Consensus still holds that the Chinese economy will grow about 7.5% this year and next, but risks to economic activity are the downside as China’s new leadership seeks to restructure the economy. Investors can expect increased policy-induced (from financial sector reform) volatility in Chinese equities. In addition, prospective strains in the Chinese financial system risk spilling over into the real economy. Investors should acknowledge that China has substantial policy flexibility to respond to economic weakness but, at the same time, monitor the market very closely. An allocation to Chinese equities is reasonable as part of a broadly diversified global portfolio, but investors should be prepared for a bumpy ride.
China’s leadership transition, initiated the same week as the U.S. presidential election, is as important a development as the re-election of Barack Obama. China is now the world’s second largest economy and represents roughly 10% of global output versus 22% for the U.S. Since the full government transition in March 2013, President Xi Jinping and Premier Li Keqiang, who holds a PhD in economics, have been surprisingly proactive. They face a daunting set of challenges, including reorienting the economy from investment led to consumption led.
A principal preoccupation of China’s new leaders, who are expected to govern for 10 years, is to avoid the “middle-income trap,” in which growth stalls because the policies that were so successful in the past are no longer effective in current circumstances. From 1978 to 2007, Chinese output and wages grew roughly at 9.5% per annum—a staggering achievement. But this trajectory was facilitated, in part, by an extraordinarily high level of savings and investment (roughly 50%) of GDP, financial repression, subsidies and an undervalued exchange rate. These policies have led to excess capacity in manufacturing sectors (such as steel and bicycles) and the misallocation of credit. The Chinese economy faces large problems (as do the U.S. and European economies), including an increasing capital/output ratio and increasing credit intensity of growth.
China’s leaders recognize these issues and are in the early phases of embarking on a series of structural reforms. They have targeted a 7.5% medium-term growth rate and are emphasizing the quality of growth.
One such reform was a recent attempt to restrict the growth of China’s “shadow banking system” (i.e., non-bank intermediated credit.) This effort led to a sharp but temporary increase in the Shanghai Interbank Offered Rate (SHIBOR). Rates fell after the People’s Bank of China provided liquidity to the market. But the incident reminded investors of the lack of transparency in China’s financial system and the difficulties small and medium-scale enterprises face in obtaining credit.
The full contours of Chinese economic policy will be evident in the months to come, particularly after a Communist Party of China meeting in October. The reforms are likely to lead to more sustainable growth in the medium term and include accelerated internationalization of the renminbi. China’s growth is unlikely to fall below 7% in the next 18 months. And, at eight times earnings, the Chinese A-share market has priced in known risks. But global investors are still getting used to a revised Chinese growth model, and the next several months could be volatile.
George R. Hoguet is a global investment strategist with State Street Global Advisors. george_hoguet@ssga.com
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