However you look at it, growth in China is decelerating. Fixed investment growth in particular – and domestic data confirms this. China's leaders have made reducing risk, ensuring financial stability and containing leverage top priorities and therefore shifted their focus from ‘growth at any cost’ to ‘quality growth’. But just how successful have they been?
In our second Credit Quarterly Outlook of the year, we refer to China as one of the three locomotives of global growth. But China’s GDP growth has been heavily dependent on debt-financed investment since the global financial crisis and credit growth has outpaced nominal GDP growth for the last few years, especially if you take shadow credit into account. This high and rising debt level has long been one of investors’ greatest concerns, as the derailment of a global powerhouse of this magnitude would have a huge knock-on effect on the global economy and bond markets. But China is taking action. Hong Kong-based Senior Credit Analyst Tiansi Wang took a closer look at how the world’s second largest economy is tackling some of the economic challenges it is currently facing.
Over the past five years, the extent to which credit-intensive investment has driven growth has gradually decreased. Since 2012, year-on-year growth in manufacturing investment has decelerated, falling from 31.8% in 2011 to 4.1% in October 2017. Low single-digit growth is set to continue in the near term, driven by investment in manufacturing upgrades and technology innovation (including AI, high-end machine tools, new energy vehicles and biomedical industries).
In terms of infrastructure, investment has continued to increase at a brisk pace, but we expect further deceleration here too in 2018. Overall fixed asset investment growth is set to slow this year from 7.2% in 2017 to around 6%, as the effects of deleveraging and the government’s tightening measures start to kick in. Central government has also halted some planned projects, sending a signal to local governments that they wish to contain debt and investment at grassroots level.
‘Services and consumption now account for around 70% of GDP growth’
So while investment in most areas is falling, services and consumption are now on an upward trend, accounting for around 70% of GDP growth. The willingness and ability of the younger, wealthier generation to consume has spurred a structural spending upgrade in terms of the products they purchase, with booming consumption in information services, smart home appliances, cultural services, tourism, healthcare and education. The stable employment situation, strong labor market and resilient wage growth will continue to boost disposable income and play a key role in GDP growth in 2018.
The government’s aim is to gradually bring down the debt-to-GDP ratio without causing too sharp a slowdown in growth; to “effectively control leverage” in the economy and to de-risk. The main focus has been on reducing financial system risk, especially shadow banking leverage, which is probably the most vulnerable piece in China’s debt puzzle. Banks are an important source of funding for shadow banking through non-bank financial institutions (NBFI). This form of financing, often via riskier vehicles, ballooned from CNY 7 trillion (USD 1.1 trln) at the end 2013 to CNY 24 trillion (USD 3.77 tln) in mid-2016, mostly through the inter-bank market. Since late 2016, tighter rules have led to a decline in banks’ shadow financing activities, with the growth of their claims on NBFI decelerating from 80% YoY in early 2016 to 11% by late 2017.
The property sector is pivotal to the Chinese economy, with property-related industries accounting for around 25% of China’s GDP in 2016. In terms of urbanization, China’s housing area per capita has risen from 2m2 in the 1990s to 41m2 today (the level of the Netherlands) but is now slowing, while the impact of leverage on the property market is also lessening due to the current tighter policy. Shantytown reconstruction remains a growth driver, boosted by local government efforts to deal with these areas of cheap housing and poor infrastructure, and to provide affordable housing while reducing the large property inventory overhang in smaller cities. We expect China’s national housing sales growth rate to continue to decelerate and bottom out in the first half of 2019, with real estate investment also slowing to around 3% in FY18, compared to a still strong 7% in FY17.
GDP remained surprisingly strong in 2017, with 6.8% real growth. This is driven in part by the structural shift towards more consumption-driven growth, but the buoyant global economy is also a contributory factor. Shadow credit growth has slowed sharply and the strong GDP figures have helped narrow the gap between debt and GDP growth. The leadership’s focus for the next five years is on reducing financial risk, combatting pollution and tackling poverty. And although the 2018 real GDP growth target is 6.5%, this will no longer be part of local government performance evaluation – which should be a key factor in helping to change behavior from the bottom up.
This paradigm shift in China offers plenty of opportunities for investors. In Robeco’s credit portfolios, the China exposure is focused on the new economy. For example, we have holdings in the gas distribution segment to capitalize on the transition to cleaner power sources and we avoid the old economy industries of mining and steel. We also invest in the bonds of companies that are set to benefit from the shift to a consumer-driven economy.
It remains to be seen whether China will be successful in completely eradicating the credit excesses of the past and tackling the negative overhang in terms of the debt-to-GDP ratio without seriously hurting longer term growth. In a market economy it would be difficult to successfully implement the current strategy, but with their ‘Chinese economic model’ they may well succeed. At any rate, the first signs look reasonably positive.