Research and analysis

China Economy - The Three Rs

Published 2 February 2015

This research and analysis was withdrawn on 1 August 2016

This publication was archived on 4 July 2016

This article is no longer current. Please refer to Overseas Business Risk - China

This publication was archived on 4 July 2016

This article is no longer current. Please refer to Overseas Business Risk - China

Summary

Data show China grew by 7.4 per cent in 2014. Media hype about slowest growth for 24 years and ‘missed’ targets ignores three more important trends: rebalancing, reform and regionalisation. Debt presents a risk but an imminent crisis is unlikely. For 2015, the most interesting variable is reform. A stronger global economy, lower oil prices and better-aligned domestic incentives suggest that the pace of implementation will (mildly) accelerate.

Detail

Official data for 2014 were recently published. The data cannot possibly be accurate as they are published less than four weeks into 2015. However, the trends they point to are likely to be right. The headline figure was growth of 7.4 per cent, consistent with the authorities’ target of ‘around 7.5 per cent’.

Predictably the media focused on the fact that growth was the slowest for 24 years. This is true but misses the point. Incremental GDP growth last year was not-far-off $1 trillion, around 30 per cent of the entire UK economy and nearly double China’s incremental GDP growth in 2009 when headline growth was more than 10 per cent.

1. Three more relevant trends are:

Rebalancing

Premier Wen previously characterised the economy as ‘unbalanced, uncoordinated and unsustainable’. This remains the case in terms of stocks. However, in terms of flows, China is gradually rebalancing. Consumption contributed more to 2014 growth than investment. The services sector is growing faster than manufacturing, delivering record numbers of urban jobs in 2014, despite slower growth. Income growth remains high, supporting household consumption, with e-commerce increasing by 50 percent year-on-year. These changes are driven primarily by powerful structural forces, including demography.

Reform

The main priority for China’s leadership in 2014 was the anti-corruption campaign. That said, significant progress was achieved on implementing economic reforms. Progress on financial, fiscal and administrative reform all exceeded expectations.

Regionalisation

China is large. There is huge variety among the 31 provinces in terms of economic development. Richer, primarily eastern, provinces are rapidly converging with advanced economies in terms of income levels, economic structure and growth-rates. Poorer, primarily western, provinces remain dependent on investment-driven growth. The north-eastern provinces face particularly daunting challenges: maintaining stable growth and pivoting away from heavy industry, their traditional comparative advantage but also major source of Northeast China’s chronic air pollution.

What about the 4th R: risk?

Debt presents the greatest risk to the Chinese economy. The total level of debt likely exceeded 250 per cent of GDP this year. Most of this is corporate debt: at around $14.2 trillion, China now holds the world’s largest stock of outstanding corporate debt. The authorities are alert to the risks and are both improving regulation and slowing credit growth. A limited tolerance for default, however, ensures moral hazard remains endemic.

An imminent debt crisis in China is unlikely. Risks of a dynamic crisis are low, given the authorities’ control of the financial system. Furthermore, the authorities’ response to any emerging problems is likely to be swift and very well-resourced. Finally, the risk of problems erupting in the first place are slowly dissipating as the authorities are very alive to the dangers and progress is being made on reform..

What should we expect this year?

Growth will continue to slow as China continues to converge on more advanced economies. Slowing credit growth combined with an ongoing property market correction will both act as economic headwinds and there is no appetite among policymakers to introduce large scale stimulus.

That said, the authorities have emphasised that reform cannot come at the expense of stability. This likely means that targeted investment stimulus will continue to be used to ensure a gradual, rather than a precipitous, deceleration in growth.

Rebalancing, regionalisation and reform will continue. The pace of reform is the most interesting variable, and the one over which the authorities have most obvious control. Three factors suggest 2015 may see a mild and gradual acceleration in the pace of reform:

a. important groundwork was laid in 2014 for reform of the rural land system, the state-owned enterprises and the household registration (hukou) system;

b. the global economy ought to be stronger, supporting China’s still-important export industry, and lower oil prices ought to offset the inflationary-pressure inherent to many of China’s necessary reforms; and, perhaps more contentiously,

c. provincial-level officials will face better-aligned incentives to promote reform. They will face tighter budget constraints as reforms from last year start to bite. They will also need to contend with rising expectations from both the centre and their populations about delivering progress. This may encourage them to increase their own efficiency (e.g. through continued streamlining of functions), realise the value of their own assets (e.g. through the sale of local level SOEs) and attract new sources of funding (e.g. through greater use of PPP-type arrangements).

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