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Housing market weakness has lowered China’s GDP growth, but China has so far avoided a hard landing. One year after the Third Plenum, really big economic reform steps still have to be made.

Strengths (+) and weaknesses (-)

(+) Sizeable growth potential

China’s GDP per capita is still relatively low and the country has so far moved up gradually on the technological ladder. As a result, GDP growth is likely to remain strong, although we expect growth to decline gradually and policy reforms will be needed to sustain growth in the longer term.

(+) Exceptionally strong external (liquidity) position

China’s vast amount of FX reserves, amounting to USD 3,888bn at the end of the third quarter of 2014, and low external debt give it an exceptionally strong external creditor position. External liquidity risk is very low.

(-) Existing growth model is unsustainable

China has to change its growth model to reduce inefficiencies and ensure sustainable growth in the future. However, China has so far lagged in the implementation of many vital reforms to make growth sustainable.

(-) Weak accountability of the government

High levels of corruption, weak protection of human rights, strong influence of the Chinese Communist Party on the judiciary and lack of democracy implies that the Chinese population cannot hold the government accountable for its actions, which increases the risk of public unrest.

Key developments

1. Growth weakens, but data do not point yet at a destabilising hard landing

Recently released data show that economic growth in China has been slowing, but that the country has so far avoided a hard landing. GDP growth in China fell from 7.5% year-on-year (yoy) in 14Q2 to 7.3% yoy in 14Q3, the slowest pace in five years. In seasonally adjusted terms, growth fell from 2% quarter-on-quarter (qoq) to 1.9% qoq. The slowdown was driven by the ongoing weakening of the housing market, as real estate investment growth decreased from 13.2% yoy in Jan-Aug 2014 to 12.5% yoy in Jan-Sep 2014. The fact that house prices fell in month-on-month terms in 69 out of 70 Chinese large cities and that average house prices fell on average for the first time since 2012 in yoy terms in September, illustrate that the adjustment process is not yet over. Meanwhile, the growth data reveal that some rebalancing from investment to consumption has been taking place, as the share of consumption growth in total growth increased by 2.7 percentage points to 48.5% in 14Q3 compared to a year earlier. Net export growth also contributed to GDP growth, as China benefitted from (some) recovery in the west and lower commodity prices. Recently released monthly data also provide some comfort. First, industrial production and electricity production figures for September were significantly better than the disappointing August ones. In August, industrial production grew by only 6.9% year-on- year and electricity consumption even fell by 2% year-on-year (see chart 1). This was partially due to the fact that, compared to 2013, August was much cooler in 2014, which resulted in much less use of air conditioning. Second, in real terms, retail sales growth has held up well, as it increased from 10.6% yoy in August to 10.8% yoy in September. Third, the employment component of the HSBC manufacturing PMI showed a strong improvement, which suggests that employment conditions remain good. It thus seems that the weakening of the housing market has so far not led to a fierce broader weakening of the economy. However, we note that western consumer multinationals such as Unilever have presented weak sales data recently. This may suggest that the official data overstate the resilience of consumption, although the sales data of these companies may also have been hit by destocking and loss of market share to domestic producers. Looking forward, a further gradual decline of GDP growth seems likely. Given the importance of the construction sector for the overall economy, housing market weakness is likely to result in lower growth. While the central bank has provided some liquidity support,  the government seems to be unwilling to launch new aggressive stimulus, also as the labour market seems to remain relatively tight. As a result, growth could fall below 7% in 2015. This should not have to result in huge social risks, given the state of the labour market.

Figure 1: Electricity and industrial production
Figure 1: Electricity and industrial productionSource: Macrobond
Figure 2: Credit growth
Figure 2: Credit growthSource: Macrobond

2. One year after the Third Plenum the really big steps still have to be made

In early November 2013, the Communist Party presented an ambitious economic reform agenda for the period up to 2020 during the so-called Third Plenum. This agenda exists of economic, financial, fiscal and social reforms. One year later there has been some progress, but the biggest steps still have to be made. On the economic front, the government indicated last year that it would seek to let market forces play a “decisive” (instead of a “basic”) role. In this respect, state owned enterprise (SOE) reform could play an important role. It seems the government is likely to launch a SOE reform plan in the coming months and wants to increase competitive pressures for SOEs. However, progress is likely to be slow and strategic sectors will remain strongly protected. There has not been much progress on the financial front, even as the growth of shadow type of lending (in the form of bank acceptance, trust loans and entrusted loans) has fallen strongly in recent months (see chart 2). Nevertheless, in year-on-year terms, credit is still growing much quicker than nominal GDP. There was a lot of attention for the default of solar maker Chaori on a bond earlier this year, as it was reportedly the first corporate default in China. However, according to recent media stories, the bond holders have in the meantime received a bail-out. It thus appears that no real progress has been made in reducing moral hazard in the financial sector. An important reform that could indicate the pace with which China will proceed with financial reforms is the introduction of a deposit guarantee, as this would be seen as precursor of deposit interest liberalisation. On the fiscal front, the government may be close to making it much easier for local governments to issue bonds to fund projects. This could help to improve fiscal transparency, as local governments have so far used often opaque local government financing vehicles. On the social front, China has embraced a limited version of hukou reform, which will allow many migrants to obtain urban status, which would give them access to social services, though obtaining this status will remain very difficult in the biggest cities. Overall, the coming years will be crucial. So far, it seems that the central government intends to progress gradually, but large steps need to be made to make China’s growth model more sustainable. The ongoing anti-corruption could boost the power of the central government to implement reforms, though there are also reports that it is sometimes freezing some decision making.

Factsheet China
Factsheet ChinaSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

China is the second-largest economy in the World - after the US - measured in both nominal GDP (USD 9,469bn in 2013) and in PPP terms (USD 16,482bn in 2013). At the heart of China’s economic success has been its successful export- and investment-led growth model. However, in recent years, growth has been increasingly driven by credit and (real estate and infrastructure) investment growth. Meanwhile, adverse side effects, such as a rapid rise in income inequality and major environmental problems have become too big to ignore. China’s growth model will have to be changed and become more consumption-driven instead of investment-driven. Innovation will have to be nurtured, while environmental responsibility will have to gain in importance. The 12th 5-year plan, launched in March 2011, and the late-2013 Third Plenum address these issues, but implementing the plans correctly and timely will be a key challenge for Chinese authorities while major downside risks, such as a sharp economic slowdown or public unrest are present.

The People’s Republic of China, established in 1949, is a socialist one-party state ruled by the Chinese Communist Party (CCP). Power is centralized in the CCP and the support of the People’s Liberation Army and a well-developed internal security system safeguards political stability. The availability of information is heavily controlled by the government. Press freedom and freedom of speech are heavily restricted, while the judiciary is not independent. As a result, developments in China, especially political ones, remain clouded and difficult to gauge due to lack of transparency. In recent years, President Xi Jinping has launched a far reaching anti-corruption campaign, which has increased his personal power.

Economic indicators of China
Economic indicators of ChinaSource: EIU, Rabobank
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