Alex Muromcew, Managing Director, Active Emerging Markets Strategy
For more than two decades, robust growth has been a hallmark of China’s economy. There is increasing evidence, however, that the rate of expansion will be slowing in the not-so-distant future. In March, China’s government announced a reduction in its annual growth target rate, from 8% to 7.5% for 2012 and to 7% over the next five years.
China’s approach to managing its lower growth rate will determine its economic future. Specifically, China will have to transform its economy from one that depends on exports for growth to one that is more reliant on domestic consumption. Along the way, we believe this transformation will affect the U.S. economy and financial markets, given the trade ties linking the two economies together. It also underscores the need for U.S. investors to be cautious when seeking exposure to the Chinese market.
Challenges facing China’s economy
China’s high-octane growth has sometimes obscured the many issues facing the country’s economy. With the government now acknowledging slower growth ahead, those challenges are likely to receive more attention from both the government and investors. The government’s ability to address the multiple challenges will influence whether or not the country meets its economic growth targets.
Real estate: One major challenge is reducing prices in the country’s residential real estate market. According to Chinese government statistics, housing prices quadrupled from 2007 through 2011.1 There has been a modest decline this year, but not enough to satisfy Premier Wen Jiabao. “Housing prices are still far from a reasonable level,” he said in March.2 With the Chinese government determined to drive down prices, and pursue more rigorous efforts to curb speculation, there’s a risk that this process could weaken the economy, given that housing and real estate development have helped to drive the country’s growth.
Banking: A related issue is the stability of the Chinese banking sector. An economic slowdown, and a major downturn in the country’s real estate market, will weaken banks’ profitability. The country’s banks are also believed to have a higher ratio of non-performing loans than they’ve disclosed, according to an April report issued by Fitch, the credit rating agency. Moreover, many Chinese banks have extended credit to local governments through off-balance-sheet vehicles, in order to skirt rules prohibiting local governments from borrowing money. There are now questions about whether the local governments will be able to pay off these debts.3
Inflation: Another ongoing challenge is maintaining a low inflation rate, which Premier Wen has cited as the country’s highest economic priority.4 The official annual inflation target is 4%, but in 2011 inflation was 5.4%. Rising food and fuel prices threaten to continue driving up prices, putting a squeeze on Chinese consumers and potentially forcing the government to impose measures that could intensify the economic slowdown.
Demographics: One of the biggest long-term economic challenges facing China is changing demographics. From 2010-2050, the country’s working-age population as a share of the total population is projected to shrink quite significantly. By 2030, nearly 25% of China’s population will be over the age of 65, according to the World Bank.5 The growing share of the population over the age of 65 will impair the country’s ability to deliver low-cost labor and could contribute to higher wages and inflation. With fewer workers to support retirees, the demographic challenge could also place economic stress on the country’s budget: Less than 25% of workers today have any pension coverage, so expanding the pension system could result in significant increases in pension obligations. But in the absence of a more robust pension system, consumption will continue to remain at a very low level, as individuals save for retirement and health care — a scenario that could also depress economic growth.
China’s currency appreciation
One example of positive change has been an appreciation in the value of the country’s currency. For many years, China has been criticized by the U.S. government and others for maintaining what was said to be an undervalued currency, which had the effect of subsidizing exports and giving China an unfair advantage in trade. Since 2005, however, there has been a 30% appreciation in the value of the country’s currency – a development that U.S. Treasury Secretary Tim Geithner has described as “very significant and very promising.”6
One byproduct of this rise has been a shrinking of the country’s current account surplus, which measures how much China exports in goods and services relative to its imports. The surplus was more than 10% of GDP in 2007, but last year it fell to 2.8% of GDP, and it is expected to continue to fall.7 The appreciation of China’s currency, coupled with a rise in labor costs, should help foster China’s transition from growth based on exports to growth that’s driven more by domestic consumption. Today, Chinese government statistics report consumption levels at approximately 33% of GDP (in contrast to the U.S., where consumption amounts to about 70% of GDP). While some believe consumption is higher in China than official statistics reflect, Premier Wen has nonetheless said that “expanding consumer demand” is a high priority.8
Economic growth disconnected from market growth
For investors, one of the oddities of the Chinese market is that the strong economic growth has not translated to strong market returns. While the country’s gross domestic product nearly quintupled from 2000 to 2011, the country’s benchmark index, the Shanghai Composite, only increased 46% during this period — and inflation ate into much of that growth.9 In 2011, the index fell more than 20%. This poor performance reflects investor concerns regarding the limited disclosure and lax regulation governing the A shares of companies listed on the Shanghai Composite. These conditions, coupled with the challenge of realizing attractive returns, have driven away retail investors, while institutional investors have tended to steer clear of the A share market. With no major reforms of regulation or disclosure expected in the near future, it will continue to be risky to invest in companies that are listed on stock exchanges in China.
The investment opportunity
A key growth driver for China has been foreign direct investment into the country’s manufacturing sector. Investing in the companies making direct investments in China can be an attractive way to can gain exposure to the Chinese market, often with less volatility than investing in China-listed companies. For instance, U.S. consumer goods companies, particularly in the automotive and food and beverage sectors, are expected to expand their presence in China: With China’s domestic consumption on the rise, U.S. luxury and fast-food brands are making inroads, while some U.S. automotive companies are now selling more cars in China than they do in the U.S. Although China’s growth is slowing, companies operating in China can still generate strong returns, given that the country’s economy is projected to expand much faster than either the U.S. or European economies.
The degree to which U.S. companies will continue to invest in China will be affected by the pace of China’s future economic expansion, and the country’s success in overcoming short-term and long-term challenges. Monitoring China’s progress in dealing with these challenges, as well as the level of U.S. exports, should be a top priority for investors determined to increase their exposure to the country.
This material is for informational purposes only and should not be regarded as investment advice or a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Past performance is no guarantee of future results.
Investing involves risk of loss of principal.
TIAA-CREF Individual & Institutional Services, LLC and Teachers Personal Investors Services, Inc., members FINRA, distribute securities products.
1 Financial Times, December 13, 2011: http://www.ft.com/intl/cms/s/0/6b521d4e-2196-11e1-a1d8-00144feabdc0.html#axzz1oriXhOUV
2 Financial Times, March 21, 2012: http://www.ft.com/intl/cms/s/0/6a003a34-7245-11e1-8497-00144feab49a.html#axzz1tpmDiiae
3 TIAA interview and http://ftalphaville.ft.com/blog/2010/04/07/196651/the-chinese-siv/
4 “Wen: Hard to Keep China Inflation Below 4%,” Wall Street Journal, Journal, June 27, 2011: http://online.wsj.com/article/SB10001424052702304314404576410541520463016.html
5 Speech by World Bank President Robert Zoellick, April 16, 2012: http://web.worldbank.org/WBSITE/EXTERNAL/EXTABOUTUS/ORGANIZATION /EXTPRESIDENT2007 /0,,contentMDK:23171466~menuPK:64822311~pagePK:64821878~piPK:64821912~theSitePK:3916065,00.html 6 “Yuan Appreciation Tops 30 Percent,” CQ Roll Call, May 3, 2012: http://media.cq.com/blog/2012/05/yuan-appreciation-tops-30-percent/
7 TIAA interview
8 “China cuts growth target to 8-year low, to boost consumption,” Reuters, March 5, 2012: http://www.reuters.com/article/2012/03/05/us-china-economy-idUSTRE82400120120305
9 Financial Times, May 1, 2012: http://www.ft.com/intl/cms/s/0/4c38bfc4-92b3-11e1-b6e2-00144feab49a.html#axzz1tpmDiiae