China remains the single largest contributor to world economic activity—therefore China’s outlook remains an important factor for investors globally.
We believe China’s economic growth is likely to slow again in 2017, but not crash.
We will be watching five main risk areas: the banking system, the property market, capital outflows, the strength of the Chinese consumer and the leadership transition next fall.
China has been flying under investors’ radars lately, with markets preoccupied with central banks and politics. Good news about an improvement in China’s economy in recent months has gone unnoticed—or perhaps dismissed by bearish investors who believe an economic crash is imminent.
China has made changes to its economy to increase the role of market forces, but progress on reforms has stalled over the past year, as stimulating growth has taken precedence. The government will be performing a balancing act in 2017 between control and growth—between supporting manufacturing and allowing the consumer economy to be the driving factor for growth. As 2017 nears, there are five main risk areas we will be watching to gauge China’s outlook.
Issue #1: Is there a threat of a banking crisis?
Our take: A crisis is unlikely due to the unique characteristics of China’s financial system.
China's debt has grown faster than its economy over the past decade. Borrowing rose to 247% of gross domestic product in 2014 from 164% in 2008¹, outpacing the rise in U.S. debt during the buildup to the 2008 financial crisis. This rapid increase may have led to the funding of poorly vetted projects that could go into default and collectively destabilize China's banking system.
Still, we see a crisis as unlikely due to the unique characteristics of China’s financial system:
- China’s government controls both sides of the banking system: lenders and borrowers. The government is the largest owner in the major banks, and banks lend primarily to state-owned enterprises. The government has exercised control over the timing of when bad loans are recognized in the past and has the financial and administrative ability to clean up debt problems in the future.
- Corporate state-owned enterprises (SOEs) account for the largest portion of borrowing, unlike the situation in the U.S. after the 2008 financial crisis, where high levels of household debt contributed to the slowdown. While SOEs continue to rack up debt, private companies—the primary source of new job growth—have been deleveraging.²
- China can fund its debts internally. China is a net creditor (versus debtor) to the rest of the world due to high levels of savings. When viewed in a global context, the multiple of China’s debt to its savings is not that extended. Additionally, debt is mostly issued in local currency, unlike in many other emerging market countries, which are reliant on foreign money to fund growth.
China’s debt is relatively low in context to its savings
Source: Charles Schwab & Co., Bank for International Settlements, World Bank. Chart compiled 10/11/2016. Debt figures are for March 2016, while gross savings use 2015 figures where available (2014 figures are used for China and India).
Despite these unique characteristics, it is concerning that China’s banks continue to lend to underperforming companies. The economic payoff from issuing debt to SOEs is lower than in the past, and China needs to reduce the government’s role in managing the economy. We believe the short-term hit to economic growth from allowing underperforming SOEs to fail in a controlled manner is likely to be preferable to the potentially larger economic drop in the longer term if overall debt continues to outpace economic growth.
Issue #2: Does China face a property market crash?
Our take: The property market could slow in 2017, but there are factors that can mitigate the slowdown.
China’s property market gained notoriety due to overbuilding that made vacant apartments famous in what have become known as "ghost cities." The government has the ability to make changes to household registration (hukou) to extend access to public services to migrants and create mobility in the work force. As a result, while some vacant cities are still dormant years later, others are now bustling after adjacent infrastructure and jobs have been created.
Housing demand tends to swing with the ebb and flow of government purchase restrictions. The government recently reinstituted purchase restrictions in many cities to slow rapid price gains, which is likely to cool the market again. A high level of cash used in purchases and therefore larger equity in homes could result in a reduced need to sell if prices fall, and could cushion a downturn. If prices fall too far, the government is likely to use its lever to lift purchase restrictions again in the future.
Issue #3: Are capital outflows a sign of money fleeing a sinking ship?
Our take: Not all capital outflows are created equal—China is maturing and expanding overseas, which should support the next stage of growth.
Capital outflows, or the movement of assets out of China, were estimated to have totaled between about $674 billion3 and $895 billion4 in 2015. Investors worried the outflows were a signal that domestic companies and households were losing confidence in the economy. However, much of the capital outflow was driven by a change in currency policy that allowed more volatility in the yuan, prompting Chinese companies to repay debt denominated in foreign currencies, lowering the risk to the financial system.
Capital outflows slowed in 2016 due to a reduced need for companies to repay foreign currency debt, controls to restrict the movement of capital out of the country, increased confidence in the government’s ability to steer the economy and reduced fears of a large currency devaluation.
Outflows are increasingly a result of China becoming a source, rather than a destination, of investment. As Chinese companies mature, they are entering new markets. The government’s "Belt and Road Initiative" to rebuild the Silk Route is directing infrastructure construction outside of China. These outflows can provide the next stage of growth for China and should not be viewed in a negative light. While a sharp fall in the yuan could drive a worrying increase in capital outflows in the future, we believe China aims to allow only a gradual decline in the currency.
Issue #4: Has China’s economy rebalanced enough for growth to be self-sustaining?
Our take: Consumer spending can cushion the economic slowdown, but China still has a significant reliance on manufacturing.
China’s economy is continuing its slow transition away from state-owned manufacturing and toward consumer-driven consumption. But as China matures, consumer spending growth is moderating—after reaching a certain level of saturation, only so many people are buying cars and smartphones for the first time or joining the internet, particularly among urban consumers.
Chinese spending on travel is healthy
Source: Charles Schwab & Co. Inc., Tsinghua UnionPay, as of 10/10/2016.
The nature of spending is changing, however. Over the past year, leisure travel and spending on entertainment and health care experienced strong growth. And consumers are trading up to more expensive items. Key to spending will be job and income growth. Hiring in the government-oriented manufacturing and mining sectors has tailed off, but private-sector service jobs are growing. Urban incomes grew 7% in the first half of 2016, and with inflation just over 1% in August5, purchasing power continues to grow. The health of consumers has supported the overall economy, with consumption accounting for 73% of economic growth in the first six months of 2016.6 However, manufacturing and mining still employ a sizeable number of people, and consumer spending could slow if these companies were forced to carry out large-scale layoffs.
Issue #5: Leadership transition next fall
Our take: China’s economy is likely to be stable ahead of the fall 2017 Party Congress.
We believe China needs to reduce the role of government in managing the economy to reduce the longer-term risks. As such, we were encouraged when the current government promised a spate of market-based reforms in 2013. China has made progress in reforming its economy, but over the past year, reforms have taken a back seat to boosting short-term economic growth.
China’s President Xi Jinping and Premier Li Keqiang have decade-long terms that end in 2022, but the remaining five members of the top leadership council, the Standing Committee of the Politburo, are expected to change at the fall 2017 Party Congress meeting. Ahead of this, the government may decide to increase control of the economy at the expense of market-based reforms to keep the economy stable. The outlook for future market-based reforms could be influenced by the new leaders on the Standing Committee, which are likely to include the eventual successors to Xi and Li.
China remains the single largest contributor to global economic activity—therefore China’s outlook remains an important factor for investors globally. We believe China is likely to resume its gradual slowdown in 2017. Volatility and uncertainty about China’s outlook could result in China returning to the headlines again. However, we believe a China-driven global catastrophe is unlikely.
1Source: Bloomberg Intelligence, October 2016.
2Source: CEIC, April 2016.
3Source: Institute of International Finance, April 2016.
4Source: Bloomberg Intelligence, October 2016.
5Source: China National Bureau of Statistics, October 2016.
6Source: China National Bureau of Statistics, July 2016.
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