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Why China's Slowdown May Be a Good Thing

Key Points
  • A slower-growing but more diversified Chinese economy could result in more stable growth, which could benefit global investors over the longer term.

  • The renminbi's move toward becoming a reserve currency, as well as the economy's shift toward consumer spending and services, are indicators of China's economic maturation.

  • Despite short-term risks, Chinese stocks may perform well over the long term.

Could slowing growth in China be a good thing? Over the long term, we think the slowdown points to more stable growth, which can benefit long-term investors.

Recent changes in China's growth rate, economic composition, and currency have raised fears of problems in the emerging economy. However, we believe these changes are an indication of China's gradual transformation into a developed economy. This transformation could be bumpy and comes with risks in the short term, but it bodes well for China and global investors in the longer term.

The renminbi is moving toward becoming a reserve currency

China is keen on making the renminbi (RMB) a global currency, so further reforms are likely. A freely tradable currency could make life easier for people who want to invest in China, as well as allow Chinese households to invest outside the country. The RMB, also called the yuan, is an increasingly popular means of settling global trade transactions, rising from the twelfth-most-used three years ago to the fourth-most-used in August.

China's renminbi is now the fourth-most-used currency in global trade

Chinas renminbi is now the fourth most-used currency in global trade

Source: SWIFT Watch, month of August 2015. 

The increased role of the RMB as a global currency provides central banks with an additional investment option for their reserves. The International Monetary Fund's (IMF) upcoming vote to recognize the RMB as a reserve currency would formalize this status by adding the RMB to the basket of currencies IMF members can count toward their official reserves, known as Special Drawing Rights (SDR). China may need to allow the value of the RMB to float more freely before it can be added to the SDR. It will first be eligible for inclusion in September 2016.

Reserve currency status is typically a sign of a developed economy, so if the RMB achieves that status it would mark a significant step in China's evolution from emerging-market to developed economy.

Still, even if China achieves reserve status, adoption of the RMB by other countries is likely to proceed gradually. China must overcome numerous hurdles before the RMB can become a safe-haven currency. Those include:

  • Insufficient RMB supply for foreigners due to China's status as net creditor to the rest of the world;
  • China’s small and relatively illiquid bond market compared to the U.S. Treasury market;
  • Investor requirements for further political and legal reforms.

Overcoming these obstacles could take decades, so the RMB is unlikely to replace the U.S. dollar as the preeminent global safe-haven currency any time soon.

Bigger economies tend to grow more slowly

While China's economic slowdown has spooked investors, we believe it is a natural outcome of a maturing economy. Due to the law of large numbers, the rate of growth slows when the thing that's growing gets bigger. In other words, it's easier to double your money when you start with $100 than when you start with $1 million.

China's gross domestic product (GDP) has more than quadrupled over the last decade. Because of that, a slower growth rate can still create a lot of economic activity. For example, the country's 7.3% economic growth rate in 2014 created $865 billion in additional economic activity during the year, while its 10.1% growth rate in 2004 added only $292 billion to the economy.1

China's average income per person remains low

Chinas average income per person remains low

Source: International Monetary Fund, World Economic Outlook. Data as of 12/2014. 

Even though we expect China's economy to slow gradually, it still has the potential to outgrow most developed markets for quite some time. Advances in innovation and use of automation could improve the quality and amount of China's economic output. These could boost China's real GDP per person from $8,280 in 2014 toward the levels in Japan ($36,222) and the United States ($54,370) over time.

Income growth aids economic transformation

As China's economy slows, it is starting to resemble more mature economies, where consumer spending and services dominate. Services surpassed manufacturing as a percentage of China's economy in 2012.

The services sector is now larger and growing faster than manufacturing

The services sector is now larger and growing faster than manufacturing

Source: FactSet, China National Bureau of Statistics. Data as of 10/23/2015. 

When incomes grow above a certain level, basic needs are covered and individuals have discretionary income. The World Bank calculates that China has reached "upper-level middle-income" status, using a comparative measure reflecting exchange rate fluctuations and national incomes. At this level, the share of spending on services tends to grow relative to goods. China’s boom in spending on leisure and entertainment illustrates the emergence of its services sector.

Chinese are spending on experiences

Chinese are spending on experiences

Source: Motion Picture Association of America, Chinese State Administration of Press, Publication, Radio, Film and Television, World Travel & Tourism Council (WTTC) and Oxford Economics, *Based on WTTC's assessment that $35,000 in household income is the threshold for better affordability of international travel, Oxford Economics 2023 forecast made in 2014. Data as of 10/21/2015. 

With incomes on the rise, consumer spending's contribution to the economy, currently at 37%, should continue to expand, as it has in developed economies. Consumer spending accounts for 68% of the U.S. economy and 61% of the Japanese economy.

Challenge and opportunity for global investors

China's gradual maturation from an emerging-market to a developed economy may come with slower growth, but we think it's likely to be more stable growth, driven more by consumer spending and services. The Chinese economy, already the world's second largest, could reduce volatility for global investors as it becomes more stable.

Growth in Chinese incomes and spending on new markets brings both opportunity and challenge for companies seeking to profit from China's transformation. China is already a growing market for goods of foreign companies, but services tend to be geared toward local cultural preferences. As a result, foreign multinationals will need to cater to the unique needs of the Chinese to reap rewards. Chinese companies are increasingly competing on par with foreign multinationals, so it's likely some will be among the future global leaders. All of these changes could mean that Chinese stocks could be volatile as the economy transitions and matures, but may perform well for investors with long time horizons.

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