China’s economic growth appeared to pick up in the second quarter of 2016. Gross domestic product (GDP) expanded at 7.1% quarter-on-quarter seasonally adjusted, compared to 6.2% the previous quarter. Factory output, retail sales and exports all looked strong, deflation continued to moderate and there was a steady improvement in corporate profits.
But these high-level figures hide a complex picture of regional and sectoral differences arising from the progress of China’s economic transition. In some areas, like Chongqing, one of four municipalities that are directly controlled by central government, the economy is growing rapidly. The province’s economy grew by 10.6% in the first half of 2016, and industrial output by 10.2% – as demand for its major manufacture – cars – rose.
However, in north-eastern provinces in China’s rustbelt, the economic picture looks pretty bleak. Provincial data show that China’s worst-performing provincial economy, Liaoning, contracted by 1% in the first half of 2016 and factory output declined 7.7%.
The service sector once more grew as a proportion of GDP to 51.9%, at a rate of 7.5% year-on-year in the second quarter of 2016. But this growth is not equally spread. What is evident, says Greg Kuhnert, Strategy Leader for Asia in the 4Factor Equity™ team, is that there’s been “a pick-up in consumption, particularly in lower-tier cities, where consumers are playing catch-up.”
He believes that this situation reflects the state of development in China’s less-developed regions and cities. “For companies to maintain their growth trajectories,” he says “they must capture this demand, particularly in higher-end products as brand awareness increases among these consumers.”
Figure 1: China gross domestic product growth by industry, 2014-2016
The private and public sectors are also behaving differently. China’s purchasing manager indices (PMIs), which take the pulse of factory activity by surveying companies, seem to present very different stories. The official government measure surveys 3,000 primarily state-owned companies, while a private one, produced by Caixin-Markit, a media and research group partnership, sends questionnaires to 500 mainly small, private businesses on China’s east coast. In July’s PMI the official measures showed manufacturing starting to dip, while Caixin-Markit showed the highest manufacturing growth since February 2015.
Figure 2: China manufacturing purchasing managers’ index: Caixin-Markit vs. official measure
The difference between the public and private sectors is also evident in fixed asset investment (FAI). While China’s overall FAI has more or less stabilised, private investment seems to have plunged and that of the public sector has jumped.
Figure 3: Private vs. state-owned fixed asset investment, 2013-2016
This is partly due to a reclassification of which companies are ‘private’, but we believe that the main driver for weaker private FAI is weaker revenue and profit growth in the sectors that account for the bulk of private investment, such as manufacturing, mining and real estate.
The strong SOE FAI mainly reflects strength in infrastructure and social service investment, as the government continues to try to boost the economy by building new infrastructure and upgrading existing networks, such as power lines, regardless of the short-term returns.
China’s credit markets continue to expand. In June the International Monetary Fund (IMF) issued a warning to Beijing to tackle corporate debt levels in state-owned enterprises (SOEs), by liquidating the weakest firms and restructurings. Defaults are rising from a low base. More than 20 bond defaults have been confirmed this year – an unprecedented number – as many companies, especially in industries with surplus production, struggle to meet their obligations amid China’s economic transformation.
Figure 4: China non-performing loans, 2011-2016
Source: Bank for International Settlements Debt Service Ratios Statistics
In August the government acted to dispel the perception that it will always backstop losses for SOEs. An editorial in the People’s Daily, the official communist party mouthpiece, stated that bond defaults by Chinese SOEs should be handled through market-based mechanisms and the legal system. “Guaranteed repayment of bonds raises risks in SOE bonds and leads to higher leverage ratios and a build-up of risks,” the editorial said.
By talking tough on defaults, Beijing seems to be keen to slow the rate at which corporate debt is growing. Currently credit growth is outstripping that of GDP by double-digit percentage points and the authorities are keen to slow this to come more in line to the economy as a whole. The China Banking and Regulatory Commission has also proposed to local banks and financial institutions for a coal and steel debt-to-equity programme to be established to help reduce the debt load.
Figure 5: China non-financial sector credit growth, 2009-2015
Source: Bank for International Settlements Total Credit Statistics
This trend may not necessarily be unwelcome, as it suggests China recognises that weaker companies should be allowed to fail. But which companies will default is hard to spot. China’s domestic credit-rating agencies have given an investment-grade rating to 99.5% of all publicly issued bonds.
But again there are mixed messages. On 4 August, the National Business Daily published a piece suggesting that banks should act together and not “randomly stop giving or pulling loans.” Rather it suggested that they should either provide new loans after taking back the old ones or provide a loan extension, to “fully help companies to solve their problems”.
The official line on SOE reform has been articulated in a commentary published on China’s official newswires service, Xinhua: “Reform is the only way forward for China’s economy… for there is no plan B.”
As Mike Hugman, strategist in the Emerging Market Fixed Income team points out, “there has been some meaningful capacity reduction plans in coal and steel this year, but the key question now is implementation.”
The consolidation of the steel industry – a sector that exemplified China’s zombie enterprise problem – is underway. The most notable example is the proposed merger of Shanghai Baosteel Group Corporation and Wuhan Iron and Steel (Group) Corporation to become the world’s second-largest steelmaker. However, in 2015 Chinese steel demand was million tonnes below steel production capacity, so the plans to reduce capacity by between 100 and 150 significantly over the next five years still appear very modest.
But Beijing is still wary of attacking excess capacity head on by shutting uneconomic factories down due to the potential economic and social impact. To soften the blow, Beijing is looking for productive ways to channel excess capacity using the huge Eurasian infrastructure initiative, One Belt, One Road. According to data from fDi Markets, China-backed greenfield infrastructure investments across Belt and Road countries in the 18 months to June 2016 doubled over the previous year and a half.
But, as Greg Kuhnert highlights, the Ministry of Finance has also set up a special fund to provide funds for layoff costs and fiscal and financial support. Greg believes that this “has encouraged local governments to implement de-capacity plans.” Indeed, some local governments may have taken assertive measures to get to grips with the enterprises they can control. Shanghai, for example, has been praised by the People’s Daily for its restructuring of local SOEs, by taking a targeted approach and treating enterprises distinctly depending on whether they were competitive, functional or public service businesses.
But while there is progress in some areas, in others there has been a step back. In June the Communist party moved to tighten its grip on SOEs, giving greater power to party cells within every SOE, which appeared to fly in the face of policies to make SOEs more efficient and market-orientated. Moreover, President Xi’s anti-corruption drive has seen the removal of many senior figures in the country’s largest SOEs. Almost all their replacements are party members – which gives them a rank equivalent to the government officials that regulate them.
The renminbi has been on a fairly consistent depreciating path versus the China Foreign Exchange Trade System (CFETS) renminbi index (the basket of trading partners’ currencies that Beijing implemented in December 2015), with some volatility around big moves in the US dollar spot index (DXY).
Initially the renminbi strengthened against the US dollar as the American currency generally weakened over the first half of 2016, but it weakened against the CFETS basket – a goldilocks scenario that helped China to contain capital outflows, as investors capitulated on their long view on the US dollar.
Figure 6: Renminbi vs the US dollar, 2015-2016
China has also benefitted from the UK’s unexpected vote to leave the European Union. The market shock that accompanied the result on 24 June, enabled Beijing to weaken in the RMB against the CFETS basket without causing market panic, as it had done on previous devaluations. The People’s Bank of China decided to manage the renminbi “with reference to a basket”, but it has not kept it stable, instead allowing the currency to depreciate steadily.
Figure 7: Renminbi, the US dollar and the CFETS basket, 2015-2016
“We have seen the pace of depreciation at times up to 20% annualised”, says Mark Evans an analyst in the Emerging Markets Fixed Income team, “but it would be hard to expect that pace of depreciation going forwards without it triggering more capital outflow pressures. We believe that depreciation of around 8% or so feels about right on the longer term.” While there is likely to be some volatility, we expect the exchange rate to be stable near-term ahead of two important policy events, September’s G20 summit and October’s renminbi inclusion in the Special Drawing Rights (SDR) basket of currencies, which effectively confers global reserve currency status.
An important aspect of integrating China into the global economy is the internationalisation of the renminbi. This aim advanced in December last year when the IMF agreed to include the Chinese currency in its SDR basket. There were, however, questions about whether the renminbi met all the criteria. By including the currency in the SDR basket the IMF hoped to encourage China to fully liberalise the renminbi by 2020. But in fact, it appears that the reverse has happened. The renminbi’s share of payments via the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network has fallen over the past year from a high of 2.79% in August 2015 to just 1.96% at the end of June 2016.
Surprised by the volatility and weakness over the past year, investors and corporates have reduced renminbi deposits held in banks in Hong Kong, Taiwan and South Korea over the past year. While investment inflows, which indicate willingness to hold Chinese assets, have also fallen 38% over the same period.
Beijing’s unpredictable policymaking history of the past year or so – state intervention in the stock markets and sudden currency devaluations – has also played its part. “We expect more policy clarity once we know the identity of the top echelons truly calling the shots after the leadership transition of the Politburo Standing Committee next year,” says Wilfred Wee, portfolio manager in the Emerging Markets Fixed Income team.
Mark is an investment specialist in the Global Emerging Market Fixed Income team. He is responsible for analysis and modelling of key emerging market countries in the research universe and is responsible for covering Asia specifically. Mark joined Investec Asset Management as part of the summer internship programme before spending the next three years in the institutional client service team.
Prior to joining the firm in 2007, he went to Loughborough University where he graduated with a Bachelor of Science (Hons.) degree in Accounting and Financial Management. As part of his degree, Mark spent one year in the industry working for AXA Framlington Investment Managers. Mark is a CFA Charterholder and also holds the Investment Management Certificate (IMC).
Mike is an emerging market debt strategist for the Emerging Market Fixed Income team. He is responsible for the in depth analysis of major emerging market economies, generating trade ideas including top-down/global themes, quantitative modelling, and building dialogues with policy makers.
Prior to joining Investec Asset Management, Mike worked at Amiya Capital, a global/emerging market equity hedge fund where he was an economist, and before that, he was an emerging market economist and strategist at Standard Bank, London. Prior to Standard Bank, he spent two years working as a technical advisor to the Budget Office, Nigerian Ministry of Finance. Mike graduated with distinction with a Master of Philosophy in Economics and a first-class Bachelor of Arts (Hons) degree in Philosophy, Politics and Economics, both from the University of Oxford.
Greg is the portfolio manager for the Asia Pacific ex Japan and Asia ex Japan Equity strategies and also co-portfolio manager of the China Equity Strategy in the 4Factor Equity Team at Investec Asset Management.
Greg joined Investec Asset Management in 1999 working as an analyst researching Asian and global equities. Prior to this, Greg spent five years at Ernst & Young in Johannesburg, South Africa, within auditing and consulting, where he specialised in mining and financial companies. He qualified as a Chartered Accountant in 1997. Greg graduated from the University of Witwatersrand in Johannesburg, SouthAfrica, in 1994 and achieved a first-class degree in Accountancy and is a CFA Charterholder.
Wilfred is an investment specialist in the Global Emerging Market Fixed Income team and a portfolio manager. He is responsible for the Asia Local Currency and Renminbi Bond funds. Prior to joining Investec Asset Management, Wilfred worked for the Government of Singapore Investment Corporation (GIC) for nine years, three of which were based in New York. At the GIC, he was a portfolio manager and lead credit analyst for emerging market credit, focused on Asia. He was also a credit analyst and strategist responsible for European financials.
Wilfred holds a Bachelor of Arts (Hons) degree in Economics from the University of Cambridge, a Master’s degree in Financial Mathematics from Stanford University, and is also a CFA Charterholder.
Please use the links below to access previous editions of The China Indicator.
Five key indicators for the Chinese economyRead more
A reform-driven proposal for Chinese growthRead more
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