Five myths about the Chinese economy (continued series on China updated Jan. 13, 2016)
Jonathan Woetzel, the author of this feature is a director in McKinsey’s Shanghai office, as well as a director of the McKinsey Global Institute. TextileFuture concludes that this feature shows some important facts on China. Please note that TextileFuture has eliminated the reference list of literature contained in the original publication by Mc Kinsey’s Global Institute. Woetzel’s colleague, Gordon Orr, Director Emeritus of McKinsey and Senior External Advisor advocates the following changes in China for 2016 and beyond, and we add his conclusions to the feature
Again, last week the stock exchange halting provoked further negative reactions, including drastic losses at the major world exchanges. During that week the battering that China’s currency and stock markets are taking is emblematic of the pessimism settling over many corners of the world’s second-largest economy. Businesses in the manufacturing heartland of the south and the east—from makers of electronic gadgets to textiles and furniture—talk of slack orders and late payments. Meanwhile, the traditional heavy industrial engines of steel, cement and glass remain saddled with excess capacity built up in the boom years.
“Everyone thinks this will be a very troubled year,” said Willy Lin, managing director of Hong Kong-based Milo’s Knitwear Ltd., which exports skirts, suits and other apparel to Europe and the U.S. from its factory in Dongguan, a city in southern Guangdong province. “No numbers point to a rosy picture. It will be pretty turbulent.”
However, investors and businesses are losing confidence in Beijing’s ability to manage increasingly complex problems as demand shrivels and growth slows. Government intervention, which seemed to supercharge growth upward for years, is now fuelling concerns as new, often poorly communicated policies generate turbulence in the stock and currency markets.
“People doing business here long-term have known for a couple of years that growth is much less than the government says it is,” said Conference Board economist Andrew Polk, who believes actual growth is closer to 4%. “Now global markets are coming to this rolling realization of economic weakness that started over the summer. I know with quite a bit of certainty we’re going to get more economic and financial volatility in China.”
In a further test of government credibility, the latest troubles come on the heels of an annual economic policy meeting last month that laid out near-term policies. That blueprint committed the government to lowering costs for businesses to spur investment and reduce the redundant factories, empty apartment blocks and high levels of debt that have dragged down growth for the past four years. A senior official described the policies as “supply-side” remedies and said the government realistically expected an L-shaped recovery, rather than a V-shaped rebound.
Economists caution that early and hard-fought momentum could slip in the first quarter as factories close for the Lunar New Year holiday celebration in February and local governments wait for economic targets traditionally released at the annual parliament meeting in March. Retail spending also could slow this year if unemployment increases in a slowing economy.
“The main problem is not rising costs now. The problem is there’s little demand,” said Li Chao, owner of a shirt and trousers maker in the eastern textile hub of Jiangyin near Shanghai. “Most firms I know of face the same problem.”
Mr. Li said he is not planning to cut his 20-member workforce, but he also is not thinking about expanding the business. Customers, he said, are taking longer to settle their accounts. “It is getting harder and harder to get paid,” he added. “We are a small business. This is not looking good.”
All told, economists said, Beijing appears reluctant to take the tough steps needed to reboot the economy away from smokestack industries to propel a shift favouring households and small businesses and avoid getting mired in a period of low growth and stagnating incomes.
Holding China back is a concern that shutting down underperforming companies will further damage growth, boost unemployment and increase the risk of social unrest that Beijing fears, economists said. China has signalled that it plans this year to set a five-year average growth target of 6.5%, a pace economists said will require more government-directed spending and less reform.
That outlook is hammering expectations among businesses and investors. “Whatever the intentions of the government are, more and more market forces are having an indelible impact on what’s happening here,” Mr. Polk said. “And those forces are putting more pressure behind the need to reform. Right now there seems to be a lot of tension between the masters and the market.”
Due to the continued turmoil, we timely offer some soothing recipe by Jonathan Woetzel :
The five arguments against such pessimism
Predictions of deepening economic woes are plentiful as we all well know. Here are five arguments against the pessimism.
A widely held Western view of China is that its stunning economic success contains the seeds of imminent collapse. This is a kind of anchoring bias, which colours academic and think-tank views of the country, as well as stories in the media. In this analysis, China appears to have an economy unlike others—the normal rules of development have not been followed, and behaviour is irrational at best, criminal at worst.
There is no question, of course, that China’s slowdown is both real and important for the global economy. But news events like this year’s stock-market plunge and the yuan’s devaluation versus the dollar reinforce the refrain, among a chorus of China watchers, that the country’s long flirtation with disaster has finally ended, as predicted, in tears. Meanwhile, Chinese officials, worried about political blowback, are said to ignore advice from outside experts on heading off further turmoil and to be paranoid about criticism.
Woetzel’s experience working and living in China for the past three decades suggests that this one-dimensional view is far from reality. Doubts about China’s future regularly ebb and flow. In what follows, I challenge five common assumptions.
1. China has been faking it
A key tenet of the China-meltdown thesis is that the country has simply not established the basis for a sustainable economy. It is said to lack a competitive, dynamic private-enterprise structure and to have captured most of the value possible from cheap labour and heavy foreign investment already.
Clearly, China lacks some elements of a modern market economy – for example, the legal system falls short of the support for property rights in advanced countries. Nonetheless, as China-economy scholar Nicholas Lardy recently pointed out, the private sector is vibrant and tracing an upward trend line. The share of state-owned enterprises in industrial output continues to drop steadily, from 78 % in 1978 to 26 % in 2011. Private industry far outstrips the value added in the state sector, and lending to private players is growing rapidly.
In fact, much of China’s development model mirrors that of other industrializing and urbanizing economies in Asia and elsewhere. The high savings rate, initial investments in heavy industries and manufacturing, and efforts to guide and stabilize a rapidly industrialising and urbanising economy, for example, resemble the policies that Japan, South Korea, and Taiwan followed at a similar stage of their development. This investment-led model can lead to its own problems, as Japan’s experience over the past 20 years indicates. Still, a willingness to intervene pragmatically in the market does not imply backwardness or economic management that is heedless of its impact on neighbouring economies and global partners.
Furthermore, China’s reform initiatives since 2013 are direct responses to the structural changes in the economy. The new policies aim to spur higher-value exports, to target vibrant emerging markets, to open many sectors for private investors, and to promote consumption-led growth rooted in rising middle-class incomes.
Today, consumption continues to go up faster than GDP, and investors have recently piled into sectors from water treatment to e-commerce. These reforms are continuing at the same time China is stepping up its anticorruption drive, and the government has not resorted to massive investment spending (as it did in 2008). That shows just how important the reforms are.
2. China’s economy lacks the capacity to innovate
Think tanks, academics, and journalists alike maintain that China has, at best, a weak capacity to innovate—the lifeblood of a modern economy. They usually argue as well that the educational system stomps out creativity.
My work with multinationals keen on partnering with innovative Chinese companies suggests that there is no shortage of local players with a strong creative streak. A recent McKinsey Global Institute (MGI) study describes areas where innovation is flourishing here. Process innovations are propelling competitive advantage and growth for many manufacturers. Innovation is at the heart of the success of companies in sectors adapting to fast-changing consumer needs, so digital leaders like Alibaba (e-commerce) and Xiaomi (smartphones) are emerging as top global contenders. Heavy investment in R&D – China ranks number two globally in overall spending – and over a million science and engineering graduates a year are helping to establish important beachheads in science- and engineering-based innovation. (See “Gauging the strength of Chinese innovation,” on www.mckinsey.com)
3. China’s environmental degradation is at the point of no return
To believe this, you need to think that the Chinese are content with a dirty environment and lack the financial muscle to clean things up. OK, they got things wrong in the first place, but so did most countries moving from an agrarian to an industrial economy.
In fact, a lot that’s good is happening. Start with social activism. A documentary on China’s serious air-pollution problems (Under the Dome), by Chai Jing—a former journalist at China Central Television (CCTV), the most important state-owned broadcaster—was viewed over 150 million times in the three days after it was posted online, in March 2015. True, the 140-minute video, which sharply criticizes regulators, state-owned energy companies, and steel and coal producers, was ultimately removed. The People’s Daily interviewed Chai Jing, and, she was praised by a top Environmental Minister.
China is spending heavily on abatement efforts, as well. The nation’s Airborne Pollution Prevention and Control Action Plan, mandating reductions in coal use and emissions, has earmarked an estimated USD 277 billion to target regions with the heaviest pollution. That is just one of several policy efforts to limit coal’s dominance in the economy and to encourage cleaner energy supplies. My interactions with leaders of Chinese cities have shown me that many of them incorporate strict environmental targets into their economic master plans.
4. Unproductive investment and rising debt fuels China’s rapid growth
To believe this, one would have to think, as many sceptics do, that the Chinese economy is fundamentally driven by overbuilding—too many roads, bridges, and buildings. In fact, as one economist has noted, this is a misperception created by the fact that the country is just very big. An eye-popping statistic is illustrative: in 2013, China consumed 25 times more cement than the US economy did, on average, from 1985 to 2010. However adjusted for per-capita consumption and global construction patterns, China’s use is pretty much in line with that of South Korea and Taiwan during their economic booms.
China’s rising debt, of course, continues to raise alarms. In fact, rather than deleveraging since the onset of the financial crisis, China has seen its total debt quadruple, to USD 28.2 trillion last year, a recent MGI study found. Nearly half of the debt is directly or indirectly related to real estate (prices have risen by 60 % since 2008). Local governments too have borrowed heavily in their rush to finance major infrastructure projects.
While the borrowing does border on recklessness, China’s government has plenty of financial capacity to weather a crisis. According to MGI research, state debt hovers at only 55 % of GDP, substantially lower than it is in much of the West. A recent analysis of China’s financial sector shows that even in the worst case – if credit write-offs reached unprecedented level – only a fairly narrow segment of Chinese financial institutions would endure severe damage. While growth would surely slow, in all likelihood the overall economy would not seize up.
Finally, the stock-market slide is less significant than the recent global hysteria suggests. The government holds 60 % of the market cap of Chinese companies. Moreover, the stock market represents only a small portion of their capital funding. Also, remember, it went up by 150 percent before coming down by 40.
Rumours drive the volatility on China’s stock exchange, often in anticipation of trading by state entities. The upshot is that the direct impact on the real economy will most likely be some reduction in consumer demand from people who have lost money trading in shares.
5. Social inequities and disenfranchised people threaten stability
On this one, I agree with the bears, but it is not just China, that must worry about this problem. While economic growth has benefited the vast majority of the population, the gap between the countryside and the cities is increasing as urban wealth accelerates. There is also a widening breach within urban areas—the rich are growing richer.
Urban inequality and a lack of access to education and healthcare are not problems unique to China. People here and in the West may find fruitful opportunities to exchange ideas because the pattern across Western economies is similar. Leaders of the central government have suggested policies to improve income distribution and to create a fair and sustainable social-security system, though implementation remains a matter for localities and varies greatly among them.
In short, China’s growth is slower, but weighing the evidence Woetzel has seen, the sky is not falling. Adjustment and reform are the hallmarks of a stable and responsive economy – particularly in volatile times.
Woetzel’s colleague, Gordon Orr, Director Emeritus of McKinsey and Senior External Advisor advocates the following changes in China for 2016 and beyond, and we add his conclusions to the feature.
Do not get distracted by talk of Chinese economic growth moving a percentage point here or there. The country’s economy is still massive—as are its potential opportunities. Here is a quick take on what he sees happening in 2016:
- The 13th five-year plan—few surprises . . . but look for a solid GDP growth target, green initiatives, and action on productivity.
- Fewer jobs, flatter incomes—and, potentially, less confidence . . . with white-collar workers being particularly vulnerable.
- The maturing of investing in China: More options for Chinese investors and foreign investment managers . . . but remember the volatile mind-set of local investors.
- Manufacturing in China is changing, not disappearing . . . with the winners becoming even more competitive on a global scale.
- Agricultural imports are rising and rising . . . bringing opportunities for countries from Australia to Russia to the United States.
- More centralisation . . . as efforts to devolve authority are shown to have failed.
- Moving people at scale—the middle class, not peasants . . . because China’s cities are bursting at the seams.
- Movies in China: $$$ . . . a Chinese movie will gross $500 million domestically for the first time.
- China continues to go global with the United Kingdom as a new focal point . . . the love affair between the two countries will continue, but others want in on the action.
And finally . . . China will win soccer’s World Cup! Maybe not yet, but real money – domestic and foreign – is now flowing into the country’s soccer leagues.
For an additional outlook, we do add also the opinion of another economist, Caroline Bain of Capital Economics, and she is an expert of metals and offers a correlation on the development of China’s GDP and copper prices. Her views offer some food for different thinking!
A different but positive view of China from another viewpoint
It’s only mid- January and the copper price is down 8% year to date.
March futures in New York dropped to USD 1.9525 a pound (just over USD 4300/t) early on January 12, 2016 and by the close on the Comex continued to languish at levels last seen March 2009.
For a sustained period below USD 2 one has to go back a decade at the early days of the China-induced super cycle.
China is responsible for nearly half of global metals demand and its slowing economy is at the heart of not just the commodities sell-off but the rout on global stock markets as well.
Given the extent of fear in the market few are factoring in industry fundamentals, but it’s worth remembering just what a different beast China is today versus a decade ago.
With copper so closely tied to the country’s economy the chart below should give metal bulls some hope.
China’s economic expansion is expected to slow to its lowest level since 1990, but measured in billions of dollars Chinese gross domestic product growth paints a totally different picture.
The country would be adding some than USD 800 billion to GDP (and that’s excluding Hong Kong) this year and over USD 1 trillion by the end of the decade.
That is greater than the size of mainland China’s entire economy in 1994, when growth rates peaked at a stunning 30% year-on-year. USD 800 billion is also bigger than Switzerland’s economy and worth almost two South Africas and four New Zealands.
Caroline Bain of Capital Economics says the chart suggests that a plausible rate of Chinese economic growth from here (8 % nominal, or 6 % real plus 2 % inflation) “would be consistent with some recovery in copper prices, even if growth is less commodity-intensive.”
The house view at Capital Economics for the copper price is one of the more bullish predictions: USD 6000 a tonne (USD 2.72 a pound) at the end the year. As Bain points out, this may be an ambitious target, but do not forget the red metal peaked at USD 4.50 just five short years ago.