Cover: A New Economic Model For China

THE HUNT FOR INTERNAL GROWTH

By Laurence Neville

China is in the midst of an economic makeover to increase domestic consumption and reduce reliance on external markets for growth. But how far are policymakers willing to go, and when?

For Sinophiles, 2012 has been a rude awakening. China’s leadership transition is complete and attention has now shifted to the economy. China’s economy grew by 7.4%, year-on-year in the third quarter—the slowest quarterly rate for three years. Some warn that 8%-plus growth is at an end—with profound consequences for China, multinationals that do business there, and the global economy.

There is a broad consensus on the immediate causes of the slowdown. “It has occurred because of the downturn in global manufacturing,” notes Jan Dehn, chief strategist at emerging markets investment manager Ashmore. “The manufacturing cycle is now globalized and synchronized, and the slowdown in Europe [which accounts for 20% of global GDP] has created an inevitable trough.”

Meanwhile, China is still recovering from the hangover caused by its fiscal stimulus—the world’s largest—in 2008 – 2009, which equated to 25% of GDP. “Some of that spending was inefficient and failed to generate adequate returns,” says Dehn. “However, these problems are not systemic and won’t last forever.” Other relatively short-term impacts on growth include China’s leadership transition itself, which put investment decisions on hold.

However, there are also signs that the slowdown reflects a deeper change in China’s economy. The headwinds from the economically weak developed world—where China sends the exports that have driven its growth since 1979—are powerful and unlikely to dissipate soon. Meanwhile, demographic and economic developments—rising domestic incomes and slowing export growth, respectively—are altering China’s society. Combined, these factors may mean the country has reached the limits of its current economic model.

ECONOMIC RESTRUCTURING

That China is looking to redirect its economy away from exports to the West is no secret. “Government targets increasingly focus on the quality of growth, which in practice means a change to a consumption-focused model,” says William Fong, lead manager, China Growth and China Select funds at investment manager Barings. The focus on consumption was mentioned before 2008 but has been increasingly emphasized since.

Fenby, Trusted Sources: The economic slowdown is in line with what the leadership wants: 7% is seen as sustainable

Equally, a move away from breakneck growth has been well remarked. “The slowdown was in line with what the leadership wants: 7% is cited as sustainable and Hu Jintao’s comment about doubling GDP per capita by 2020 works out at a compound 7% per year,” says Jonathan Fenby, managing director of the China team at London research firm Trusted Sources. “The question is whether the government can manage this decline in growth.”

The willingness of government to let growth drop below the previously sacrosanct 8% level is, according to Dehn, a judicious recognition of global realities. He contends that China is positioning itself for the unwinding of global imbalances—of unsustainable debt in developed countries and overly large foreign exchange reserves in emerging markets. “That unwind will result in euro and dollar depreciation against emerging markets currencies—possibly in the second half of this decade,” he says. “China’s farsighted plan is to have switched the economy to a domestic consumption-driven model, so that it won’t be affected by the appreciation of its currency.”

NEED FOR SOCIAL INVESTMENT

If it is accepted that investment growth must slow sharply as the economy shifts from an export focus and that only a surge in consumption growth can replace investment, how will China cause consumption to surge, asks Michael Pettis, senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. “Since at least 2005, Beijing has tried to force up the growth rate of consumption, and it has not been able to do so,” he notes.

Chan, AllianceBernstein: In developing economies, the availability of surplus rural labor limits wage growth. In China this has been the case for 30 years

“It is hard to boost consumer confidence, certainly harder than it is to simply invest in infrastructure,” concedes William Fong, at investment manager Barings. There have been government initiatives aimed at increasing consumption directly, such as subsidized energy-saving household appliances or the issuance of coupons providing discounts to rural people to buy washing machines. “However, such initiatives have little impact compared to the broader government goal of making people feel comfortable about spending their own money,” notes Kristina Sandklef, macro economist for Asia at emerging markets asset manager, East Capital.

To create more fundamental structural change, Sandklef believes the government needs to find ways to encourage people to “dare to spend” rather than save. “Welfare provision in China remains minimal: Farmers’ subsidized healthcare increased from RMB80 ($12.84) [per capita] in 2008 to RMB240 this year,” she says. “That compares to the typical RMB500 cost of childbirth in a rural area in 2008. There is a need for substantial increases in education, welfare and health provision to make people feel safer.”

Unfortunately, the kind of social investments required to increase the overall sense of security in the general populace takes time to produce results. “There are, of course, many areas in which the value of investment is likely to be positive in the very long term, such as primary education and social housing,” says Pettis. “But it is important to remember that these don’t pay off their investments for at least a generation or so, in which case they do not help address the current imbalances.”

FUNDAMENTAL POLICY CHANGE

Even if China is successful in switching to a consumption-driven economy in the medium term, in the long term it faces huge structural impediments to growth, according to Fenby at Trusted Sources. Credit continues to be allocated by quotas rather than interest rates, the currency is controlled, the rule of law is not applied, energy and water are massively underpriced and state-owned enterprises enjoy privileged access to markets and investment capital.

Green, Standard Chartered: The country is only 50% urbanized, so it still has room to invest. The need for a consumer-led model is more than a decade away

In addition, “all land in China is owned by the state and is allocated to individuals in small parcels that result in inefficient agricultural production,” Fenby notes. “Similarly, household registration means that rights such as education and property ownership only exist in an individual’s home town or village.” As a result, labor mobility is restricted.

Serious policy changes must occur to address these issues. “Those problems could be ignored for the early part of China’s development, but they have to be tackled if it is to avoid being caught in a middle-income trap,” says Fenby. A middle-income trap occurs when wages rise to the point that a market loses its former competitive advantage. As a result wages stop rising and remain in the “middle income” range of $1,006–$12,275 gross national income per capita on a nominal basis, as listed by the World Bank World Development Indicators report in July 2011.

China’s income per capita is currently $5,500 on a nominal basis, or around $8,000 in purchasing-power-parity terms: 7.5% growth a year until to 2020 will take that to $9,800 nominally, or around $15,000 on a PPP basis, notes Anthony Chan, Asian sovereign strategist at investment manager AllianceBernstein. “Based on the growth trajectories of other countries, a marked slowdown is then likely,” he says. If China is to grow after that time, major change may be necessary.

But addressing China’s long-term structural growth impediments will be politically difficult. “State-owned companies have huge political clout but also restrain unemployment: That [advantage] would be lost by the introduction of greater competition,” says Fenby. The implications of structural reform could also be more complex. For example, land privatization and changes to the registration system would require local government funding reform, because the government makes 40% of its direct income from land sales. Fenby notes that if local fund-raising capability is established, central control is effectively weakened—an outcome the government is unlikely to welcome.

IS AGGRESSIVE REBALANCING NECESSARY?

While few doubt the government’s commitment to rebalancing the economy, some observers believe the pace of change needed has been overstated and that investment in fixed assets—essentially in export capacity—still has room to grow.

China’s investment-to-GDP ratio is almost 50%, but its accumulation of capital stock is just three times its GDP, according to Chan. “That reflects the fact that its economy was essentially agrarian before 1979: There has been a lot of catching up to do. Moreover, China’s capital stock per worker is only about 8% of the United States’. If its pool of labor were equipped to US standards and reached similar productivity, there would be a lot of room to invest further.”

Stephen Green, head of research, Greater China, at Standard Chartered, agrees: “Much of ‘end of the model’ talk is exaggerated. On the important parameters of capital stock per person, urbanization, or even road and rail capacity per person, China has more to do: The country is only 50% urbanized. I don’t see why it can’t continue to invest.” Green says China’s need for a consumer-led model is more than a decade away.

IMPLICATIONS FOR MULTINATIONALS

A slowdown in China’s growth sounds negative for multinationals that have pinned their hopes on the country’s domestic market. However, the shift to a consumption-led economy—even if slower than some hope—could offer a silver lining. Certainly, there is evidence of strong growth: Retail sales grew by 14.5% year-on-year in October versus the projected third quarter GDP growth of 7.4%.

Sandklef, East Capital: Increasing education, welfare and health provision will make people feel safer, and grow consumption on a structural level

Green at Standard Chartered says that multinationals will “do fine” in China: “Where else will you find such a large and fast-growing consumer market? China already likely has the largest car market—[which] has grown at 10% this year.”

However, Fong at Barings warns against complacency. “For international companies targeting the domestic Chinese market, many of the easy opportunities have already gone: PC and smartphone markets, for example, are already fairly mature,” he says. “Therefore, companies need to focus on product and distribution model quality if they are to succeed.”

For multinationals that source goods from China, the country’s demographic changes—particularly its rising middle class—could reduce the advantage against other labor markets, according to Chan at AllianceBernstein. “In developing economies, the availability of surplus rural labor limits wage growth: In China this has been the case for 30 years,” he says. “However, it has become clear in recent years that China has reached the so-called Lewis turning point [the point at which the subsistence labor pool is absorbed into the above-subsistence labor pool]: Rapid wage growth has occurred.”

This change in China’s labor market will likely affect the business model of multinationals operating in China, Green says. “Wages will rise, gradually pushing labor-intensive, low-value-added export processing offshore,” he notes. “But stuff for the domestic market will stay. And as wages go up, household incomes go up, and that creates a domestic consumer market. It’s pretty simple.”