Will China Keel Over in 2019?

Will China Keel Over in 2019?

Thu 21 Mar 2019

The key question in 2019 is not Donald Trump or the trade wars between the US and China. The real Gordian knot is China itself.

The world’s second largest economy is going through a painful transition, weaning off its dependence on manufacturing and exports and focusing on improving the standard of living for its citizens, who have already experienced a significant bump in their per capita disposable income, from 6.3K Yuan in 2000 to 36.4K in 2017 (roughly $5,000). This represents an almost 500% rise, at a time when western incomes have stagnated. However, citizens of the world’s second largest economy are still taking home nearly a sixth of the amount of their US counterparts and significantly less than many other, smaller nations. Naturally, Chinese consumers, imbued with national pride at their country’s big player status, would want more.

Achieving it is a difficult proposition. Apart from the economic transition, which has already come at a significant cost to manufacturing jobs, China has to contend with a litany of other challenges:

Debt: An increasing total debt/GDP burden, eerily similar to that of Japan before the country went into a 30-year stagnation cycle. While government debt adds up only to around 30%-40% of GDP, total debt, including municipal, is well over 260%.
Unfavourable demographics: The one-child policy has already warped the demographic bell curve. Interestingly, even after the policy was lifted, fertility rates have collapsed.
Inefficiencies: An equity market dominated by grossly inefficient State Owned Enterprises. Despite the removal of significant barriers for foreign investors, corporate governance remains poor. Chinese companies fail to attract the “slow” institutional money, necessary for the sector to develop over the longer term. Thus, Emerging Market tumult, similar to what we experienced last year, may still lead to large outflows from China. Additionally, its shadow banking system has been aggressively rolled back and new loan creation from shadow banks has been consistently falling. The Belt and Road initiative is facing hurdles, as some countries resist taking Chinese money, considering the stipulations involved.

So is China done? Over the longer term, structurally, probably not. The economy is still structurally on course to outperform over the longer term.  The Chinese government is geared towards investing in the future. Its infrastructure spending continues unabated, and may even accelerate as part of its effort to re-stimulate its economy. It is already investing heavily in quantum computing, the natural home for real Artificial Intelligence, spending as much as $10 Billion for a Quantum Research Laboratory. The US is planning to spend anywhere between $200 million to $1.2 Billion on a similar project. Japan’s navy has developed a pulse gun, which can deliver a hit at great distances, at only 1/25th of the cost of a Tomahawk missile.

Just 10 years ago, China was 18% of the MSCI Emerging Markets. Now it is 32%. The country’s GDP is an estimate one fifth of global GDP. The Chinese market has gradually opened up to investors and has allowed its currency to fluctuate. Still, according to the Economist, global investors own just 2%-3% of Chinese stocks and bonds. As the market opens up and more institutional money willingly flows into it, the better for its financial system and ultimately the economy.

That still does not answer whether it will survive shorter term shocks. In short, we believe the Chinese economy is in good position to avoid a crash landing. For one, loyalty and trust to the Party and the leader go a long way into maintaining a positive consumer sentiment, which is key not only to maintaining consumption rates but to achieving the economic transition goal.

There are of course cyclical reasons why we believe a recovery may be at hand.

First and foremost the global economy is cyclical in nature. The latest PMI data suggest an improvement in total demand (although still mainly in the service sector).  A pick up in global trade could have an outsized impact in China.

Additionally, economic stimulation and loans have increased, suggesting that the official sector is picking up the slack from shadow banking. Total social financing reached a record $685B in February. The recent dovish rhetoric from the PBOC and the cut of the Required Reserve Ratio indicate that monetary policy will be used alongside fiscal stimulus.

And of course, there’s always the possibility that Messrs Xi and Trump will reach a final trade settlement which should remove uncertainty from the global supply chain.

While the underlying economic fundamentals currently suggest weakness, which is certainly being felt around the world and especially exporting countries, we think that there’s a good probability that China will experience both a cyclical and eventually a structural rebound.

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *