rural cash income was up 9.2% last year, compared to 9.3% in 2013. (As a reference point, U.S. real disposable personal income rose 2.2% last November.) Wages for migrant workers, who move from China s countryside to staff the nation s urban factories and construction sites, rose by almost 1 last year. The country s overall labor market remained stable despite slower macro growth. Figure 5. AVERAGE WAGE OF MIGRANT WORKERS RMB per capita 3,500 2 3,000 2,500 2 2,000 1 1,500 1 1,000 500 0 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Sep-10 Dec-10 Average monthly income of migrant workers Dec-11 Growth rate (right axis) In my view, as long as there is no spike in unemployment and real income growth remains strong, the Party is unlikely to deploy a significant stimulus. This holds even though I expect GDP growth to slow to the 6. to 7% range this year, and then to to 6% by 2020. Another important factor in understanding why gradually slower growth does not constitute a crisis is the base effect. At 7.4%, last year s GDP growth was significantly slower than the 10.1% pace of 2004. But because the size of the economy (the base to which the 7.4% increase was applied) was three times larger than the 2004 base, the incremental increase in the size of China s GDP at last year s slower growth rate was 10 larger than the increase at the faster growth rate a decade earlier. Figure 6. BASE EFFECT RMB billions 8,000 12% 6,000 10.1% 7.4% 1 8% 4,000 5. 6% 2,000 4% 2% 0 2004 2014 2020 estimate Incremental increase in nominal GDP Sources: CEIC, MICM estimates Real GDP growth rate (right axis) 4
Similarly, if we look ahead to the bottom range of my GDP growth forecast for 2020, growth, that will be applied to a base which will likely be over 6 bigger than the base in 2014 and about 60 bigger than the 2004 base. Therefore, at growth in 2020, the incremental increase in the size of China s economy will be 39% larger than the increase at 7.4% in 2014, and more than 18 larger than the increase at 10.1% in 2004. In other words, the slower growth rate will generate a much bigger addition to the size of China s economy and a much bigger opportunity for the companies we invest in. Will China s Consumer Story Hold Up this Year? Yes, but as with almost everything else in the Chinese economy the growth rate will be slightly slower. As noted earlier, income growth has been decelerating, and that process will continue. I also expect the Party s anti-corruption campaign that has had a modest negative impact on retail sales to continue. Both of these factors have led to slightly slower growth in consumer spending, with real (inflation-adjusted) retail sales growth going from 11. in 2103 to 10.9% last year. With income growth expected to continue to slow, this year will likely deliver only about 1 real retail sales growth. Slower, but still the world s best consumer story. (For reference, in the U.S., retail sales were up about 2% last year.) Figure 7. REAL GROWTH RATE OF RETAIL SALES 2 1 1 Jan-10 Dec-10 Dec-11 Will there be More Reform Progress? Yes, for several reasons I m confident that more economic reform is coming. First, because the Communist Party has no choice. With previous reforms the Party has already bet its future on China s entrepreneurs, so it must continue down the path of creating a more market-based economy in order to generate the growth necessary to remain in power. When I first worked in China 30 years ago, the economy was dominated by stagnant state-owned enterprises (SOEs). Today, however, small, privately owned companies account for 8 of urban employment and more than 7 of investment and industrial sales. In a relatively brief period of time, China has become very entrepreneurial, and the Party must continue to improve the economic infrastructure everything from the tax code to access to bank loans so that it better supports the private companies that create all of China s new jobs. Second, I expect continued reforms because the Party has a track record of delivering significant economic restructuring. For example, although China still has a fake banking system, where all of the banks are closely controlled by the Party, the Party 5
has succeeded in giving its fake bankers the incentives (bonuses and promotions) and tools (greater flexibility to price risk) to steer an increasingly larger share of lending to private sector. The following chart illustrates that the companies that drive China s growth are now getting most of the loans. Only 29% of loans outstanding were to SOEs as of 2013, down from 41% in 2006, while the share of loans outstanding to private firms rose to 43% last year from 36%. Add in the 18% share for consumers, and last year the private sector and households accounted for 61% of loans outstanding, up from 47%. Figure 8. LOANS OUTSTANDING TO DIFFERENT SECTORS Share 5 4 3 Private sector State-owned enterprises 2 Consumer and mortgage loans 1 Government and public institutions 2006 2007 2008 2009 2010 2011 2012 2013 Sources: People s Bank of China, CEIC, MICM estimates This is also consistent with central bank data showing that today more than 7 of new loans are priced above the benchmark lending rate, up from 48% in 2006. This reflects more lending to (riskier) small private firms, as it is unlikely that a significant share of loans priced above the benchmark rate are made to SOEs or government agencies. Figure 9. SHARE OF LOANS EXECUTED AT ABOVE, BELOW OR AT BENCHMARK INTEREST RATE 10 7 5 2 Dec-09 Dec-10 Dec-11 At benchmark Below Above This data is consistent with the conclusions of Nick Lardy s recent book, Markets Over Mao: The Rise of Private Business in China. Nick, an economist who has written presciently about China since the 1970s, concludes that the access of private firms to bank credit has improved so much that on average new bank lending to private firms in 2010 12 was two-thirds more than to state firms. 6
Another example of reform is that last year, for the second consecutive year, the tertiary* part of the economy (services, retail and wholesale trade in addition to finance and real estate) accounted for a larger share of GDP than the secondary* part (manufacturing and construction). *Industries defined as: Primary industry refers to agriculture, forestry, animal husbandry and fishery and services in support of these industries Secondary industry refers to mining and quarrying, manufacturing, production and supply of electricity, water and gas, and construction Tertiary industry refers to all other economic activities not included in the primary or secondary industries, including real estate, finance, wholesale and retail, transportation and other service industries Figure 10. GDP BY PRODUCTION APPROACH Share of GDP 6 5 4 3 2 1 1954 1959 1964 1969 1974 1979 1984 * Primary industry Secondary industry Tertiary industry 1989 1994 1999 2004 2009 2014 The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect the writer s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. 2015 Matthews International Capital Management, LLC Last year the Party began reform of the hukou, or household registration system. Launching this complex and expensive reform program is a sign that the new Party leadership is willing to take on big challenges. Hukou reform should also reduce the risk of social instability for some of the 230 million people living in cities who face de jure discrimination on a daily basis, particularly due to their ineligibility for social services and subsidized housing. Over time, hukou reform should also boost consumption and raise manufacturing productivity. (See the August 2014 issue of Sinology for more on reform of the hukou system.) But we need to maintain realistic expectations for the pace and scope of reform. The days of dramatic, big-bang changes are over, in large part because Chinese society would not accept the mass state-sector layoffs that were tolerated 20 years ago. This is one reason why I have low expectations for further SOE reform in the near future. Closure of many money-losing and indebted steel and cement plants isn t likely for a few more years, while the Party wrestles with the problem of how to deal the unemployment consequences of shutting the largest employer in small cities. I recognize that more modest reforms designed to boost the efficiency and productivity of SOEs are likely to only generate modest results. For me, however, this is acceptable, as I prefer the Party continue to focus on improving the operating environment for the private firms that drive China s growth. Andy Rothman Investment Strategist Matthews Asia SI013B 7