Matthews Asia, the specialist firm, gives another detailed analysis of big trends changing the Chinese economy.

Editor’s note: A few days’ ago, this publication run the first of a three-part series by Matthews Asia, the San Francisco-headquartered wealth management specialist firm, about its views of major themes in China’s economy. The start of the Chinese New Year is an auspicious time to be thinking these issues through. Here, Andy Rothman, investment strategist, examines the policies the country is embarking on. (See the first of the items here.) As always, the views expressed are those of the author and firm, and not necessarily those of this publication.

We are witnessing the odd scene of Communist Party leaders being comfortable with a gradual deceleration of economic growth that is making most foreigners very nervous.

Significant stimulus or monetary policy easing not expected this year, but continued economic reforms are coming, and China will remain the world’s best consumer story.

China is complicated and raises many questions for investors. On the one hand, China’s economy is growing more slowly at 7.4 per cent last year, compared to 7.7 per cent for the two prior years. On the other hand, because the base was far larger last year, the incremental increase to the size of the economy was 100 per cent greater than the increase a decade ago, when GDP rose 10 per cent. This is why the International Monetary Fund estimates that China accounted for almost one-third of global growth last year. With inflation-adjusted income up about 7 per cent in China, compared to 2 per cent in the US, consumer spending is booming, up 11 per cent vs 2 per cent here. Media headlines, however, continue to tell us that China’s economy is doomed.

We explore the reasons why the Communist Party is comfortable with slower growth, and just how slow a pace might be tolerable. This segment will also answer questions about the health of what has been the world’s best consumer story, and about prospects for further economic reforms.

The final instalment will answer the question: Is China’s property market heading for a crash? And it will discuss what we feel are the biggest long-term risks to growth and stability - an absence of the rule of law and trusted institutions.

The first part of this series, published in early February, addressed the impact of falling oil prices and the risks for deflation. We also considered the prospects of certain policy moves—cuts to interest rates and bank required reserve ratios—that have led to a booming domestic Chinese stock market, and concluded that many domestic investors are likely to be disappointed.

Why do I keep saying China won’t “ease” this year?
Because we are witnessing the odd scene of Communist Party leaders being comfortable with a gradual deceleration of economic growth that is making most foreigners very nervous.

China won’t - and doesn’t need to - ease significantly because current conditions are not “tight”; because the macro deceleration is largely the inevitable result of structural changes; and because the slower pace of growth is still fast enough. Let’s look at each of those three points.

Current conditions are not “tight.” The growth rate of total social financing (TSF, or aggregate credit) has continued to cool, from 19.1 per cent year-over-year at the end of 2012, to 14.3 per cent at the end of last year, but that was still considerably higher than nominal GDP growth of 8.3 per cent. Broad money (M2) rose 12.2 per cent YoY last year, compared to 13.8 per cent in 2012. Hardly tight, in my view.

Deceleration is largely the inevitable result of structural changes. After two decades of 10 per cent annual GDP growth, it is inevitable that the growth rate is slowing. Many factors contribute to this slowdown. Demographics, for example, play a big role: in past years, the workforce grew rapidly, making a significant contribution to GDP growth. Now, the working age population is beginning to shrink, eliminating the “demographic dividend.” Similarly, so much public infrastructure has already been built that the growth rate of new construction is significantly lower. Commercially built, privately owned housing boomed during its first decade of existence in modern China, and is now growing more slowly as that sector matures.

This slower growth is, however, still pretty fast. GDP growth averaged 8.6 per cent between 2010 and 2014, and 7.4 per cent last year (compare this to 2.4 per cent GDP growth in the US for 2014). And the absence of a significant stimulus last year is strong evidence that the Party is comfortable with this gradual deceleration. The Party controls the financial system, and did not reaccelerate credit growth last year. TSF outstanding rose 14.3 per cent last year, down from 17.5 per cent in 2013.

Contrast this with the sharp rise in outstanding credit growth engineered by the Party in response to the 2009 Global Financial Crisis: from 19.7 per cent in November 2008 to 33.4 per cent a year later.

There was also no sign last year of stimulus in the growth rate of fiscal spending, which averaged 1.4 per cent YoY during the September-November 2014 period, compared to 12 per cent during the same period in 2013.

China’s leaders took no significant steps to reverse last year’s gradual deceleration, signalling that they are comfortable with this trend.

How much of a slowdown will Xi Jinping tolerate this year?
A starting point to answer this question is to understand that the GDP growth rate is not the Party’s main economic indicator. Chinese citizens pay no more attention to GDP than do Americans. As in other countries, the important factors are employment and people’s sense that their standard of living is improving.

China’s official unemployment statistics are (as their economists readily admit) useless, but there are no signs that slower growth has led to rising joblessness. A study of privately-owned, small- and medium-sized manufacturers by the research brokerage firm CLSA found that in 4Q14, 7 per cent of firms reported it was easier to find new unskilled labour, compared to a year earlier. This compares to an 8 per cent response by SMEs in 2Q08, which then jumped to 76 per cent in 4Q08 as the global financial crisis set in. Similarly, 3 per cent of SMEs reported it was easier to find new skilled workers in 3Q14, while the rates were 2 per cent in 2Q08 and then 61 per cent in 4Q08.
 
The same CLSA study found that SME wages rose by more than 6 per cent YoY for unskilled factory workers and by almost 8 per cent for skilled workers in 4Q14, growth rates that have remained fairly stable over the past few years after bottoming in early 2009 at -1 per cent for unskilled and 1 per cent for skilled workers.

The independent data from CLSA is in line with official numbers showing continued strong income growth. Inflation-adjusted (real) urban household disposable income rose 6.8 per cent YoY last year, compared to 7 per cent in 2013. Real rural cash income was up 9.2 per cent last year, compared to 9.3 per cent in 2013. (As a reference point, US real disposable personal income rose 2.2 per cent YoY last November.)

Wages for migrant workers, who move from China’s countryside to staff the nation’s urban factories and construction sites, rose by almost 10 per cent last year. The country’s overall labour market remained stable despite slower macro growth.

In my view, as long as there is no spike in unemployment and real income growth remains strong, the Party is unlikely to deploy a significant stimulus. This holds even though I expect GDP growth to slow to the 6.5 per cent to 7 per cent range this year, and then to 5 per cent to 6 per cent by 2020.

Another important factor in understanding why gradually slower growth does not constitute a crisis is the base effect.

At 7.4 per cent, last year’s GDP growth was significantly slower than the 10.1 per cent pace of 2004. But because the size of the economy (the base to which the 7.4 per cent increase was applied) was three times larger than the 2004 base, the incremental increase in the size of China’s GDP at last year’s slower growth rate was 100 per cent larger than the increase at the faster growth rate a decade earlier.

Similarly, if we look ahead to the bottom range of my GDP growth forecast for 2020, 5 per cent growth, that will be applied to a base which will likely be over 60 per cent bigger than the base in 2014 and about 600 per cent bigger than the 2004 base. Therefore, at 5 per cent growth in 2020, the incremental increase in the size of China’s economy will be 39 per cent larger than the increase at 7.4 per cent in 2014, and more than 180 per cent larger than the increase at 10.1 per cent in 2004.

In other words, the slower growth rate will generate a much bigger addition to the size of China’s economy—and a much bigger opportunity for the companies we invest in.

Will China’s consumer story hold up this year?
Yes, but—as with almost everything else in the Chinese economy—the growth rate will be slightly slower.

As noted earlier, income growth has been decelerating, and that process will continue. I also expect the Party’s anti-corruption campaign - that has had a modest negative impact on retail sales—to continue. Both of these factors have led to slightly slower growth in consumer spending, with real (inflation-adjusted) retail sales growth going from 11.5 per cent in 2103 to 10.9 per cent last year. With income growth expected to continue to slow, this year will likely deliver “only” about 10 per cent real retail sales growth. Slower, but still the world’s best consumer story. (For reference, in the US, retail sales were up about 2 per cent last year.)

This is also consistent with central bank data showing that today more than 70 per cent of new loans are priced above the benchmark lending rate, up from 48 per cent in 2006. This reflects more lending to (riskier) small private firms, as it is unlikely that a significant share of loans priced above the benchmark rate are made to SOEs or government agencies.

This data is consistent with the conclusions of Nick Lardy’s recent book, Markets Over Mao: The Rise of Private Business in China. Nick, an economist who has written presciently about China since the 1970s, concludes that “the access of private firms to bank credit has improved so much that on average new bank lending to private firms in 2010–12 was two-thirds more than to state firms.”

Another example of reform is that last year, for the second consecutive year, the tertiary part of the economy (services, retail and wholesale trade in addition to finance and real estate) accounted for a larger share of GDP than the secondary* part (manufacturing and construction).

Last year the Party began reform of the hukou, or household registration system. Launching this complex and expensive reform program is a sign that the new Party leadership is willing to take on big challenges. Hukou reform should also reduce the risk of social instability for some of the 230 million people living in cities who face de jure discrimination on a daily basis, particularly due to their ineligibility for social services and subsidized housing. Over time, hukou reform should also boost consumption and raise manufacturing productivity.

But we need to maintain realistic expectations for the pace and scope of reform. The days of dramatic, big-bang changes are over, in large part because Chinese society would not accept the mass state-sector layoffs that were tolerated 20 years ago. This is one reason why I have low expectations for further SOE reform in the near future. Closure of many money-losing and indebted steel and cement plants isn’t likely for a few more years, while the Party wrestles with the problem of how to deal the unemployment consequences of shutting the largest employer in small cities.

I recognise that more modest reforms designed to boost the efficiency and productivity of state-owned enterprises are likely to only generate modest results. For me, however, this is acceptable, as I prefer the Party continue to focus on improving the operating environment for the private firms that drive China’s growth.