China’s transition from a manufacturing-driven economy to one led by services and innovation is likely to prove challenging. Given concerns over employment numbers and the potential for social unrest, however, it would appear that policies to ensure short-term growth and stability are taking precedence over those required to follow through on China’s long-term plans for economic transformation and market transparency.
At the National People’s Congress (NPC) in early March, Premier Li Keqiang targeted gross domestic product growth of between 6.5 and 7 percent for 2016. Although we at Northern Trust Asset Management have confidence that this target will be met, we question whether such a number accurately reflects underlying economic activity and is sustainable. To gauge economic growth, we prefer to look at factors that the government has less ability to massage: power generation, freight volumes, truck sales, cement production and private construction activity. With legacy industry — government infrastructure investment, low-value-added manufacturing and commodity mining/refining — making up a larger component of GDP than does new industry, the latter would need to accelerate at a much faster clip than the former decelerates to meet the long-term 6.5 percent GDP growth target set out in this, the NPC’s 13th Five-Year Plan (2016–’20).
China is reverting to its tried and true path: infrastructure spending. We believe Li gave a nod to this during the NPC when he noted that urbanization and industrialization will continue to be key factors driving economic growth. Indicative of this move, the government has lifted the fixed-asset investment growth target for 2016 to 10.5 percent, compared with 9.8 percent in 2015. Key to recent fixed-asset investment growth has been infrastructure-related spending by state-owned enterprises, which was up 20.2 percent year-over-year in January and February. Improving heavy-equipment demand would suggest that further infrastructure spending is forthcoming. Heavy-duty truck sales were up 2 percent in January and February, following a year of declines. Excavator sales grew by 7 percent in the first two months of 2016, after dropping by 39 percent in 2015.
One plank of China’s long-term growth platform is the so-called One Belt, One Road initiative, announced in fall 2013. This initiative aims to increase trade in part by leveraging the domestic manufacturing and labor force to bring products and services to global markets. We find recent examples in which China is investing capital to build manufacturing capacity in high-cost regions as possibly indicative of a focus on short-term growth at the expense of long-term sustainable economic reform. Chinese state-owned enterprise CRRC Corp. won a contract last month to manufacture 846 railcars for the Chicago Transit Authority with a $1.3 billion bid, 20.3 percent below that of a main competitor, Bombardier. In addition, the state-owned enterprise, the world’s biggest trainmaker by revenue, agreed to construct a $40 million plant in Chicago and employ 170 people.
We see comments from Liu Shiyu, the new chair of the China Securities Regulatory Commission, as indicative of the government’s renewed focus on shorter-term economic growth and stability, which is at odds with previously articulated plans for economic reform. Liu noted in mid-March that it was “far too early” to think about state rescue funds leaving the stock market and vowed to step in “decisively” if needed to curb “panic.” We view this as contrary to the country’s long-term plan for transparent and open markets. A key concern is that, given that this type of government intervention could be perceived as an implicit guarantee by investors, it likely encourages speculative activity. State-owned Shanghai Securities News has reported that investment arms of the People’s Bank of China are now top ten shareholders in more than ten companies that trade on Chinese stock exchanges. Providing further support to the equity markets, it was reported, restrictions on margin loans are once again being relaxed. This is worth monitoring, as we believe the availability of margin loans was a key factor behind the 159.7 percent move upward in the Shanghai Composite index from June 12, 2014, to June 12, 2015, and the subsequent correction.
We see government intervention in real estate, akin to what we have witnessed in the equity markets, increasing speculative activity and price volatility. We would note that this is contrary to Beijing’s goal of stabilizing the markets to support economic growth. The government had attempted to deal with excess housing inventory by relaxing property purchase restrictions, allowing the use of loans to cover down payments and reducing down payment requirements for both first and second home purchases. Although the goal was to promote stability, these actions have instead caused a further imbalance in the markets. Prices in tier-1 cities, the country’s four largest, have inflected sharply higher, while the policy changes failed to clear excess inventory in tier-3 to -5 cities.
We anticipate that China’s economy, amid all these crosscurrents, will accelerate in the second quarter of 2016. We believe reported GDP growth could move toward the 7 percent mark, supported by short-term growth and stability initiatives that rely, as in the past, on infrastructure spending, accommodative monetary policy and government involvement in the markets. As evidence that government policy is gaining traction, industrial profits increased by 4.8 percent in January and February over the same period in 2015, the first such positive reading since December 2014. We would also highlight the February manufacturing PMI, which came in ahead of the consensus, at 49.4. Although maintaining short-term growth to ensure social stability does not preclude a shift toward a sustainable economic model, we believe it increases the risk to the broader economy, given escalating debt burdens, nonperforming loans, bond defaults, capital outflows, speculative activity and market disequilibrium.
Edward Trafford is a senior investment research analyst at Northern Trust Asset Management in Chicago.
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