Reforms aimed at reshaping China’s economic prospects in 2015 may have mixed implications for firms.
Future historians may remember 2014 as an epochal year for China’s economy: the moment when the country regained its position as the world’s biggest economy, by one measure, for the first time since the 19th century.1
This momentous historical achievement was, however, overshadowed by more immediate concerns. China’s economy last year was beset by falling property sales, deflating producer prices and sporadic defaults. One might have expected these problems to weigh on China’s stock markets. But mainland markets strengthened in the final six months of 2014 and soared spectacularly in its final six weeks.2
China’s economy, its leaders insist, is undergoing a “triple transition”. That phrase, which is our translation of 三期叠加 (san qi die jia), peppers official commentary almost as frequently as the term “the new normal”3. It sums up three new facts of life for China’s economy. First, the country’s natural rate of growth is slowing, as its population ages and its economy matures. That first transition necessitates a second: China must embark on another round of reforms to give market forces a more “decisive” role in allocating resources. That will help China’s third transition, which is to “digest” the excess capacity, including large inventories of property, left behind by its stimulus efforts after the global financial crisis.
1. A slowdown in the natural rate of growth
2. Structural reforms that give market forces a more decisive role in the economy
3. The digestion of excess capacity left behind by the post-crisis stimulus
This triple transition will shape the economy’s prospects in 2015. The phrase reflects a welcome recognition that the breakneck growth of the past is unsustainable, further reform is necessary and the 2008-9 stimulus efforts had unwelcome side-effects. That is a message well worth communicating to provincial party chiefs and local leaders who might otherwise strive too hard to restore the double-digit growth of yesteryear. China should emerge on the other side of this transition with a more efficient economy, albeit one that may be harder to stabilize. The only danger is that the leadership’s preoccupation with this triple transition in 2015 complicates their efforts to shore up demand in the economy, which remains unnecessarily weak. China should accept the new normal of slower trend growth. But in doing so, it should not fall prey to a new subnormal of below-trend growth.
Some critics of China’s economy have accused its leadership of trying to “fight the trend”4. They argue that China’s slowdown is entirely structural. Its maximum, sustainable growth rate has dropped, a trend its leaders cannot defy by easing credit in a bid to stimulate demand. Economic historians point out that South Korea made just such a mistake in 1989. It faced a structural slowdown, which it misinterpreted as a cyclical dip. Its efforts to fight this new reality only made things worse5.
China’s natural rate of growth is indeed slowing. And stimulus will not change that fact. But far from denying this slowdown, China’s leaders seem keen to embrace it. They have spoken ad nauseam about a “new normal” of slower growth. This gentler pace of expansion is “normal” both in the sense that it is here to stay and in the sense that it is nothing to get too exercised about.
In this spirit the National People’s Congress (NPC) is likely to endorse a lower growth target of 7% for this year, we believe. As well as cutting the target, China’s leaders also seem keen to downplay its significance. Li Keqiang, China’s premier, and Lou Jiwei, its finance minister, have both explained that China’s growth target is now subordinate to its jobs target6. In other words, the government will aim for whatever growth is necessary to create a sufficient number of urban jobs.
That task is made easier by the growing role of services in China’s economy. Its services sector is about 20% more labor-intensive than industry. As services contribute a larger share of China’s economy, it will require less growth to generate the same amount of jobs7.
China’s natural rate of growth—the growth rate it requires to sustain full employment without excessive inflation—is therefore lower than it was. But China now appears to be falling short of that lower limit. In the final quarter of 2014, employment in its non-manufacturing sectors was the weakest ever recorded by the official Purchasing Managers’ Index (see Figure 1), which began in 2007. This slack is also evident in China’s inflation figures. Producer prices fell, year-on-year, in December for the 34th month in a row, according to the National Bureau of Statistics. This downward pressure on prices suggests that demand is insufficient to fully employ China’s economy. The country should embrace the “new normal”. But its recent economic weakness represents something worse: a new subnormal.
Will demand pick up in 2015? The chief economist of the People’s Bank of China, Ma Jun, and his colleagues forecast that China’s economy will grow by 7.1% this year8. But, as they acknowledge, that will not be fast enough to dispel the forces of producer-price deflation: they foresee prices falling by another 0.4% in 2015. A year ago, in his previous role as chief economist for Greater China at Deutsche Bank, Mr Ma argued that the country would have to grow as fast as 8.5% to generate producer-price inflation of 2%9. The upper limit on China’s growth is presumably lower than that now. But a look at China’s recent growth and inflation figures nonetheless suggests that the country has more room to grow than is commonly supposed (see Figure 2).
China’s deflationary pressures are not evenly spread across its economy. Nineteen of China’s 31 provinces and municipalities appear to be suffering from falling prices, according to the GDP deflator (see Figure 3)10. In the coal-mining province of Shanxi, prices have fallen by 4.5% in the first three quarters of 2014, compared with a year earlier. Since 2011, they have fallen by over 9.5% (see Figure 4).
This low inflation gives the Chinese authorities room for further stimulus in 2015. This stimulus is necessary not to fight the trend but to fulfill it. Additional cuts in benchmark interest rates and reserve requirements are possible, in our view. Such cuts would help offset the increase in real interest rates entailed by declining inflation.
Rather than allowing credit to slip the leash again, the authorities will also resort to fiscal stimulus. Recent reports by China’s Economic Observer newspaper and Bloomberg suggest that China will hasten the implementation of about 300 investment projects in seven “packages”, including agriculture and water conservation; transportation; environmental protection; healthcare; information technology networks; clean energy; coal, oil and gas11.
For China’s critics, these reports revive unhappy memories of China’s stimulus efforts after the global financial crisis. But such comparisons can be misleading. These 300 projects are drawn from a larger pipeline of 420 that the National Development and Reform Commission had already scheduled for the period from 2014 to 2016. They are then part of a longer-term plan overseen by China’s central planning agency. That distinguishes this infrastructure effort from the local government free-for-all after 2008, which was hastily planned and loosely coordinated.
There is a sound economic case for this kind of counter-cyclical spending. Governments should postpone projects in boom times, lest they add to overheating, and hasten them in busts, when financing is cheap, labor is available and opportunity costs are low. China is not wrong to vary the timing of its investments in counterpoint to the economic cycle. In my view, more governments should try it.
The authorities do not want to replicate the 2008-9 stimulus not least because they are still dealing with the consequences of the original version. Although that lending and investment spree helped rescue China from the financial crisis, it also precipitated a property-price bubble and wasteful additions to capacity in a variety of industries, including steel, cement, aluminum, plate glass, shipbuilding and solar. To give some sense of the scale of China’s building boom, note that in just three years, from 2011 to 2013, China produced enough cement to turn the whole of Great Britain and Northern Ireland into a car park.12
Digesting this excess capacity represents the third of China’s transitions. The process is still weighing on China’s property market, where home sales have declined throughout 2014. To stabilize sales, China’s local authorities have now lifted home-purchase restrictions in all but a handful of cities. China’s central bank has also relaxed its mortgage regulations13. It can take up to eight months for cuts in interest rates to translate into increases in sales, according to China Index Academy, a division of Soufun, a Chinese real-estate agency. Sales may therefore pick up towards the second half of 2015.
What about other industries blighted with excess capacity? In a number of these industries prices have fallen substantially from their peaks (see Figure 5). These price declines are an obvious symptom of overcapacity. But they also represent the beginnings of a solution to it.
Lower prices will improve demand. In principle, they should also curtail supply: unremunerative prices should discourage further investment in these industries and force some existing producers to exit altogether. In practice, many firms soldier on with the help of forgiving banks and indulgent local governments.
This indulgence slows the pace of corporate restructuring in China. But it would be wrong to assume that China’s industrial mix is therefore preserved in aspic. Labor is highly mobile across industries and regions, much more so than in many other countries. And although the banking system in China is less ruthless than elsewhere, bank loans are not the biggest source of finance for many Chinese firms, which rely instead on retained earnings. This kind of internal finance naturally accumulates in profitable industries and evaporate in unprofitable ones. There is, therefore, a natural tendency for retained earnings to gravitate towards industries with the highest returns.
As China’s GDP has increased vastly in size, it has also changed considerably in shape. China’s economy has evolved as it has expanded. Despite all of the fuss about industrial overcapacity, industry’s share of China’s GDP has declined by 6.3 percentage points over the past eight years. The share of retail and wholesale trade has increased by 2.4 points (see Figure 6). By this measure, indeed, China’s economy appears to have enjoyed far more creative destruction than America’s.
In the past two months, China’s stock markets have enjoyed a dramatic rally. Is this bull run an endorsement of China’s “triple transition” and the reforms it represents?
In truth, China’s transition is a mixed blessing for its stock market. The first transition reflects a slowdown in China’s underlying rate of growth, which is unwelcome, even if it is also inevitable. By digesting excess capacity (the third transition), China should restore profitability to some industries cursed by falling margins. That will be good news for the surviving firms. But it also implies that many firms will not persist in their present form.
The reforms implied by the second transition also have mixed implications for the share prices of incumbent firms. Financial reforms, for example, aim to bring greater diversity and discipline to China financial system. If they succeed, these reforms could increase pressure on both sides of the balance sheets of incumbent banks. By giving banks greater leeway to raise deposit rates, they will oblige banks to fight more fiercely for depositors. By nurturing the bond market, these reforms may also force banks to compete harder for corporate borrowers, who will otherwise raise funds from the capital markets. These reforms could therefore put pressure on banks’ interest margins, hurting their future earnings.
Ultimately, these financial reforms should make Chinese capital more productive, but also less patient. Banks will become more discerning in their lending decisions, which will improve the return on capital to the economy’s benefit. But banks will also become more skittish, quicker to pull loans that might otherwise turn sour. China will become less prone to credit binges, but also newly vulnerable to credit crunches.
Beijing is also seeking to impose greater fiscal discipline on local governments. The State Council sketched out its plans in October in its “No.43 document”14. The new rules will allow local governments to issue bonds in their own name, subject to a quota overseen by the central government. But the regulations will also prohibit local governments from financing their ambitions indirectly through financing vehicles and other implicitly guaranteed entities.
These plans will ultimately increase the efficiency and transparency of local-government spending, which is emphatically a good thing. But in the short term, the overhaul may also inhibit local-government spending. That is not necessarily welcome in an economy that appears to be suffering from weak demand. It may therefore fall to the central government to offset weaker spending at the local level with stimulative measures of its own.
China’s stock market rally is marked by two great ironies. For all the talk of the new normal, the sectors that have performed best in recent months include traditional capital-intensive industrial stalwarts, such as oil and gas, coal, and construction, according to Thomson Reuters. Thus far the “new normal” has been remarkably good for “old China” stocks.
The other great irony is that the bull run has been largely confined to onshore markets. The CSI 300 index, which spans both Shanghai and Shenzhen bourses, rose by over 50% in 2014, even as the offshore MSCI China index, closely followed by global investors, rose by less than 5%. Similarly, ‘A’ shares listed on the mainland are now substantially more expensive than the same companies’ ‘H’ shares, listed in Hong Kong. This premium amounted to almost 30% at the end of 2014, according to an index calculated by Hang Seng, which weights companies by their market capitalization. We are not the only ones to note that this disconnect between A- and H-shares coincides with the November launch of the Shanghai-Hong Kong Connect scheme, which was supposed to bring the two exchanges closer together.
If the prospect of economic reform were responsible for China’s stock market rally, the gains should have been shared by all the companies exposed to its economy, wherever they were listed. Instead, mainland indices have massively outperformed their offshore counterparts. This outperformance suggests that something has changed for mainland investors, not for mainland companies.
The sharpest gains were triggered by the Chinese central bank’s decision to cut its benchmark interest rates in November. Such cuts make more difference to local valuations than to offshore valuations, because offshore investors discount returns by the world interest rate not the mainland rate. The November cut was not enough by itself to warrant the extraordinary run-up in share prices in the weeks that followed. But if investors expect further cuts in the coming quarters, it was enough to provide a trigger. The share-price gains then appeared to feed on themselves. The fire created its own fuel, tempting Chinese retail investors to open accounts and buy shares on margin.
“Despite the strong rally, however, Chinese shares are still not conspicuously expensive, as judged by their price-earnings ratios. It is possible that what we are witnessing on the mainland is not a bubble of optimism, but the popping of a three-year bubble in pessimism.”Simon Cox, Investment Strategist, BNY Mellon Investment Management
There are, then, a variety of reasons to be cautious about the mainland bull market. The price gains reflect revised valuations, not revised earnings. This rerating has been remarkably sudden. The rally has been both cause and consequence of an influx of new investors, many of whom appear to be investing on margin.
Despite the strong rally, however, Chinese shares are still not conspicuously expensive, as judged by their price-earnings ratios. The ratio for the CSI 300 was 15.55 on January 6th 2015, according to CSI, hardly a forbidding figure. Recent price gains follow a long period of undervaluation. If valuations are mean-reverting, they must sometimes revert upwards as well as downwards. It is possible that what we are witnessing on the mainland is not a bubble of optimism, but the popping of a three-year bubble in pessimism.
* Data Source: National Bureau of Statistics of the People's Republic of China, www.stats.gov.cn.
1 In April 2014 the World Bank published the results of a worldwide comparison of prices. Based on these numbers, the IMF calculated that China’s output of goods and services in 2014 would be worth more than America’s if similar items were priced similarly. In practice, China’s prices tend to be lower than America’s when converted at market exchange rates. Therefore China’s GDP is still considerably smaller than America’s when converted into dollars at the prevailing exchange rate, which averaged 6.14 in 2014, according to Oanda. There is one final wrinkle: China’s National Bureau of Statistics will soon adopt a more modern method of calculating GDP, known as the 2008 System of National Accounts. This may result in an upward revision of China’s GDP, according to the Rhodium Group and other scholars. If the restatement is big enough, it may show that China’s GDP overtook America’s a year earlier—in 2013—if similar items are priced similarly. It’s worth emphasizing that none of these calculations is terribly precise.
2 The CSI 300 index rose by 63% in the second half of 2014 and by 39% from November 20th to December 31st, according to Thomson Reuters Eikon.
3 See, for example: http://cnews.chinadaily.com.cn/2014-12/10/content_19058024.htm
4 See, for example, the criticism in the latest Geneva Report on the World Economy, published by the Centre for Economic Policy Research: www.voxeu.org/sites/default/files/image/FromMay2014/Geneva16.pdf
5 “From Miracle to Maturity: The Growth of the Korean Economy”, by Barry Eichengreen, Dwight Perkins, Kwanho Shin
7 One million yuan-worth of output in services creates about 10.7 jobs. The same amount of industrial output creates only nine jobs.
9 China: Themes and Strategy for 2014, Deutsche Bank, January 2014
10 These regions reported that their nominal growth rates (which include inflation) were lower than their real growth rates (which strip out the effects of price changes) in the first three quarters of 2014. This suggests the GDP deflator, the broadest measure of inflation, is now negative in these parts of the country.
11 http://industry.cfi.cn/p20141227000142.html ; http://www.bloomberg.com/news/2015-01-05/china-said-to-accelerate-1-trillion-in-projects-to-spur-growth.html
12 BNY Mellon calculations based on National Bureau of Statistics, China, and “Designing Quality Concrete Parking Areas” by National Ready Mixed Concrete Association. Calculations assume 280kg of cement per cubic meter of concrete and a parking surface 100mm thick.
BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.
The information in this document is not intended to be investment advice, and it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for Professional Clients only. This material is not for onward distribution to, or to be relied upon by, retail investors.
Any statements and opinions expressed in this document are as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of its affiliates. The information contained in this document has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. This document is not investment research or a research recommendation for regulatory purposes as it does not constitute substantive research or analysis. To the extent that these materials contain statements about future performance, such statements are forward looking and are subject to a number of risks and uncertainties. Information and opinions presented in this material have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from use of this material. If nothing is indicated to the contrary, all figures are unaudited.
Any indication of past performance is not a guide to future performance. The value of investments can fall as well as rise, so you may get back less than you originally invested.
This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.
This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management.
This document is approved for Global distribution and is issued in the following jurisdictions by the named local entities or divisions: UK and in mainland Europe (excluding Germany): BNYMIM EMEA, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Conduct Authority. • Germany: Meriten Investment Management GmbH which is regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. • Dubai, United Arab Emirates: Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act upon it.• Singapore: BNY Mellon Investment Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. • Hong Kong: BNY Mellon Investment Management Hong Kong Limited. Regulated by the Hong Kong Securities and Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission. • United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil: this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ, Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM).
The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation
BNY Mellon Company information
BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms’ services or funds to any U.S. investor, or where otherwise unlawful. • BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People’s Republic of China. • BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm.• BNY Mellon owns a 19.9% minority interest in The Hamon Investment Group Pte Limited, the parent company of Blackfriars Asset Management Limited and Hamon Asian Advisors Limited both of which offer investment services in the U.S.• The Newton Group (“Newton”) is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S.• BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).
©2015 The Bank of New York Mellon Corporation.