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Could China surprise on the upside?

Manu Bhaskaran
Manu Bhaskaran • 10 min read
Could China surprise on the upside?
SINGAPORE (Oct 14): The relentless slowing of the Chinese economy is one important reason why the global economy has been so lacklustre in the past year. The latest full set of economic indicators, for August, showed the economy continuing to struggle. Ho
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SINGAPORE (Oct 14): The relentless slowing of the Chinese economy is one important reason why the global economy has been so lacklustre in the past year. The latest full set of economic indicators, for August, showed the economy continuing to struggle. However, preliminary data for September has raised hopes that the economy may be starting to regain a bit of traction. So, what exactly is happening to the Chinese economy and what does it mean for us?

Our impression from our recent visit to China is that there are two areas where China could do better than many observers expect. The first is the near term, where the risks are indeed real. But, China’s policy measures are finally working, and we expect economic growth to pick up momentum in the coming months. The second is the longer-term outlook — it appears that the authorities are re-formulating strategy so that China could surprise the pessimists by containing the impact of an increasingly hostile US and pulling off a successful transition to a higher-value economy.

The economy is gradually overcoming the current headwinds

The economic and financial trends were sobering over the past few months. Economic activity — such as industrial production, investment and exports — was trending down, despite all the government’s efforts to reverse the slide. Even consumer spending lost traction, with car sales in particular performing poorly. As exports contracted, many small and medium-sized businesses in the coastal provinces closed down and laid off their workers. Partly as a result, there was more evidence of financial stresses. For example, three small city banks had to be bailed out by state-affiliated parties. Many shadow banking platforms also went out of business.

However, the Purchasing Managers’ Index surveys for September detected the beginnings of a turnaround. The Caixin manufacturing PMI picked up in September to reach its highest level since February last year. Caixin’s services PMI nudged lower for the month, but the forward-looking indicators were strong — the pipeline of new businesses grew at the fastest pace in 20 months and firms increased employment at the most robust pace in 32 months.

Going forward, there are more reasons to expect a revival in economic growth.

  • First, local governments have brought forward their bond issuance aggressively, giving them the firepower for a surge in infrastructure spending in the next few months, which will boost demand and encourage private sector firms to raise capital spending. In addition, we hear that local officials are overcoming their fear of the anti-corruption campaign and now signing off on contracts because they feel that since China is under pressure from a hostile US, it is their patriotic duty to help out with boosting the economy through infrastructure spending.
  • Second, the monetary authorities have been pushing banks to step up credit to the small and medium private enterprises. As these firms, representing the most vibrant segment of the economy, are fuelled up, they are likely to help drive the economy to a faster pace. The central bank has also reformed the structure of interest rates to improve the effectiveness of policy changes to boost credit.

The remaining risk in the short term then is the financial sector. The excessive expansion of credit after 2008 took place in the context of an economy with a poor credit culture and where new but weakly regulated financial platforms had become more active. Not surprisingly then, there are many financial imbalances that could threaten stability. For instance, more small city banks are likely to need rescue in the coming months; there are many more that have failed to report their 2018 financial results, a possible indicator that they are in trouble. However, financial regulators are aware of the risk and have been quick to act. There will be a cost to this, of course, in the sense that government resources will have to be used to rescue these banks or the big national banks will be forced to bail out the small banks. But, the financial system should hold up.

The key to policy will be what happens to unemployment, since that can lead to social unrest. For now, it looks like the workers who lose jobs in manufacturing are being fairly quickly absorbed in services vocations, and at reasonably good wages. Policymakers will watch the economy closely and if unemployment worsens, they have a reserve of other stimulus measures that they will feed into the economy in a calibrated manner.

What is the outlook for the longer term?

After trade talks with the US broke down in mid-year, prompting US President Donald Trump to ramp up aggressive tariff increases on Chinese exports, China’s immediate outlook seemed threatened, but there were some positive effects for the country.

First, the political and business elite as well as the intelligentsia decided to rally around Chinese President Xi Jinping. Where before there had been murmurings of discord over Xi’s consolidation of personal power, the feeling now is that with China under attack from an aggressive foreign power, it was no longer right to point fingers and quarrel. Xi thus came out of the turbulent past few months stronger and facing less resistance to his foreign and domestic policies.

Second, and more importantly, China’s leaders paused to rethink and overhaul their approach to girding China for the longer term. A new strategy, still evolving, is taking shape:

  • China will ramp up efforts to create more self-sufficient manufacturing supply chains and build up its indigenous innovation capacity. There will be an aggressive increase in spending on R&D.

  • China will press ahead with financial sector reforms, with a focus on interest rate liberalisation and careful internationalisation of the renminbi.
  • State enterprises will be reformed and encouraged to work more closely with private sector firms. In some cases, hybrid mixed-ownership enterprises involving both state and private firms will be formed to spearhead industrial upgrading in specific priority areas.
  • There will also be a push for rural revitalisation. Farm plots, currently too small to allow improvement in agricultural yields, will be consolidated into more optimally sized plots run by the more successful farmers, while other farmers will be encouraged to move to urban areas.
  • Urban policy will be focused on creating several massive urban agglomerations: A total of 10 such metro regions are planned, which will bring together a critical mass of capital, labour, knowhow and ideas to unlock economies of scale and scope. The coalescence of smaller markets also creates the potential for domestic demand to undergird future growth. There is an instinctive sense that scale is in China’s favour.
  • The Belt and Road Initiative will continue to be a major plank of policy, with the aim of weaving the rest of Eurasia into China’s political and economic space. Chinese policymakers have recognised that the initial iteration of the BRI had caused some problems, so they are recalibrating the BRI to make it more appealing to China’s partners.

While these initiatives are laudable and have a good chance of success, there is one area that these plans do not address, and that is China’s weakening performance in productivity. An authoritative study of productivity trends in China by the World Bank found that much of the slowdown in total factor productivity growth since the global financial crisis can be accounted for by the lack of “churn” in the corporate sector — that is, not enough unproductive, loss-making firms are closing down and being replaced by the entry of more productive ones. The larger reason behind this is the current leadership’s keenness on state enterprises and its reluctance to shift away from policies that essentially disadvantage the private sector, and a political economy that keeps “zombie” state enterprises alive. Unless there is some change in this area, China’s grand strategy to become a more technologically sophisticated economy will struggle to deliver results.

What are the implications for this region?

China’s footprint in geopolitics and the global economy is now so large that anything it does will have a sizeable impact on others. The big changes described earlier will affect Southeast Asia in many ways.

First, at the diplomatic level, China will step back from its highly assertive stance of the past decade — but only selectively. It will continue to pursue its national ambitions in a vigorous and unapologetic manner, as is evident in its still-aggressive operations in the South China Sea, where both the Philippines and Vietnam have recently complained about Chinese intrusions into their territories. But China better understands now that it is engaged in a long tussle with the US and that it needs as many friends as possible, so aside from territorial disputes, it is likely to be more careful than before not to alienate countries in the region.

Second, China is more confident that it can withstand US pressure on the trade and other fronts, such as the rash of measures recently to blacklist Chinese technology companies and restrict visas to Chinese officials involved in security measures in Xinjiang. On trade, it will not make concessions demanded by the US in areas such as industrial policy and the role of state enterprises, which it believes are core to its model of development. But it is likely to give the US enough to allow a limited deal on trade to be agreed with the Americans.

Third, if we are right, and China is able to revive its economy in the coming months and eventually secure a short-term deal with the US on trade, there will be positive effects on the region. Global business confidence will improve, commodity prices should recover and demand for the region’s exports is likely to improve. Global investors would feel less risk-averse if they believed that China’s recovery would improve the global economy, and that would encourage more capital to flow into the region’s financial markets.

Fourth, because any deal with the US will be limited in nature, the long-term strategic contest between the two powers will continue. That will encourage firms that are still wavering to get on with relocating more of their production facilities out of China. In that case, Southeast Asia will be a big winner.

Fifth, China’s economic strategy will now focus on self-reliance and indigenous technological development. This may mean that China will depend less and less on this region for intermediate goods such as electronic components. This strategy could also bring China more into conflict with the US, and raise the risk of a bifurcation of the technology world into rival US and Chinese camps. That outcome would be a setback for everyone, including this region.

In short, the Chinese economy will undergo important inflexions in the coming years. On balance, most of these changes are likely to have a positive impact on Southeast Asia.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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