While the news headlines continue reminding us of China’s stock market woes, investors should dig deeper to understand the economic underpinnings that can spark growth in China—and, in turn, present opportunities for growth seekers.
The Chinese economy recently entered a slowdown period, with reported economic growth rates falling to around 7% and as low as 5.3%, according to some economists’ calculations. While this may seem robust from a developed markets perspective, it is a far cry from the years of double-digit growth rates China had previously enjoyed. Slowing growth is problematic for the nation, as high rates of economic activity are needed to absorb the influx of labor into the country’s burgeoning cities and to use the massive production capacity China installed over the past decade.
The Beijing government is acutely aware of the problem. When new leadership took over in 2013, it adopted the term New Normal to reflect the nation’s current economic reality and rejected calls for further stimulus measures. However, since late 2014, the slowdown of economic activities has intensified. The question for now seems to be, is New Normal enough? And if not, what are the long-term solutions for reigniting China’s economy?
Assessing China’s short-term economic fixes—supportive, but not enough
In recent months, Chinese policymakers have dramatically stepped up efforts to support the economy:
- The People’s Bank of China slashed the reserve requirement ratio for banks twice and cut interest rates several times.
- The central government injected fresh capital into the country’s three policy banks to support lending for infrastructure projects, trade, and agriculture.
- The Ministry of Finance launched a local-government debt swap program to replace high-cost bank borrowings with local-government bonds.
- In addition, housing policies were relaxed to support the slumping property market.
Despite the Chinese government’s best efforts, the results of its policies are mixed. Economic growth continued to slow in early 2015. Major macroeconomic indicators, such as the Purchasing Managers’ Index, retail sales, and fixed investment, remained sluggish.
Government officials also implemented a number of policies aimed at supporting the stock market, including the Shanghai–Hong Kong Stock Connect program, which expands foreign investors’ access to the domestic market and domestic investors’ access to Hong Kong–listed securities. It appears the government has been trying to use the stock market as a stimulus to channel savings into the corporate sector, and direct financing through the stock market was encouraged over indirect financing through the banks. This drove a massive rally in Chinese stocks through May 2015. But even then, the rally was due, in part, to a buying frenzy among local Chinese investors, and the stock market’s absence of fundamental drivers suggests that a substantial speculative element was at play.
Today—without fundamental growth drivers in place—China’s markets have collapsed into bear-market territory, exposing the fragile foundations on which the recent bull market was built. Investors who follow China are likely to see a tug-of-war between speculative fervor and tepid fundamentals for some time.
China’s long-term economic solution—focusing on the middle class
The root cause for China’s slower growth is a decline in investment activity, primarily in infrastructure and property. Unsold apartments are piling up across the country, and municipalities have indigestion from a decades-long, debt-fueled spending binge in anticipation of growth that never fully materialized. China’s overinvestment resulted in the undesirable consequence of high leverage in the economy because most investments were funded by bank lending. The total credit-to-gross domestic product (GDP) ratio in China exceeds 200% (depending upon who is doing the measuring), the bulk of which accumulated after the financial crisis.
Now, every percentage point of incremental economic growth requires about twice the amount of credit growth as before, meaning more debt is required just to keep growth rates stable. As a result, already-high leverage is bound to rise further if China’s current growth model remains unchanged.
China’s long-term economic solution lies in finding new sources of growth, including developing the country’s domestic market and expanding its exports into value-added products and services. To its credit, the Chinese government has implemented policies to promote such growth. For example, recently enacted household registration reform, which allows migrant workers to settle in cities in which they are currently employed, should stimulate local demand. In addition, the so-called One Belt, One Road strategy to expand infrastructure investment cooperation with countries along the historical trade routes covering Asia, the Middle East, and Africa should drive regional trade and help soak up excess capacity in the Chinese economy.
With Beijing’s policy moves in motion, how are Chinese businesses finding and capitalizing on future sources of growth—and which industries are showing potential?
We favor companies that serve China’s middle class, which should benefit from the government’s long-term plan to encourage domestic consumption. As people gain income, they tend to indulge their desires for higher-quality foods, cigarettes, and clothing, so consumer staples stocks seem especially well positioned. We are also positive on industries such as life insurance, health care, and online services. One example of a company serving the nation’s middle class is Ctrip.com, a leading online travel agent in China. As Chinese consumers continue to become more affluent, they will travel more and increasingly use the internet to make their arrangements. Ctrip.com seems poised to take advantage of that trend.
In short, China’s New Normal looks much like the old normal of the developed world. It just might take the country a while yet to get there, with plenty of opportunities for investors along the way.
Jerry Zhang, Ph.D., CFA has more than 15 years of experience managing emerging markets portfolios and is the lead portfolio manager of the Wells Fargo Advantage Emerging Markets Equity Fund.
As of 6-30-15, Ctrip.com was 1.36% in the Wells Fargo Advantage Emerging Markets Equity Fund.
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This story originally appeared in Advisor Perspectives.
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