by Michael Collins, Investment Commentator at Fidelity
Australia’s record of 23 years of continuous economic growth is impressive. Yet it is well short of China’s 37-year expansion since Deng Xiaoping introduced free-market reforms in 1978. Even more worthy of note in China’s case is that the past seven years cover a period when Chinese authorities acknowledge their economy has been in crisis.
China’s export-driven, investment-led economic prototype has been busted since the global financial crisis battered demand for its exports. China’s low-wage-based, manufacturing-centred export model became inefficient to the point where reform was unavoidable. But duck reform did Beijing when the global financial crisis struck. Instead, the government doubled-down on the old model by injecting fiscal stimulus and allowing a borrowing binge that, while propping up growth and employment, led to surplus capacity and bloated financial imbalances and debt levels.
A debt-fuelled construction boom and turbo-charged property market enabled by a shadow banking sector led to strains in the financial system that forced the government to restrict monetary policy in 2013, a tightening that has triggered a disinflationary slowdown in China that saw economic growth slow to 7.3% in 2014, the worst outcome since the 1980s. But at least authorities were wise enough in 2013 to embark on the reforms needed to morph China’s economic model into a more sustainable one based on consumption and services.
The slowing in China’s debt-heavy economy and the reform program undertaken by Beijing to rejig China’s economic model pose three questions. The first is: How much is China’s economy slowing? The second: Is a consumption-driven economic model gaining shape? Under this model, consumption’s share in output would rise from about 40% of GDP towards the 60%-plus level it sits in advanced economies. The last and most important question is: Can China shift smoothly to a new model – that is to say, without a recession?
The export-led economic model is shattered throughout the emerging world so China is not unique. The advanced world’s model based on debt-charged government and consumer spending is wobbling enough to be called in crisis too. China has much ammunition to support what is a centrally controlled economy. Benchmark monetary tools are well above zero – the one-year lending rate is at 4.85% – while public debt at only 50% of GDP gives Beijing much scope with fiscal policy. The country’s trade surplus is expanding again and property markets have stabilised in many cities. A crisis, properly managed, can deliver a political environment ripe for implementing ambitious reforms. China has vast resources and capacity to do just that.
Slowdown or stall?
Determining the extent to which China’s economy is slowing is a task more fraught than usual because many don’t trust the official statistics. China reports its GDP result about two weeks after quarter end compared with the more than two months it takes Australia. Not only are China’s GDP results quickly available they are rarely revised, whereas the revisions to the ABS results are common over the following four years and don’t stop there.
Many analysts think that China overstates its GDP outcome. They assert that provincial officials exaggerate output levels for career reasons; to win acclaim for achieving faster growth or simply to survive in their positions by meeting centrally set targets. Some allege China’s statistical gathering isn’t savvy enough; the arithmetic often doesn’t add up but the discrepancies just as likely overestimate as underestimate growth. Others say the figures are deliberately doctored upwards, for China’s National Bureau of Statistics is just another public organ whose overriding aim is to prop up the Communist Party of China and embellish China’s image to the world. The person who most undermined the credibility of China’s economic statistics is Premier Li Keqiang who in 2007 dismissed them as “man-made” and said he only looked at electricity consumption, rail cargo volume and bank lending to judge the speed of China’s economic growth.
The almost-satirical Li Index that these comments inspired paints a grimmer picture of China’s economic vitality. For the first quarter of 2015, when China officially expanded at a six-year-low 7% annual pace, analysis by US intelligence group Stratfor found that rail freight transport fell 9% from a year earlier while power demand fell 2.2% in March and only rose 1.3% in April. The UK-based Capital Economics estimated China’s first-quarter annual pace of growth at 4.9%, well below the 7% official result. The China Centre of the US-based Conference Board put China’s first-quarter growth at 4% while the UK-based Lombard Street Research plumped for 3.8%. Many investors openly scorned China’s second-quarter result when it officially came in smack on the government’s goal of 7%.
If China’s economy is faring worse than the official score then the economy is skirting peril. A debt-heavy economy that is unbalanced in investment’s favour is more likely to enter a downward spiral if it slows beyond a certain point. This is because such an economy is prone to undue excess capacity, which would trigger savage cutbacks in investment. At the same time, any economic slowdown makes debt repayments harder, which would prompt further investment reductions.
China’s flailing export-driven economic model was built on four mispricings; of the exchange rate, interest rates, labour and land (the latter because corrupt officials grabbed it cheaply and illegally from peasants). The big hope for China is that reforms are moving the economy towards a consumption-driven model by giving the free market a bigger role in setting the prices of these items.
Authorities have let the yuan (which trades in a daily 2% band against a basket) rise 30% over the past decade, an increase that boosts the purchasing power of Chinese consumers and sets it close to being “fairly valued” according to the IMF. On salaries, government pressure has helped China’s real wages soar 12% in recent years, nearly double the average of G-20 emerging countries, a huge boost for consumption, even if it erodes competitiveness. With interest rates, the People’s Bank of China is easing controls on money-market rates and has flagged removing the ceiling on deposit rates. As part of allowing market forces greater sway over China’s economy, authorities are developing a Chinese bond market, which forces through the interest-rate liberalisation, and have eased restrictions on capital flows across its border. These moves end the cross-subsidy that Chinese consumers have given state companies and better allocate capital, especially to worthy private companies. With property, authorities are establishing a national registration system to pin down ownership and land-use rights, as part of a campaign to fight corruption.
Other worthwhile reforms are taking place that are harder to lump in the mispricing categories. Some of the most crucial are aimed at improving local government finances by boosting their tax and borrowing reach, thus lowering their reliance on land sales and property development to raise revenue. Others, such as the decision in June to unilaterally lop tariffs by 50% on consumer goods including clothes and makeup, are blatant attempts to boost consumption. Better social security and free schooling are other steps to encourage people to save less. A bank-deposit insurance scheme was introduced in May to encourage faith in the banking system and introduce consequences for bad lending (by creating the possibility of banks going bust through poor lending decisions). On the administrative side, business regulations have been reduced to help private companies flourish. The government is encouraging foreign investment in securities by increasing the quotas.
While these reforms in isolation might appear ho hum, together they are formidable and show urgency. They are self-reinforcing too, especially the interaction between wider international use of the yuan and market-controlled interest rates. They are achieving the desired shift to a consumption-driven model. Retail sales are growing at a 10% pace while consumption grew 12% last year and drove 60% of China’s growth in the first half of 2015.
But for all the good moves by Chinese authorities, many lack bite, crucial ones are being overlooked, one foolish one in particular has backfired and U-turns have occurred. Among the measures yet to goad vast change, market-set interest rates can often turn into higher real rates during a disinflationary period. Cheaper Estée Lauder lipstick and Gucci shoes won’t change the consumption-investment mix too much. Dud state companies still come with implicit government guarantees that lower their borrowing costs. Officials whisper to banks to keep deposit rates low. Above all, state companies and local governments have enough power to resist central directives that threaten their vested interests.
Among the reforms yet to be made, Beijing is still to announce an end to the household registration system that denies about 300 million urban migrants access to social security, a limbo that discourages consumption. Another area left untouched is political reform, which means that mooted legal reforms are to ensure greater central control (rule by law) rather than the rule of law that enshrines property rights. The biggest step to backfire so far has been the government’s always-doomed attempt to boost the Shanghai and Shenzhen stock markets to help state companies gain cheaper access to capital and to encourage consumption by making retail investors feel wealthier.
U-turns include that Beijing in May overturned a decision to stop indebted local governments from raising money from government-sponsored financing companies, in what is effectively backdoor government financing. Authorities have used currency reserves to take stakes in state banks to ensure lending flows. While the government’s all-out attempts to stabilise the stock market recently are the most publicised policy retreat from relying on market forces, perhaps the biggest U-turn of all is that Beijing has opted to pursue short-term pro-growth strategies to ensure the economy doesn’t slow too much. Four cuts in interest rates since November, reduced bank reserve requirements and the announcements of hundreds of infrastructure projects run the risk of inflating the economy’s imbalances and setting up a bigger crash.
And that brings us to the overarching question hovering over China’s economy: Can the country update its economic model without a major dislocation? The Communist Party’s legitimacy is derived these days from delivering economic growth so any rapid easing in monetary and fiscal policies would indicate that authorities see that they are losing the fight to rebalance the economy with minimum pain for the population. One asset Communist leaders have is that the country’s one-party political system makes it less prone to a Lehman-style shock. Banks and the financial system are under state control so it can ensure lending, most funding is domestically sourced, the capital account is largely closed and a one-party dictatorship can issue whatever directives it wants in emergencies to cover financing gaps while calling on US$3.7 trillion of foreign reserves if needed. This power was on display during the stock market’s 30% dive from mid-June, even if the steps authorities took made them look hamfisted and panic-prone. A nasty recession that leads to political instability, while it can’t be ruled out, is unlikely.
The powers that Beijing can call on in an emergency will most likely buy the government the time it needs to overhaul its economic model and strengthen its financial system. At the same time, however, these powers, which allow authorities to make endless fudges needed to navigate the inherent contradictions of a centrally planned economy under dictatorship hosting market-set financial markets and a private sector, will extend the time it will take to achieve these feats. So expect China’s evolution to a services-based, consumption-driven model to occur in a languid way that will still extend the country’s impressive record of uninterrupted growth. But most likely China’s expansion will occur at a most unimpressive pace and China will be of much less help than it has been in extending Australia’s growth record.
 Data compiled by Bloomberg shows that outstanding loans for companies and households stood at a record 207% of GDP at the end of June, up from 125% in 2008.Bloomberg News. “China debt accelerates to record as economic expansion decelerates.” 15 July 2015.
 The Australian Bureau of Statistics applies the following revisions policy to GDP and components in normal circumstances. The September quarter releases normally allow up to 16 quarters of revisions for original current price and chain volume estimates. For chain volume and price measures, the annual re-referencing of the series each September quarter will cause revisions to the levels for the entire series. Revisions resulting from seasonal re-analysis are allowed to flow through to the whole seasonally adjusted time series at the time the seasonal reanalysis is undertaken.
From time-to-time, the ABS will also implement an ‘historical revision’ outside of the normal cycle, whereby the whole historical time series is opened up for revision.
 For more views on the reliability of China’s GDP numbers, read: “China’s misleading economic indicators” by Yukon Huang, a former World Bank country director for China, in an op-ed in the Financial Times on 29 August 2014. http://blogs.ft.com/the-a-list/2014/08/29/chinas-misleading-economic-indicators/
 Reuters. “China’s GDP is ‘man-made,’ unreliable: top leader.” 6 December 2015. http://www.reuters.com/article/2010/12/06/us-china-economy-wikileaks-idUSTRE6B527D20101206
 Stratfor. “How China’s housing sector growth is misleading.” 10 June 2015.
 The Wall Street Journal. “China’s true growth is a mystery; economists weigh the clues”. 26 April 2015. http://www.wsj.com/articles/chinas-true-growth-is-a-mysteryeconomists-weigh-the-clues-1430071125
 The yuan’s controlled rally is enough for the IMF to be set to declare it “fairly valued” for the first time in more than a decade, according to The Wall Street Journall. “IMF to brighten view of China’s yuan.” 3 May 2015. http://www.wsj.com/articles/imf-to-brighten-view-of-chinas-yuan-1430697814
 International Labour Organisation. “Global wage report 2014/15.“ http://www.ilo.org/wcmsp5/groups/public/—dgreports/—dcomm/—publ/documents/publication/wcms_324839.pdf
 Stratfor. “Chinese real estate slowdown opens avenues to reform.” 27 December 2014. https://www.stratfor.com/node/213258?utm_source=paidlist-a&utm_medium=email&utm_campaign=*|DATE:|*&utm_content=How+China%27s+Housing+Sector+Growth+Is+Misleading
 Geoff Raby, managing director of Geoff Raby & Associates, opinion articles in The Australian Financial Review. “Now it’s the turn of China’s consumers to shake the world.” 20 May 2015 http://www.afr.com/opinion/now-its-the-turn-of-chinas-consumers-to-shake-the-world-20150520-gh5tot and “For China, the Party is a long way from over.” http://www.afr.com/p/opinion/for_china_the_party_is_long_way_Ss05uHEHV32EaHjiEBUxTN
 The Wall Street Journal. ‘China backtracks on local government debt.” 15 May 2015. http://www.wsj.com/articles/china-urges-banks-to-continue-lending-to-local-financing-vehicles-1431682151