Is a pivotal change in the Chinese economy hiding in plain sight?

Liu He – Who he?

Well, just possibly, Liu He is the most important economic policymaker in the world. In a formal sense, he has no more impressive a title than “Economic Adviser” to China’s President Xi Jinping, who has just given himself an open-ended grip on power over the world’s second biggest economy.

He (Mr Lui that is, pardon the pun) may, or may not be the “anonymous person with authority” who wrote an article in the People’s Daily in May 2016 articulating the need for structural reform. But we do know that he was accorded the considerable honour earlier this year of being the only keynote speaker at one of Davos’ main sessions who was not a national leader.

Has China’s change gone unnoticed?

It is often the case that seismic change in China comes without some great declaration from the metaphorical heights of the Forbidden City. A small experimental commune in Chayashan, Henan province, was the early warning of the catastrophic Great Leap Forward. Similarly the obscurely named “May 16 Notification” of 1966 was the harbinger of the Cultural Revolution.

In the late 1970s, few realised that the snappily named “Household-Responsibility System” marked the start of key agricultural reforms that marked the beginning of an astonishing economic transformation of the Middle Kingdom.

We would argue that the evidence suggests the article of 9 May 2016 may well be an equally pivotal moment. Hopefully a harbinger of a benign change in China’s economic direction.

It is perhaps germane to recall the gist of the article, as reported by Reuters.

“China may suffer from a financial crisis and economic recession if the government relies too much on debt-fueled stimulus, the official People’s Daily quoted an “authoritative person” on Monday as saying.

“The People’s Daily, official paper of the ruling Communist party, in a question and answer interview quoted the person as saying excessive credit growth could heighten risks and trigger a financial crisis if not controlled properly.

“Trees cannot grow to the sky. High leverage will inevitably bring about high risks, which could lead to a systemic financial crisis, negative economic growth and even wipe out ordinary people’s savings,” the person, who was not named, said in response to a question on whether stimulus should be used in future economic policy.

“We should completely abandon the illusion of reducing leverage by looser monetary conditions to help accelerate economic growth.”

This time they’re serious

So are these more than pious platitudes to placate the many foreign critics (amongst whom we number ourselves) of China’s credit-fuelled growth model?

It is easy to be cynical, but the hard evidence would suggest that the authorities are serious about rebalancing growth. That is, away from its dependency upon ever larger dollops of mis-priced capital to mobilise resources (ghost towns, roads to nowhere, white elephants) and towards greater productivity, better returns on capital, and more rational pricing of that capital.

In the first place, it is clear that China is steadily tightening monetary conditions, as seen in monetary conditions indices and the recent course of interest rates, leading to a more rational pricing of capital (see Charts 1 and 2 below).

It is also clear that, after the now traditional quick “panic” resort to state owned enterprise (SOE) investment spending (see the spike up in SOE and Central Government Fixed Asset Investment (FAI) in Chart 3 below) the stimulus has been allowed to fade surprisingly rapidly and is now growing at almost the lowest levels in a decade.

This has been accompanied by a vigorous campaign (for which it was high time) against some of the more egregious private sector empires built up on the shaky foundations of short-term insurance and wealth management products.

The effective nationalisation of Anbang, and arrest of its principle executive (grandson-in-law of Deng Xiao Ping himself) is of more than symbolic importance. A side benefit has been the collapse in outward direct investment (Chart 4). In short, a marker is being put down on mis-investment whether its genesis is public or private sector.

(An exception will, of course, be made for projects with over-arching geopolitical motivations. Do not bank on One Belt One Road (OBOR) or New Silk Road projects sharing in the new found parsimony.) 

Consequently, the ratio of credit growth to nominal GDP growth is now as low as it has been since a brief period in late 2011, primarily thanks to a steep slowdown in credit channeled through non-bank agencies (see Charts 5 and 6).

And at least, in the short-term, the incremental capital-output ratio (ICOR)¹ is improving…but the big issue is will it last?

Will it last?

In the last decade (since the great spending splurge of 2008/9), the Chinese economy has responded to stimulus with a regularity of which Pavlov’s dog would be proud.

The last time the ratio of credit growth to nominal growth flirted with this level presaged the dramatic slowdown in nominal growth seen in 2012 (see Chart 5). However, while we accept that the engineering of “a bit of a slowdown” is always tricky, it is notable how each fiscal/monetary stimulus has been progressively milder, and how far the leadership has accepted (again without any big pronouncement on the subject) a steadily lower trend growth, of which consumption is contributing a consistently increasing proportion. We have highlighted in red the years of fiscal/monetary stimulation – and the picture is clear (Charts 8 and 9).

The analysis also highlights a crucial difference between the most recent (in many ways rather mild stimulus) and previous ones, and that is the degree to which credit creation has been channeled through the consumer sector (see Charts 10 and 11 below).

However, we believe that this is more than simply re-jigging in which balance sheet to flex, which would be somewhat akin to the old switching deck chairs on the Titanic trick.

A clue came in Liu He’s speech at Davos, where he said “Our focus needs to change from “Is there enough?” to “Is it good enough?”…this transition to a new model of development will create huge opportunities for many industries. This may well include manufacturing and service industries related to higher-quality consumption, as well as energy-efficient buildings, smart transportation, new energy…it means new opportunities for businesses…”

The key message is that the leadership fully recognises that, as a middle income economy, growth will inevitably slow, and that the factor-intensive growth model (more cheap capital and labour) is no longer valid.

No-one needs to tell the leadership in Beijing that the working age population has started to decline.

The mantra now is productivity and supply side reform to move up the value added scale. Talk of 600 km/hr trains and hypersonic planes capable of Mach 7 sounds aspirational. And it probably is. But it is also symptomatic of the ambition which, in a more practical way, is handing 80 exabytes² of data over to medical researchers, aims for 20% of auto sales to be electrical vehicles or hybrids EV by 2025, and has mandated significant cuts in low grade capacity across steel, coal and chemical production.

Welcome developments for stockpickers

However, there also seems to be a recognition that there are limits to how far the state can either dictate or achieve these aims. As stockpickers, we welcome the increasing participation of the private sector given a more rational pricing of capital, less crowding out, and (potentially of very great significance) the fact that productivity growth is now outpacing labour cost growth (See chart 12 below). No more than a cloud the size of a man’s hand, perhaps. 

In summary, the cooling of the Chinese economy is, in many ways, to be welcomed as it reduces the unsustainable imbalances that have grown over the last decade. There are inevitable risks of over-shoot, but China still has the capacity to touch on the accelerator (aka a quick call to the China Development Bank for half a trillion or so), while a more sustainable (albeit lower) growth model would be rewarded with a sharp reduction in the China risk premium.

Of equal interest from a stockpicking point of view is the (qualified) unleashing of the private sector, and the long-term investment opportunities that  will bring. Taiwan produced one company of global importance, TSMC. It does not seem out of proportion for there to be 20 or so among the 3000 plus companies listed on the A share markets.

Sadly, as the scale of Liu He’s strategic vision comes to be more fully recognised, the paucity of the West’s strategy (eg tariffs on steel) is all too apparent. However, there has arguably never been a more exciting time to be a stockpicker in Asia.

^{1. ICOR basically refers to the additional capital required to generate additional output. For example, if 20% additional capital is required to push the overall output by a percent, the ICOR will be 20.↩}

^{2. An exabyte is equivalent to one billion gigabytes. One estimate is that an exabyte could contain 100,000 times the printed content of the Bodleian Library in Oxford.↩}