We think that after almost four decades of pursuing a growth-at-all-costs development model, it’s probably time for China to ease off the gas pedal and figure out where it should go during the next 40 years.
Decades of turbocharged growth may have lifted hundreds of millions out of poverty, but millions more may well ask whether the price paid was worth it.
That’s because the country’s export-driven economy is losing potency, there is environmental degradation on an epic scale, and social stability — a linchpin of government policy — is being challenged. Annual growth rates of 10 percent may have been fine decades ago, but that level isn’t sustainable for the world’s second-largest economy.
President Xi Jinping has already articulated his vision for an invigorated, prosperous and confident nation. At the center of his so-called Chinese Dream is a blueprint for reforms that seek to tackle some of the most serious problems. These include, but aren’t limited to, wasteful state-controlled companies, governmental meddling in financial markets, institutionalized discrimination against migrant workers from the countryside, chronic bad debt, life-threatening pollution and serious demographic imbalances.
Xi, perhaps the country’s most powerful leader since Deng Xiaoping, has staked his reputation on the outcome. He knows China’s self-appointed rulers must find a way to share the fruits of growth more equitably and curb abuses within their own ranks or risk the voices of protest becoming too loud to silence.
“Growth defined by quality, not quantity” could be the new ideological slogan guiding the Communist Party apparatchiks tasked with turning Xi’s Chinese Dream into reality. At the heart of the party’s reform agenda is the transition from an economy driven by state-directed investment in fixed assets and export manufacturing into one in which market forces and domestic consumption play more important roles. For example, China proposes forcing state-controlled firms to scrap any subsidies they may enjoy and allowing greater private sector ownership in these companies.
Banks will eventually set their own deposit rates, and the yuan will be allowed to trade freely. Plans are under way for a new registration-based stock approval system in which investors and companies would help determine the timing and valuation of offerings, rather than the present approval-based one in which the regulator has the ultimate say. Authorities will also help accelerate the pace of urbanization, which is important because city dwellers tend to earn and spend more than people living elsewhere. People in the countryside and migrants to cities will also be granted certain legal rights that can help free up more disposable income.
From an investor’s perspective, the domestic consumption story is very attractive. China has one of the world’s highest savings rates as a proportion of household income. That will pave the way for years of economic expansion in the country. Reducing the role of the state in the economy is likely to create better companies. In the anticipated corporate landscape, companies will increasingly have to compete for funding and market share.
That is potentially good news for domestic stock markets that, bloated by value-destroying state enterprises, have been serial underperformers.
Let’s be clear about this. A slowing China provides a once in a generation opportunity. Reformers can finally tackle policies that produced impressive headline growth numbers but masked the extent to which growth was fueled by credit that eventually propped up inefficient industries and created dangerous asset bubbles. A slowing China strengthens the case of reformers pitted against powerful officials who have enriched themselves and their families and who will seek to protect their own interests, even at the expense of the nation. A slowing economy is also an opportunity to learn from the experience of archrival Japan, which beat the so-called middle income trap by relentlessly improving productivity, only to succumb to decades of anemic growth and chronic deflation because of an aging population and resistance to structural change.
The transition period will be long and painful. Defaults are needed to reduce moral hazard and to weed out unfit companies. There will be redundancies, and not everyone will find comparable employment. A more sustainable pace of development will mean permanently slower growth.
The rest of the world will have to adapt too. For example, countries that enjoyed a financial windfall selling commodities to China may have to adjust to lower demand as new infrastructure needs start to peak and industries such as steelmaking dial back output. Western consumers accustomed to cheap products made or assembled in China may have to accept higher prices as factory wages and benefits improve to attract a shrinking workforce, a legacy of the one-child policy of population control.
Meanwhile, currency investors who regarded the slow appreciation of the heavily managed yuan as a sure thing will need to look elsewhere for easy profits. The currency is down this year, and volatility is bound to increase as the capital account is liberalized. Those risks should be kept in perspective, though.
A China that continues to grow at double digit rates by flooding its financial system with liquidity; that continues to exercise a policy of pollute now, pay later; and that routinely ignores the concerns of its own people is something that is really scary. Eventually no government, no matter how powerful, would be able to stop that hurtling economic policy juggernaut. At least a controlled deceleration will allow the economy to change course as the inevitable bumps in the road appear. We imagine investors will be better off.
Nicholas Yeo leads the China/Hong Kong equities team at Aberdeen Asset Management in Hong Kong.
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