Strong pessimism has become the norm when conversations gravitate to China. Ever since last August’s domestic stock market crash and disappointing first-quarter economic growth, being a China bear seems to have become more popular. Most recently, negative sentiment has focused on China’s debt level, slowing growth and sluggish implementation of reforms.
But there are good reasons not to give up on China just yet.
China’s debt level is a problem but not at an imminent debt-crisis level.
China certainly has a high absolute level of debt, with levels much higher than those seen in other emerging market (EM) countries who experienced debt crises, according to Bloomberg data. But an imminent debt crisis seems unlikely, due to the different nature of China’s current debt.
First, consider who owns the debt. During the Mexico debt crisis in 1994, the Asian debt crisis in 1997 or the Brazil crisis in 2002, foreign investors were the dominant stakeholder. In contrast, according to UBS, more than 90 per cent of Chinese debt is currently domestically owned.
Second, past crises centered around currency devaluations and foreign money flowing out. The potential for a Chinese currency devaluation is low, in our opinion. So, now it’s more about how Chinese investors feel about the debt issue. The irony is that the growth of Chinese debt is related to Chinese citizens’ limited set of investment options: invest in debt or save (as capital controls restrict money from flowing out of the country). The corporate sector has been a large borrower, happy to issue debt to provide interest to the Chinese investor. Corporate debt grew from 102 per cent of Chinese gross domestic product (GDP) in 2007 to 165 per cent by 2015, as the chart below shows.
The national savings rate may in fact justify the high debt level, as some have argued, with Chinese savings matched to debt issuance. Case in point: China’s gross savings rate has been high for decades, averaging around 45 per cent of GDP for the last 20 years, per the World Bank.
The Chinese economy still has the potential to grow, just not at double-digit rates.
The recent decline in China’s GDP to below 7 per cent from an average of 10 per cent from 1980 to 2010 has some worried that the country is on the verge of hitting the middle-income trap, and a dangerous downward growth streak is ahead. The numbers contest this worry. China’s real GDP per capita (person) is US$8,100, compared with US$56,000 in the U.S., $33,000 in Japan and an EM average of US$10,600. Furthermore, there have been instances where EM countries have managed to escape the middle-income trap.
China is also likely to benefit from its 1.2 billion population. Creating economic growth will not only be about bringing people into the labor force, but it’ll also be about how to allocate those human resources efficiently. The relaxation of the Hukou system means people can move from rural areas to cities where economic growth is vibrant. This relocation process, still in progress, is likely to support growth going forward. According to the World Bank, China’s urban population was 54 per cent at the end of 2014 versus 81 per cent in the U.S. and 79 per cent in Mexico. Lastly, the elimination of the one-child policy has the potential to boost household consumption in the short term and to slow China’s worsening demographic picture over the longer run.
Policymakers recognize what needs to be done.
Reforms need to be implemented to support the country’s long-term growth potential. The goal is to transition the economy to a more sustainable and stable path based around consumption rather than investment. And, as I’ve written before, though the pace of reform has slowed lately due to cyclical pressures, the reforms that have been implemented are ones that are supportive to growth. These include the privatization of State Owned Enterprises (SOE) and structural reforms, like the relaxing of the Hukou system and the one-child policy mentioned above.
Though we have adopted a more favorable view of China lately, we are cognizant of headwinds to Chinese growth. Excessive leverage and overcapacity remain major risks for the country’s long-term growth prospects. Debt levels that are left unmanaged and allowed to grow exponentially would create problems.
But China has proved the skeptics wrong before, experiencing many bumps along its road to economic power. Bottom line: Don’t give up on the Chinese economy and Chinese equities just yet, but be prepared for market volatility as China’s new chapter is written.