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Concerns about a Chinese slowdown have increased, but most indicators suggest that the downturn is concentrated in industry and construction. The direct impact of the stock market rout is limited, but it has damaged the credibility of the crucial reform agenda of the government.

Strengths (+) and weaknesses (-)

(+) Exceptionally strong external position

China’s vast stock of FX reserves, amounting to USD 3,557bn per August 2015, and low external debt give it an exceptionally strong external position. Capital controls also reduce external vulnerability, though growing capital outflows in recent quarters suggest that controls have become more leaky.

(+) Large economy with growth potential

China has a large and growing economic market. In PPP terms, China is now the world’s biggest economy. Meanwhile, growth potential still seems present, as China’s GDP per capita is still relatively low and the country has so far successfully moved up gradually on the technological ladder, though policy reforms are crucial to sustain growth in the medium term. 

(-) Existing growth model is unsustainable

China has to change its growth model to reduce inefficiencies and ensure sustainable growth in the future. However, many crucial reforms still have to be implemented. 

(-) 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. Equity rout damages credibility of reform agenda 

After a long rally prices on China’s equity markets began to fall strongly in June, when the government took measures against margin trading (figure 1). To halt the decline the government took far-reaching measures, e.g. large shareholders were not allowed to sell shares and the government (indirectly) bought a large number of shares. Nonetheless, this failed to stem the decline. On Monday 24 August (dubbed Black Monday even by official Chinese newspapers) the government seemed to capitulate, which resulted in a further plunge. After five trade days of heavy losses, stock indices went up again on the last two trading days of August. There are reports that the government has started to again purchase shares. The direct economic impact of the fall of share prices may be not that severe, as stocks represent a relatively modest share of total household wealth. The reliance on stock market financing of most Chinese companies is also not that big. Nevertheless there are clear dangers. First, in recent quarters the financial sector’s contribution to nominal GDP growth was remarkably big. This contribution could fall strongly. An even bigger casualty might be the credibility of the government’s reform agenda. The extremely rapid increase of welfare levels in China in recent decades has contributed to trust in the competence of its leadership. However, this confidence is likely to be damaged (also by the recent Tianjin disaster). Meanwhile, adjusting China’s growth model, which requires important and difficult reforms, has become a more and more urgent issue. While some progress has been made in recent years, as the service sector has grown in importance, a lot remains to be done. For example, still high credit growth has even picked up somewhat further in recent months.

2. Services sectors seems to hold up well, but uncertainties have increased

Next to the equity market rout, a depreciation of the currency in August and disappointing export and manufacturing PMI data have also raised concerns about a further fall of economic growth in China. In mid-August China surprised financial markets when it revised its currency regime and allowed the yuan to depreciate by about 3% against the USD. The exchange rate adjustment seemed partially aimed at obtaining an IMF reserve currency status for the Chinese currency. Another reason, however, also seemed to have played an important role, as shortly before the announcement data were published that revealed that exports in July had fallen by 8% y-o-y. However, the positive impact of the depreciation the currency underwent so far on net exports is likely to be limited, as the Chinese currency has appreciated rapidly in real terms against the currencies of most of China’s important trade partners. While the central bank has intervened to avoid a further depreciation in recent weeks, it may still allow the currency to depreciate later on.

Figure 1: Equity rout
Figure 1: Equity routSource: Macrobond
Figure 2: Decoupling services & industry?
Figure 2: Decoupling services & industry?Source: Macrobond

So far, the slowdown seems concentrated in the industrial and construction sectors. According to official data, in both the first and the second quarter economic growth was 7% y-o-y. However, these data appear hard to reconcile with the trade data, as exports have disappointed this year, while imports even fell in y-o-y volume terms in the first five months of the year. There are two explanations. First, the over-repporting of growth seems to have increased this year. In reality, growth might have been a couple of percentage points below the officially reported rate. Second, the slowdown seems to be concentrated in the import-intensive industrial and construction sectors. While the Caixin/Markit manufacturing PMI was very disappointing in both July and August, the Caixin/Markit services PMI has been rather good in recent months (figure 2). Most other indicators, such as retail sales or air traffic data, also suggest that growth of consumption and the service sector has held up well. On the other hand, the vacancies-to-job-seekers ratio has fallen in the most recent two quarters. While the number of vacancies is still high, a continuation of this trend could weaken consumption growth. Car sales have also disappointed in recent months and data reliability also remains an issue. This means that we cannot rule out that consumption and the service sector have taken a bigger hit than the official data reveal.

Looking forward, recent data suggest that overall economic activity growth has been slowing somewhat, after a pick-up in the second quarter. What is more, the contribution of the financial sector to growth could fall sharply due to the stock market rout. The drag on government spending due to local government financing reforms that took place in the beginning of this year, is likely to ease in the coming quarters after the government created new financing avenues. While the impact of monetary stimulus might be smaller than in the past, credit growth appears to have been picking up recently. This may also provide some stimulus. As a result, the slowdown in growth may stabilise in the course of the second half of 2015. However, uncertainties have increased and stimulus measures could slow the necessary adjustment towards a more sustainable growth model.

Factsheet of 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 in nominal GDP terms (USD 10.4 trillion in 2014) and the largest economy in PPP terms (USD 18 trillion in 2014). 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 helped him to increase his personal power.

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