For local authorities, China may seem a long way away, especially given their focus on bank deposits and secured UK investments for the treasury portfolio and the limited exposure to emerging markets on the pensions side. But its undeniable impact on the global economy, its flexing of geopolitical muscles and its growing role as an international source of capital are all highly relevant for the macroeconomic environment that local authorities are exposed to today.
6.9%.
That was the rate of expansion for the Chinese economy in 2018. It exceeded the government’s target of 6.5% and the 2016 low of 6.7%, and it may seem stratospheric compared to the growth we see these days in the UK.
But that is all scant comfort. In actuality, the number continues to hug the trough of the last three years and is a far cry from the average growth of recent decades, for example, the 10.2% average annual rate for the thirty years from 1981 to 2011.
At the same time, it hid nuggets of hope. The per capita disposable income for urban households grew by 6.5% in real terms compared with a year ago, while that for rural households jumped by an even stronger 7.3% in real terms.
The numbers tell a narrative of two poles. The first is that growth is slowing. The second is that the Chinese consumer continues to grow in affluence and spending power.
How that narrative evolves is key to the future trajectory of the Chinese economy and the global economy.
Fuel & Faust
The record growth of the last few decades was fuelled by the growth of the manufacturing sector and enormous amounts of investment in fixed assets, initially industrialisation, then property and more lately infrastructure.
The reason was simple. It is far easier to boost GDP through projects. Ambitious large scale development initiatives require large amounts of investment. As GDP is a measure of expenditure, the only real limitation to growth is how much you wish to spend. And of course, that spending may be fuelled both through revenue and debt.
The net result is faster growth to the bottom line. In a system of command capitalism, the concentrated control of monetary and debt levers, as well as the need to meet ambitious regional targets, often in the short-term, provide additional incentives. Lastly, there was the belief that all this investment would provide jobs for China’s vast labour force, mitigating social tensions.
In all this, China has been unconsciously retreading the policies of the first Roman Emperor, Augustus, who constructed 82 temples and undertook countless other projects, all in an effort to palliate the ire of a Roman populace weary of economic stagnation and where one-third depended on the state for sustenance. However, as Augustus and his successors found to their cost, the boost to both growth and employment was transient and required constant investment to maintain.
Nevertheless, China has embraced this complex Faustian bargain. Wages have been suppressed in an effort to contain labour costs — the largest expense for most businesses — and provide a valuable subsidy to the growth of the export sector. The dominance of state-owned enterprises (SOEs) in the financial services sector has ensured savings have been concentrated into large deposit pools that can be effectively directed to provide financing as needed. Alongside, caps on the interest paid have been an effective form of financial repression that has lowered the cost of capital.
The result has been an economy that has become increasingly unbalanced over the last three decades. The consumer has shrunk from contributing some 50% to the economy (already a low number compared to the developed world) to a nearer 40% today. Meanwhile, fixed asset investment has grown rapidly to take its place.
Consumers
This trajectory, however, is now under threat. Current levels are unsustainable. First, the required growth rate (in excess of GDP growth) requires an ever larger supply of debt. Second, the growing misallocation of capital means increasingly lower returns on capital deployed and a greater danger to social stability. Consequently, as bad debts pile up beneath the surface and painful corrections beckon, the current model of Chinese growth is no longer a feasible or politically palatable option going forward.
The Chinese government has been very open about its desire to transform the economy from being export-led to instead being domestically driven. In short, the consumer is being asked to step up to the plate and take over.
That is eminently sensible. Proponents point to arguments such as the steep fall in the poverty line over the period; the strong growth in incomes; and the rapidly growing middle class and their conspicuous appetite for pork, luxury goods and so on. Indeed, China is now the second largest market for luxury goods in the world, and the largest consumer of automobiles.
These are impressive facts. However, something important has been lost in translation when moving from a collection of isolated statistics to the holistic stage of the Chinese economy.
The current economy has left some large boots to fill. Unfortunately, the Chinese consumer has swaddled his feet over the last three decades to the extent they are too petite today to fit immediately.
The arithmetic does not work. The vicious circle of suppressed wages leading to low demand leading to the need for more investment than ever to drive growth has meant that the levels of growth now needed for domestic consumption to take over again are staggering. For example, to return the consumer back to constituting a 50% share of the Chinese economy over a decade whilst maintaining GDP growth even at the current growth rate of 6.9% would require household consumption to compound at 9.6%.
These are numbers far in excess of historical growth rates and optimistic. They also face the powerful headwind of a savings rate that has rapidly increased over the same period to north of 50%. Unless this is addressed, any attempt to stoke domestic demand is doomed to failure. Simply put, the Chinese need to save less and spend more. The Chinese will not save less by edict. Rather, the government needs to tackle the fundamental causes as to why an entire population is obsessed with hoarding an ever greater proportion of their newfound wealth.
Geopolitical muscles
This may all seem domestic detail and far removed from English shores, but its tremors are reaching globally.
China has been a growing engine of global growth, but it also has significant challenges to overcome if it is to maintain this, as noted above, and a commensurate growing debt pile to work out. Today, China debt to GDP ratio is comparable to the UK and may rise further yet. That creates fragility and the risks of a credit-led financial crisis, just as the world is finally moving on from the last one.
As the US obsesses inwards and moves further away from the international stage, China is stepping up. The country is certainly flexing its geopolitical muscles and seeking to emphasise its position as a new pole of influence in today’s world. Beyond economic policy and military initiatives, Chinese capital — plentiful for now — is moving globally.
Chinese firms are making significant international acquisitions, investing more overseas and buying trophy assets, for example, the Leadenhall Building in the City of London. Chinese influence and participation is growing rapidly in areas such as technology, renewables and retail.
For UK investors, it is a double edged sword. The influx of capital and the engine of Chinese growth are needed if the economic perils of Brexit are to be navigated effectively. Certainly, in a post-Brexit world, China is a key partner to court for any UK government. It may also provide a valuable support to markets that seem largely expensive today.
But the excess of capital accentuates the low yield environment, and increases reliance on China as a driver of UK growth. It also exposes the UK more to the underlying fragility of China’s awkward debt pile and the politics of reorienting the Chinese economy. As an example, the stretch of property developments from Battersea to Nine Elms are now colloquially called ‘Singapore upon Thames’, thanks to the investment largely flowing from China and Singapore. In renewables, Chinese overcapacity and a desire to grow their own economy has led to a dramatic fall in costs, making projects economically viable.
To ignore the dynamics and influence of the Chinese economy, even in a UK centric investment portfolio, would be to miss a key influence.
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Dr Bob Swarup is Principal at Camdor Global Advisors,
a macroeconomic, investment and risk advisory firm
focused on helping local authorities innovate to meet
today’s unique challenges.
He may be contacted at swarup@camdorglobal.com.
