Is a China economic crisis on the horizon?

September 7, 2015 Categories: Markets

russell-investments-wire-blog-market-china-overlook

Maybe, but not right now

The timing hinges on two major issues:

  • Structural factors
  • Short term pain

Firstly, China has tremendous structural challenges that it’s trying to navigate regarding economic growth. Over the last 20 years, China’s economic growth rate has been spectacular and has been driven by two principal factors: investment and exports. China has been transitioning from a rural agrarian economy to an urbanized industrial one in order to massively increase labor productivity and the country’s wealth. Effectively, they’ve gone through their own intense industrial revolution.

The development of urban areas and industrial capacity required massive investments but the good news is that these investments yielded even larger gains in productivity and national wealth. The challenge is that after 20 years of spectacular investment, the impact on productivity now is significantly lower than on previous investments (your first best investment idea is almost always better than your 10,000th idea). One market concern is that many of the investments made in China over the past five years are not going to turn out to have been good ones. If this is true, the inefficient allocation of capital likely lowers future economic growth rates. And massive inefficient allocations of capital create massive economic challenges in the future. This is what worries us.

An investment-led economy comes at the cost of consumption. In addition to the challenges noted above, a low domestic consumption rate ensures that China’s growth rate will continue to be enormously dependent on the developed world. Given these challenges, the Chinese government has sensibly embarked on a long-term economic policy to balance their economy, raise domestic consumption from the current level of 37% of GDP1 and lower the dependence on investment.

This transition has been extremely difficult for every country that has accomplished it because consumption doesn’t dramatically increase over night and it’s impossible for the government to directly control the rate of consumption. Government fiscal stimulus through investment can immediately impact economic growth (Keynesians2 rejoice). The principle being that if you shut off the investment spigot, the economy might “immediately” slow down, but consumption doesn’t necessarily immediately expand at the same rate—and this can result in short-term pain.

On this second point, what China is trying to do is limit the amount of short-term pain while effecting this transition. But last week, we got confirmation from the People’s Bank of China (PBOC) that their pain threshold is actually quite low3. Think of it as “if the target economic growth rate is 7%, below 6% seems to be too painful” for the Chinese government. So, we expect to see more monetary easing and an increase in fiscal investment. China has between US$3.5 trillion (with a T) and $4 trillion in hard currency reserves4; a lot of money in the bank to ease the pain of this economic transition. As I recently mentioned in our Global Market Outlook Q3 Update video, we think that the growth rate in China will be between 6% and 7% over the next year. And we believe that the current softness of the Chinese economy does not pose a serious threat to the global economy.

That said, just because the Chinese government thinks it’s necessary to ease the pain doesn’t make investments any more attractive. If we’re right about pain threshold, China could be throwing good money after bad to “sleep better” tonight. The short-term cost likely makes future problems bigger and could potentially lower the standard of living going forward. This should not come as a surprise because it is almost always the case that everything you do to make it easier to sleep better tonight, creates a problem in the future—a lesson that applies to individuals and governments alike.

1 World Bank. Data, “Household final consumption expenditure, etc. (% of GDP)” – China 2014.
2 Keynesian economics is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy).
3 Source: People’s Bank of China (PBOC), August 25, 2015. Monetary policy is countercyclical. The fact that the PBOC lowered rates and the reserve requirement ratio indicates a threshold was reached for them to take action.
4 Bloomberg.com. “$4Trillion Peak in China’s FX Hoard Frees PBOC’s Hands: Economy.” January 11, 2015.

Editorial note: This post first appeared on our sibling blog, the Russell Blog, and was produced in the US for an American audience on 28th August 2015.
 
Erik Ristuben, Chief Investment Strategist
 
Erik-Ristuben

  1. No comments yet.
  1. No trackbacks yet.

This blog is not intended for retail investors. The opinions expressed herein are that of Russell Investments, are not a statement of fact, are subject to change and, unless they relates to a specified investment, do not constitute the regulated activity of “advising on investments” for the purposes of the Financial Services and Markets Act 2000.

This material does not constitute an offer or invitation to anyone in any jurisdiction to invest in any Russell product or use any Russell services where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation.

Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate.

The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

Copyright © Russell Investments 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

The Russell logo is a trademark and service mark of Russell Investments.

Issued by Russell Investments Limited. Company No. 02086230. Registered in England and Wales with registered office at: Rex House, 10 Regent Street, London SW1Y 4PE. Telephone 020 7024 6000. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS.