China bears lumber back to their caves

Markets and media pundits are again overreacting to the latest economic data out of China, but this time on the upside. Headlines are calling the end of the China 'slump'. The economy is said variously to be 'recovering' or 'stabilising'.  Predicted imminent financial meltdown of just a few weeks ago is now a thing of the past. The Aussie dollar is strengthening partly on the back of renewed China optimism and China-exposed stocks are generally higher.

As this column has shown for many months, however, China’s economy has not been in a slump. The published data show that over the course of five or six quarters, growth has slowed from somewhere near the top end of the 7 to 8 per cent range to somewhere near the lower end – hardly a crash. Moreover, during the course of this year, the rate at which economic activity was easing was slowing down. China’s economy is neither recovering nor slowing, but has recorded a fairly consistent growth rate throughout the course of this year.

The key indicators causing the most recent frisson in markets were industrial production, up 9.7 per cent in July from a year earlier, the biggest increase since February this year, and trade data, which showed both exports and imports increasing. Exports were 5.1 per cent and imports 10.9 per cent, higher than a year earlier.

Retail sales were virtually unchanged in July from June, increasing 13.2 per cent from a year earlier, as was fixed asset investment, which in July was up 20.1 per cent year-on-year, and investment in real estate, which was up 20.5 per cent year-on-year.

Completing the picture of stable economic conditions, China’s CPI for July was unchanged from June at 2.7 per cent. The government’s self-imposed upper limit is 3.5 per cent. Meanwhile, producer prices continued to fall but at a slightly slower rate than in June.

The bigger China story, however, is well known but little understood. That is the question of whether “rebalancing” in China will mark the end of China’s sustained high rates of economic growth. This often gets caught up in analysis of short-term growth indicators, such as quarterly GDP or alarmist concerns about imminent financial collapse. These issues are largely unrelated for whether China is rebalancing or not; it will have short-term economic cycles in response to policy changes, international conditions and, most often, sentiment.

Rebalancing is about longer term secular trends in the underlying rate of economic growth. Those who argue China needs to change its growth model with a sense of urgency assert the redundancy of the current model based on “financial repression” – essentially transferring income from the household sector via a combination of negative real savings deposit rates at banks, low wages due to restrictions on trade union activity and an undervalued exchange rate. The current model has transferred financial resources to the state-owned sector, which has captured the rents and like all rent-seekers used them to buy political support, thereby shoring up the model. 

As a result, household consumption is a smaller share of GDP than it would be in the absence of financial repression. This of course is true by definition. It is also true that at 45.2 per cent of GDP China’s domestic consumption as a share of GDP is abnormally low, especially as this figure includes government expenditure. Investment has led growth and as this model has delivered over thirty years of near double-digit growth it is argued – though notoriously difficult to measure – that the marginal efficiency of capital (that is, for every dollar invested returns are diminished) is falling and consequently growth will eventually fail unless the system is changed and capital is allocated more efficiently.

Around this central thesis many variants are woven, including China’s inefficient financial system, systemic corruption, property bubbles and so on. As with almost all economic debates, elements of truth and insights can be found on all sides. The problem is the balance of the arguments, the range of alternatives and the capacity of government policy to address the problems. Also as time passes, things of course move on and change.

Financial repression, for example, may be less severe than previously thought. China’s real effective exchange rate (that is, after adjusting for relative inflation rates) has been appreciating strongly for several years. Few today complain about China’s undervalued currency. Many today, however, complain about China’s rising wages, especially in the more developed eastern provinces, although free trade unions still do not exist.  

This would leave negative real deposit rates as the primary instrument of financial repression. But bank deposit savings are not the only way to look out for the future. Property is a favourite vent for savings and the empty apartments we hear so much about may be an important means to escape financial repression. Pundits have been predicting an imminent property collapse, but with investors with low levels of leverage, low inflation and low borrowing rates, it is perhaps not surprising that this has not yet happened.

Considering China’s economy continues to grow and per capita income has doubled at least every decade, if not more quickly, consumption in China has been rising at an even faster rate than GDP. China’s services sector is also expanding rapidly and increasing its share of GDP. It now accounts for 45.3 per cent of GDP.

This is also unremarkable. As economies mature, services increase their share of GDP. This is also consistent with rising household consumption. And the declining marginal efficiency of capital similarly is an indicator of increasing economic maturity. It would seem that “rebalancing” is well underway. Whether this will be enough to avoid some sort of crisis and collapse of the growth rate remains to be seen but government policy statements point to more efforts to address the imbalances while sustaining growth at more or less current levels.

Crying wolf does not mean that one day the beast will not turn up at the door. China’s economy is certainly beset by major problems that would challenge any government’s capacity to address them, especially the now urgent need to do more to reform the financial system so that capital is allocated much more efficiently in the future.

The challenge for the bears in making their case, however, is that very able analysts for thirty years have predicted the imminent collapse of the Chinese economy. There has been one crisis predicted after another, but the government in its muddle-through approach to policy has managed to do just that – muddle through.

Meanwhile, Beijing city alone will have to provide an additional 2.5 million car parking spaces over the next two years just to keep up with demand. China will also need to build 10 million housing units each year to keep up with normal (i.e. non-speculative) demand. It is not surprising then that in July a record 73 million tonnes of iron ore were imported. But a weak set of numbers next month will have the bears again growling outside their caves. That is one prediction about China that can be made with certainty.

Dr Geoff Raby is chairman and chief executive of Beijing-based advisory firm Geoff Raby & Associates, and a former Australian ambassador to China. He is a Vice Chancellor's Professorial Fellow at Monash University and a member of the Board of Directors of Fortescue Mining Group and Yancoal Australia.