China: Facing collapse or slow decline?
A postcard from...China: If, as some bears claim, China is in the middle of economic collapse, the country is hiding it well.
Unstructured Learning Time
We come away from a week in China feeling, if not optimistic, then reassured that things are not so much worse than the data is telling us. Corporates, analysts and officials were candid about many of the challenges faced, but there is little evidence of a crisis at present. But while current activity seems to be holding up, we remain concerned about the years ahead given some of what we heard.
Prospects of reform
Reform hopes which bloomed in the Third Plenum have wilted in the frosty indifference of President Xi to investors’ wishes. Sentiment has soured on the prospect of China becoming more market-oriented as it has become increasingly clear that the main purpose of reforms is to centralise power wherever possible. Market reforms, it is perceived, will be tolerated only where they serve the purposes of the state and the goal of enhancing social stability. In addition to this, reform is meeting strong resistance from senior management at state owned enterprises (SOEs), who have obvious vested interests in not being merged with one another. Optimism is muted at best that the Fifth Plenum will make substantial changes in this regard.
One-child policy scrapped
Perhaps the banner policy so far has been the ending of the one child policy, but as we have already written (see Schroders Quickview: Will the end of China's one child policy spark a demographic boom?) this is likely to have limited impact.
Boosting the fertility rate would definitely help, but it is not certain that ending the one-child policy will be effective. Previous relaxations have seen relatively limited uptake; the last, in 2014, made 11 million couples eligible for a second child, but only 1 million applied to do so. It may be that after so long, the one child norm will take time to reverse. In addition, anecdotally many young Chinese cite the cost of children, particularly education, as a major barrier to considering large families.
Reform of state-owned enterprises (SOEs)
SOE reform, including mergers, would be a key part of reducing spare capacity in China, which is particularly prevalent in a handful of industries. Globally, this is particularly noticeable in steel, where accusations of Chinese dumping are on the rise. Within China, we found it reflected in the estimates large SOEs provided on overcapacity in their workforces, with some employing almost twice as many people as they actually needed. Of course, this is the problem for the government; how to reduce spare capacity without causing massive unemployment, which would call into question the Party’s legitimacy and threaten social stability. The realpolitik of the situation provides further grounds for gloom. SOEs in overcapacity sectors have begun expanding into “emerging industry” areas, in the service sector, but it is questionable how quickly, if at all, existing staff can be retrained for these new industries.
Overcapacity in the property market remains a problem but the divergence between Tier 1 cities and the rest is widening, with some divergence even within individual Tier 1 cities. Though it is unsurprising that central Shanghai property should be more resilient than property in a small city in the Western provinces, it creates problems for smaller developers concentrated in the less salubrious regions. All the same, sector consolidation is proceeding at what could best be described as a stately pace. More failures are likely among the market minnows.
One area of reform that has proceeded reasonably smoothly and rapidly is financial liberalisation, with deposit rates now fully liberalised and the local government debt swap doing much to reduce debt costs, even if it is squeezing bank margins. At long last, too, local government bonds are seeing buyers other than banks strong armed into it by the state. However, this has much to do with the bond market bubble which has seen a remarkable compression of spreads across the credit space. Local government bonds themselves are still trading at very tight spreads to the sovereign – in no small part due to the assumption of central government support.
Of course, not all financial reforms have been without problems. The devaluation of the renminbi (RMB) in August caught everyone by surprise, including well connected SOEs, who had previously not given much, if any, thought to the exchange rate. In the wake of the policy shock, somewhat panicky firms showed a marked increase in their desire to hedge currency exposure and also began paying off dollar debt. At the same time, wealthy clients of asset managers have also reportedly become keen to diversify their portfolios away from RMB-denominated assets. While the hedging and debt repayment activity has seen a peak and will now wind down, reducing pressure on the currency, the desire for diversification will mean that any relaxation of currency controls will likely see further depreciation.
Prospect of hard landing?
Our expectation remains that Chinese growth will avoid a calamitous collapse and instead slowly drift lower. But without successful reform the risk of a hard landing rises. Vested interests will have to be challenged if the misallocation of resources is to be addressed, itself key to transitioning to service led growth. If inefficient SOEs are allowed to continue to dominate, productivity will be hurt and growth will slow much sooner – the next five years will be vital.