21 July 2015

The Chinese economic powerhouse is here to stay

By Gerard Lyons

China’s economy is slowing. Much of this slowdown has been planned but in recent weeks a collapsing Shanghai stock market threatened to undermine confidence at just the wrong time and triggered fears among the authorities that they might lose control. It explains why the Chinese authorities intervened aggressively recently to halt the stock market’s decline.

In mid June, the Shanghai market started to collapse and at one stage had fallen by one-third. Since then it has rebounded some of the way, as the authorities pulled as many levers as possible to help: suspending trade in some shares, telling pension funds not to sell, encouraging banks to lend to securities firms, in turn to help many people who had borrowed on margin to speculate in the market. Despite recent gyrations, the stock market’s performance needs to be kept in context, as it is still up on the year.

Part of the problem is that China’s financial system is repressed, both because it is still developing and because of heavy state intervention. The choice for people is limited: invest in stocks despite poor governance; put money in bank deposits but returns are low as deposit rates are being freed slowly from state control; buy property but that has been subject to controls to prevent a bubble; or invest overseas if there is an opportunity to do so. The wealthy seem to constantly do the latter, as the buying of London property testifies to.

China is trying to move from strong, unsustainable double-digit growth of a few years ago, to a slower, more sustainable pace around 7%. Last week official data suggested the economy did indeed grow 7% in the second quarter. Not for the first time, this raised questions about the accuracy of the data as other indicators suggest the economy may be weaker.

Part of the challenge is that it is hard to manage a slowdown, particularly as China does not have the institutional framework in place that we take for granted in the West. Underpinning official thinking is the 12th Five Year Plan, implemented in 2012, aimed at boosting consumption, social welfare and the green economy as well as identifying seven strategic industries to help China move up the value curve. Already, detailed thinking is well underway for the 13th Plan, with a focus on a development agenda and with a likely target growth rate around 6.75%.

Moving from investment-led to consumer driven growth is not easy, particularly when investment used to be well over 40% of GDP. A small decline in investment can hit overall economic growth very hard, as China is now seeing.

The investment led slowdown is apparent in other data, contributing to a correction in global commodity prices, and to strong deflationary pressures within China. Producer prices are now declining by 4.8% and have fallen for 39 consecutive months.  In turn headline inflation is only 1.4%. This suggests the central bank, the PBOC, which has cut rates four times over the last year, has plenty of scope to ease further. Reserve requirements have also been cut. Official rates are 4.85% and there is nothing to stop rates heading towards zero in coming years, mirroring what has been seen in the West. Lower rates will also ease the debt burden, as lax credit control in the aftermath of the financial crisis has seen a steady rise in personal and corporate debt. At one stage local government debt had risen too. Overall debt is around 250% of GDP, double the rate at the height of the crisis, although the government component is low.

The scale of China’s shadow banking sector is a perceived problem by many in the financial markets, but data from the Financial Stability Board suggests it is only $3 trillion of a global $75 trillion, which if correct would be more than manageable. Indeed, despite current challenges, China still has room for policy manoeuvre.

Part of the challenge is the desire for further economic progress, which brings with it constant change. China clearly aims to be at least a regional power, and while that focuses attention on the geopolitics of the China Seas, it also has seen China take a proactive role in other areas, one of which is the creation of the Asian Infrastructure Investment Bank. Its currency is also gaining international recognition, used more to settle trade and there are hopes it may soon be accepted in the IMF’s composition of the Special Drawing Right. Meanwhile, Chinese firms continue to invest overseas, buying brands, technology and seizing opportunities wherever they can. Last year an official backed document was released to inform firms about buying assets in the UK, the first such document of its type.

The Shanghai Free Trade Zone, still in its early stages, is also seen as the template for the next stage of economic reform at home, as China aims to become a more service sector economy. Services have indeed already overtaken manufacturing in terms of contribution to growth.

President Xi continues to push his reform agenda, with anti corruption playing an important part. Some of it, like reforming agricultural, is in line with his predecessors, as too is the scale of urbanisation and industrialisation in much of Western and Central China. The most interesting focus is the ‘One Belt, One Road’ policy. Effectively it is a modern day Silk Road, linking China by land and sea with around two-thirds of the world’s population. Greece, despite its economic problems, is one beneficiary. Last December the Chinese announced a major thirty five year investment in the Athens port of Piraeus, to develop it significantly as China’s Mediterranean Port on the new Silk Road. Such long term thinking suggests we should keep China’s current economic slowdown in context. There will be set backs but the trend is clearly up.

Dr Gerard Lyons is author of The Consolations of Economics (Faber&Faber) and is Chief Economic Advisor to The Mayor of London.