Striking out misconceptions on China
It was a bumpy summer for investors in the Chinese equity market, and those watching their short term investments could be forgiven for experiencing the jitters. However, despite this short term volatility, a thorough analysis of the underlying characteristics of the Chinese economy suggests that longer term investors still have every reason to feel positive. Many commentators are currently not fully appraising the large-scale shifts occurring in the Chinese economy and may be judging its prospects using indicators such as GDP growth, which fail to capture these changes. Contrary to the sentiments of some detractors, many negative issues related to the Chinese equity market are overstated in the context of long-term potential.
A long term perspective invariably smooths out short-term noise, and an examination of the solid fundamentals of the Chinese economy will correct those misconceptions based on limited data collected in the immediate term.
Misconception 1: Official growth statistics are unreliable
The greatest economic movement occurring in China is the shift from a secondary to a tertiary economy. As this shift takes place, so should the economic indicators which analysts use to judge the health of the Chinese financial system. However, this isn’t currently the case: while residential property prices, airline passenger volumes, 4G subscriber growth and box office grosses all look resilient, these are largely ignored in appraisals of Chinese growth statistics. Historically, power demand has been closely correlated to growth in China, an economy reliant upon power-hungry activities such as manufacturing. The service economy is much less energy-intensive, so it would be expected that an economy shifting towards the tertiary sector could continue to grow while only demonstrating minimal increases in power consumption. As a result, it is entirely reasonable that the kind of growth demonstrated in the first half of 2015; 7%; could be achieved without a commensurate increase in energy consumption.
Misconception 2: Consumption won’t replace the declining portion of the economy
As the secondary sector declines, the tertiary sector will continue to grow. However, in the short term, there may be a vacuum effect as the growth of the service economy catches up with the relative shrinkage of manufacturing. As evidence, some consumer brands such as McDonalds, TingYi (the biggest Chinese instant noodle company) and various luxury brands have reported negative numbers from China. This only tells half the story though. We also see companies like UNIQLO and Nike continue to generate greater than 20% growth, while Netease is growing its online gaming revenues by more than 40%. It is clear that Chinese consumption behavior is changing rapidly. It is getting more sophisticated thanks to the development of e-commerce and an increasing number of young consumers, as well as the expanding middle class. Despite all the changes and occasional gloom, the fact remains that China’s headline retail growth stands firmly above 10%. The huge consumer demand of 1.3bn people is China’s biggest advantage. A tertiary sector which is now close to 50% of the total economy continues to grow at double digit pace, and it will continue to drive the Chinese economy to grow and rebalance in the long term.
Misconception 3: High debt level will delay any reforms.
The Chinese total debt/GDP ratio is above 200%. This is not a reassuring figure in isolation, but we have seen clear signs that Chinese government has recognised the major problems and is working on different ways to contain the risk. Several measures are already in place, such as greater transparency in local government debt borrowing, gradual opening up of capital markets targeting the inclusion of the RMB in the IMF’s Special Drawing Rights (SDR). It is also important to emphasise that, despite recent volatility, there has been no large scale default in the financial or corporate system to date. On the contrary, some credit should be granted to the Chinese government: that the property market has been stable and economic regulation is moving in the right direction. For those with a long term interest in the Chinese economy, there are signs that investments will be able to flourish.