China: Hoping For A Chinese Soft Landing

Last Updated: 4 February 2016
Article by Ian Stewart

At the top of most economists' worry list for 2016 is the risk that the Chinese economy crashes. Such concerns have led to wild gyrations in Chinese equity markets. The Shanghai exchange was frozen twice in the first week of trading this year, after big sell-offs triggered 'circuit-breakers' designed to stop panic selling. Despite the best efforts of the authorities, Chinese stocks have collapsed, with the benchmark Shanghai index down 23% this year, to almost half last summer's levels.

The effects of the rout in Chinese stocks and the slowdown in its economy have rippled out across the world.

Trade, supply chain and investment links between China and neighbours, including Japan and South Korea, have acted as conduits for the Chinese slowdown to the rest of the region. Slowing Chinese growth has removed one of the key supports for energy and commodity prices. Lower commodity prices, in turn, have had a devastating effect on growth in commodity-dependent nations including Brazil and Russia. Meanwhile, the slowing pace of activity in China has hit demand for imports of plant and machinery from the West. Last year German exports to China fell by over 4%, the worst performance in 25 years.

Nervousness about China is also dampening confidence among businesses and investors in the West. The German Ifo index of business sentiment has fallen to its lowest level in almost a year while the US S&P500 equity index has fallen by 8% since the start of the year.

All of a sudden, China's previously unstoppable growth machine looks more fragile. Between 1980 and 2014, the Chinese economy expanded at an average annual pace of 10%, growing by a factor 25 and easily dodging recession during the global financial crisis. Last year China grew by 6.9%, a significantly slower pace than its long-term average and the slowest in 25 years.

Three factors make a slowdown in China's long term growth rate inevitable.

First, the period of ever-increasing labour supply is drawing to an end. Urbanisation, rapidly rising prosperity and the China's one child policy have transformed Chinese demographics.  After more than tripling between 1950 and 2010 China's labour force is forecast to shrink by 16% over the next 35 years. An ageing population and shrinking workforce spell higher welfare costs and slower growth.

Second, labour costs have soared. Wages in the manufacturing sector have more than tripled since 2008 and are likely to go on rising. This has eroded China's competitiveness and its position as the world's primary source of cheap labour. The "on-shoring" of manufacturing capacity back to the US testifies to the diminishing appeal of China as a low cost manufacturing base.

Finally, Chinese policymakers want to rebalance growth away from investment towards consumption. The World Bank estimates that investment accounted for 44% of China's GDP in 2014, the highest share of any major economy, while household consumption accounted for about 33%. (Investment accounts for under 20% UK GDP; consumption makes up the lion's share, around 66%). A slowdown in the runaway pace of investment is likely to dampen growth in the long term.

There is widespread agreement that the days of 8-10% a year growth for China are over. The real question is whether the attempt to engineer a slowdown to a long term growth rate around the 5-7% a year mark will cause the economy to crash.

A long period of breakneck growth has led to an accumulation of imbalances in the Chinese economy. Credit-driven investment has spawned excess capacity, bad loans and inflated asset prices. House prices doubled between 2010 and 2013 since when prices have fallen, leading to a glut of unsold properties and a slump in housebuilding.

Just as happened in the West during the financial crisis, lower asset prices and slower growth are creating problems for the banks. Loans which looked solid during the boom times are suddenly looking shaky. China's banking regulator estimates that the level of non-performing loans has doubled in the last year.

External factors have contributed to China's woes. The ultra-low interest rates maintained by the US Fed led to a surge in issuance of dollar-denominated bonds by Chinese corporates. That looked like a good idea when US interest rates were at rock bottom levels and the dollar was weakening. Now, US interest rates are heading up and the renminbi is weakening against the dollar. Chinese corporates with dollar denominated debt are seeing the value of that debt, and their debt servicing costs, rise.

The expectation of higher US interest rates has also contributed to a massive outflow of capital from China, as investors take their money in search of higher and safer returns elsewhere. This has added to the downward pressure on the renminbi and Chinese asset prices.

For the People's Bank of China the immediate challenge is what to do about capital flight and how to stop the renminbi from falling. As my colleague and Deloitte China's Chief Economist, Xu Sitao, pointed out last week, policymakers have two powerful weapons at their disposal. China has vast foreign exchange reserves, worth $3.3tn, which could be used to buy renminbi and support it against the dollar. And while the government's long-term aim is to move to free movement of capital, the authorities could impose temporary capital controls to staunch capital outflows.

Engineering a soft landing for the Chinese economy is no easy task. It will involve managing rising levels of bad debts in the corporate sector, risks in the banking system and capital outflows.

But policymakers are not powerless. They are increasing government spending and easing monetary policy to boost the economy. China's central bank has cut rates six times since November 2014 and is injecting liquidity into state-owned banks – a form of quantitative easing.

Despite the wider economic slowdown, consumer sentiment and spending have remained resilient. Retail sales volumes rose by 11% in the year to December and car purchases have picked up from their trough last summer. Lower commodity prices boosted consumer spending power, with per-capita disposable income up by 7.4% last year. Recent stock market movements have had little effect on Chinese consumers, partly because they keep less than 20% of their savings in equities.

The most likely outcome then is that China will avoid a hard landing this year. The IMF has a similar view and is forecasting Chinese growth of around 6% this year and the next. Nonetheless, the risks remain skewed to the downside. In monitoring those risks we will keep a close eye on China's housing market, on levels of stress in the corporate sector and on the performance of the banks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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