China’s economy slowing but far from freefall

Listening to the news of late, you would think China is in financial meltdown. This simply isn’t the case – growth is slowing down but the country is not heading for financial collapse. It is important to remember that the Chinese economy is being restructured so there is a better balance between consumption and investment spending. The current slowdown is a largely a reflection of this transition.

Of course, it is critical to understand the nature of the risks posed by China. The sharp rise in the Chinese debt burden means the solvency of various heavily indebted sectors has come under scrutiny. We should also remember that the Chinese economy remains extremely closed in terms of their capital account. As at the end of 2013, before capital outflows started in earnest, it was a net creditor to the world to the tune of around $2tn (€1.8bn).

Growth in China continues to slow as a result of the slowdown in big-ticket Fixed Asset Investment (FAI). At one point, this reached a high of almost 50 per cent as a share of GDP. Emerging nations transitioning towards more developed economies often have sustained cycles of elevated fixed investment expenditure as they aim to push productivity closer to developed economy levels. Indeed, Japan and Korea went through similar periods in their move to developed economy status.

The good news for China is that the non-manufacturing sector is expanding at a steady pace. The non-manufacturing PMI remains in expansion territory (above 50), averaging 53.7 over the last 12 months.

This compares to a manufacturing PMI which has averaged 50.1 over the same period, signalling little or no growth. This is a clear sign the economy is rebalancing in favour of non-manufacturing, the majority of which is services.

In the past high levels of investment have, in some instances, been channelled into uneconomic projects where the rates of return have been inadequate to service the debt. However, most financing has been domestic. This gives the government more room to cushion the investment slowdown by selectively supporting struggling projects. This helps to avoid the domino effect of falling asset prices and tightening credit conditions.

Furthermore, with a central government debt to GDP ratio of 41 per cent in 2014, the Chinese government has considerable fiscal space to support growth. Large foreign exchange reserves are available should the need arise to support various systemic entities in the case of financial stress. Total international reserves stand at around $3.5tn, including $1.2tn in US treasuries.

The Chinese government is committing to a number of reforms to drive consumption spending. The easing of the one child policy is one which will help boost consumer spending among younger households. Investment needs to be eased further in order to address economic imbalances but the transition to consumption led growth is ongoing and will be gradual.

Of course, monetary policy has a role to play here given the effect the manufacturing sector is having on broad-based economic growth. As inflation is falling, Chinese policymakers have ample room to reduce real interest rates to support economic growth.

In terms of opportunities, we see these in the consumer discretionary sector of the Chinese equity market, which appears cheap both in relative and absolute terms as it has been impacted by the sharp rise in uncertainty, while displaying stronger underlying fundamentals. 

Salman Ahmed, Global Strategist, Lombard Odier Investment Managers