China: Managing the Slowdown

China continues to manage its long-term economic slowdown relatively smoothly, despite dangerously high debt. But how much longer it can keep things smooth, as the economy continues to slow, is questionable. Defaults on bonds have risen and the industrial sector remains chronically weak. That said, the trade agreement, as well as a global economic lift in H1 should hold things together this year. I worry that China will struggle in future years since it is losing the capacity to stimulate the economy.

Official data show GDP growth slowed to 6.1% year-on-year in Q4 2019. This is almost certainly an over-statement in our view and real growth, properly measured, would likely be in the 3-5% pa range. Still, this is sufficient for a country which now has a declining working-age population. And the growth slowdown has had the desired effect of restraining the rise in the debt ratio. But debt remains worryingly high.

Heavy industry is weak

Behind the economic slowdown are two big stories. One is the weakness in the heavy industrial sector as years of rapidly growing investment, particularly in property and infrastructure, grind to a halt. Property construction held up well in 2019 but residential floor space sold was almost flat suggesting that a slowdown in construction is in store. Meanwhile the government continues to direct money into infrastructure, particularly in inland regions, but spending is not growing much anymore, partly because local authorities face greater debt constraint. This means that not only is China left with overcapacity in sectors such as steel, cement and glass, but there is no need to invest further in these areas.

The trade war is on pause

The trade war exacerbated this weakness in 2018-19 as business confidence waned and manufacturers struggled to route exports and production via other countries to avoid US tariffs. The phase one agreement on trade this month is bringing some improvement in confidence, already evident in business surveys, but the effect is likely to be muted. President Trump’s attitude to trade has prompted a root-and-branch reappraisal of supply chains among both Western and Chinese companies and is likely to mean lower investment in China and more in south-east Asia as well as Mexico and the US. A new US President would not alter this as the Democrats are not much in favour of free trade either, especially with China.

Too much debt

The second big story is China’s excessive debt. To deal with the 2008 slump, China embarked on a massive infrastructure boost. When the economy slowed again in 2011, the stimulus was renewed. As a result, China has seen the biggest credit binge in history. Government debt expanded from 45% of GDP in 2009 to 80% (estimated) in 2019, according to the IMF’s ‘augmented’ debt measure which includes local government and other off-balance sheet vehicles. Meanwhile household debt has risen from very little to 56% of GDP and non-financial corporate debt to 124% of GDP. All these levels are high for an emerging country although, on the plus side, China’s savings rate is also quite high and China still has a current account surplus.

High debt (across the board) has three consequences. First, there is a great deal of bad debt in the system even though it is not reported as such. If the economy were to slow too much or especially if GDP actually declined, there would be major distress. Secondly, awareness of this means that creditors and investors are very much looking to the government to keep things stable and bail out the system if necessary. Thirdly, any attempt to boost economic growth by encouraging more borrowing will make the economy even more vulnerable. Hence the delicate balancing act.

A dynamic service sector

Over the last year, the government has managed to steer a middle course between re-inflating credit growth and allowing too much of a slowdown. Helping them considerably is that despite the problems in the industrial and property sector, China has a dynamic service sector – including retail, software, education, restaurants and other personal services - which is helping to provide growth and jobs even as industry stagnates. There has been a rise in defaults on bonds, even from state enterprises, but the government continues to tread very cautiously, anxious not to undermine confidence.

China’s slowdown is a global risk

Investors should be aware that China’s slowdown is a key force in the world economy. It hurts emerging countries, particularly commodity producers, though it is also helping to keep a lid on world inflation. In 2019 it was already a major factor in Germany’s economic weakness. If it were to get much worse, or more unstable, it could easily trigger the end of the world economic upswing. In short China’s unbalanced economy is one of the key risks to the world economy and markets, though, at the moment, I think the risk is unlikely to crystallise in 2020.