China rebound: built to last?

The background

Much of the turbulence that has hit stock markets during the past year stems from concerns about China. Its economy has grown at break-neck pace over the past 30 years, to become the second-biggest economy in the world, worth more than $10 trillion as measured by annual gross domestic product according to the World Bank.

However, as we’ve said before, the pace of growth in China was never going to be sustainable. Having grown at a rate of more than 10% a year during much of the 1990s and 2000s, annual economic growth fell to 6.7% in the first quarter of 2016 according to Thomson Reuters Datastream. This is still a relatively strong number by international standards especially if one considers that the UK economy grew by 2.0% during the same period.

Part of the reason for the slowdown in Chinese growth is the country’s shift from an industrial economy dominated by manufacturers which make goods for export, to one that is more similar to economies in the US and Europe, which tend to rely on services industries and consumer spending to generate growth. However, the scale of the slowdown has taken some investors and, one could argue, the Chinese authorities by surprise.

However, recent economic data have provided some cause for encouragement. The country’s official Purchasing Managers’ Index survey, which measures activity among manufacturing companies, has risen to a level that indicates healthy expansion. Meanwhile, export figures showed that shipment of Chinese goods overseas rose by 11.5% in March, compared to a year earlier.

Global economic growth depends to a large degree on the health of the Chinese economy, so there is a lot of interest in whether Chinese growth can be sustained.

Economic stimulus

To encourage borrowing and spending by businesses and consumers, in late 2014, the People’s Bank of China (PBoC) began to cut interest rates. The official interest rate has fallen from 6.00% to 4.35%. The PBoC has also cut banks’ required reserve ratios, i.e. the proportion of consumer deposits that commercial banks are required to hold in reserve with the central bank. This ratio has been lowered from 20% to 17% and should provide banks with more scope to lend to businesses and individuals. This, in turn, encourages spending, investment and economic growth.

Meanwhile, government spending has increased and policymakers have also relaxed property purchase regulations to stimulate the housing market.

China’s currency, the yuan was allowed to fall in value against the US dollar at the start of this year. This helped China’s exporters, as it made Chinese goods cheaper to overseas buyers.

Built to last?

So is this recent upturn built to last?

Perhaps not. The Chinese economic recovery faces a number of obstacles. One is an excess amount of supply in the manufacturing sector. If the supply of goods exceeds demand, this pushes prices lower (i.e. deflation).

There is a similar potential problem in the housing market where years of soaring prices encouraged a massive increase in house building. Again, supply is exceeding demand and many now fear a crash.

There are also worries about excessive amounts of debt that built up over the past 20 years. The International Monetary Fund estimates that up to 15% of commercial lending in China is at risk of not being paid back (sometimes known as “bad debt” or “non-performing loans”). If correct, the amount of non-performing loans in China could equal 4.9tn yuan ($746bn), which is equivalent to about 7% of China’s economy.

There is a risk that this figure could be even higher as a lot of debt has been issued by small lenders, which can be more difficult for the government to monitor and manage.

There are concerns that the stimulus measures mentioned above might have amplified these problems by boosting loans, encouraging investments in unprofitable parts of the market, and further stoking house price inflation. Supporting businesses that should be allowed to change or fail could act as a drag on economic growth, exposing over-priced housing and potentially triggering a “hard landing”, i.e. a rapid slowdown in China’s economy.

Reasons for optimism

The Chinese government will also do all it can to avoid a hard landing. Politically, it is in the interest of China’s President Xi Jinping to keep the economy growing steadily. Stimulus measures, such as further cuts to interest rates, could be implemented to help sustain economic growth.

Chinese growth concerns were a key trigger for the sharp fall in global markets in August and September last year, and helped to dissuade the US Federal Reserve from raising interest rates in September 2015. Those concerns returned again at the start of this year, when financial markets reflected sharp sell-offs once again; surveys of investors have shown that the Chinese slowdown is high on their list of worries. But if these worries are allayed and recent signs of Chinese economic improvement continue, the prospects for global stock markets in 2016 could be positive.

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