China’s markets were under tremendous pressure during the past year from fears of a
slowing economy and the impact of a trade war with the U.S. The benchmark Shanghai
SSE Composite Index fell by roughly 25% in 2018 and China’s bond markets and currency,
the renminbi, also fell.
Ivy Global Economist Derek Hamilton traveled extensively through China to better
understand the current situation, the views of policymakers and business leaders, as well
as the potential policy response from China’s government. He found that concerns about
the economy had increased. While policymakers expressed a more constructive tone and
focused on protecting the downside, companies were concerned about falling demand.
Hamilton provides his analysis of the challenges China faces now and the potential
responses from its leaders.
Limiting debt increase weakened economy
During the Global Financial Crisis, China
decided to boost economic growth with a large
increase in government debt. The increase in debt
spread to the private sector, and corporate and
household debt rose during the last decade. In
2017, policymakers in China decided to slow the
increase in debt because of concern that total debt
would reach an unsustainable level, especially
when considering a rising debt burden in the face
of a rapidly aging population. The screws were
tightened throughout 2018, especially for shadow
bank lending and local government borrowing.
But this resulted in a dramatic slowdown in
economic activity, especially in investment
and consumer spending, during the first three
quarters of the year.
In addition, the viability of the private sector was called into
question, with some in China’s Communist Party wondering if
the private sector would become too large at the expense of stateowned
enterprises. Policymakers began to talk about less need
for tightening in the middle of 2018 but didn’t really become
concerned about the pace of the economic slowdown until the
President Xi Jinping has come under mounting pressure to
act. Citizens in China have shown they are willing to accept
less personal freedom in exchange for improvements in their
personal well-being. If the economy slows and unemployment
rises rapidly, the people of China only have one party to blame.
Thus, the legitimacy of the Communist Party rests on a
contented population. I believe the government is likely to
become increasingly accommodative in a variety of areas
in order to stabilize growth in gross domestic product and
prevent a large increase in unemployment:
The central government cut personal income taxes in 2018.
The next round of tax cuts is likely to focus on corporate taxes
and value-added taxes.
I think infrastructure spending is likely to reaccelerate. Projects
that were put on hold are being released. In addition, the central
government is allowing local governments to issue debt at an
accelerating pace to fund infrastructure projects. I believe these
initiatives are likely to focus on environmental protection, water
conservation, subway/railway expansion and rural development.
China likely to pursue railway expansion
During the last several years, China has tried to limit home
price appreciation by dramatically increasing the cost of buying
a home, upgrading a primary residence or buying a second
home by imposing higher down payments and other onerous
restrictions. Home sales began to weaken rapidly in late 2018.
Weaker home sales can lead to less property development, and
land sales for such development are a key source of revenue for
While taking steps to limit home price appreciation, China also
supported demand for housing through a plan called shantytown
redevelopment. Originally intended to demolish old units and
rebuild new ones in their place, the plan was changed several
years ago to deal with an oversupply of housing by introducing
cash payments from the central government in order for families
to buy new units. The government in recent months has been
reverting to a process of giving units to families, rather than
cash for individual purchases.
China seeks to manage urban migration; sign in Shanghai with a farmer greeting
a city resident and the word “Equality”
Given the importance of housing to the overall economy and
to local-government revenues, I think local governments are
likely to begin reducing down payments and removing some
purchase restrictions. I have seen signs of this on a small scale
since returning from China. If property markets weaken further,
then the central government could mandate changes in these
areas, which would be a more powerful and effective signal. In
addition, I think the shantytown development program is likely
to continue for the foreseeable future.
Chinese cities are typically classified in a tiered system based
on population. It is worth noting that Tier 1 cities, which include
five of the largest cities, continue to have an undersupply of
housing. Inventories remain quite low in Beijing and Shanghai.
There is a need in these cities for local governments to release
more land for development. Policymakers continue to want
migration from rural to urban areas, but they want those
migrants to move to smaller cities. By contrast, many migrants
want to move to Tier 1 cities. Given that urbanization will
continue to be an important driver of economic growth, local
governments are pushing urban residents to accept rural
migrants into their communities.
Headwind from U.S. - China trade war
The trade war between the U.S. and China has been a headwind
for markets in both countries. Companies doing business in
China, both domestic and foreign, are increasingly worried about
the long-term implications of the trade war. Many are looking
for opportunities to move production to other countries. This is
putting further pressure on China’s policymakers to stimulate
the domestic economy.
Several months ago, China thought it had struck a deal with
the U.S. during negotiations with Treasury Secretary Steve
Mnuchin, only to have the deal overturned by President
Donald Trump. While this made China nervous about future
negotiations, it appears that China is now willing to meet
many of the U.S. trade demands.
For example, Chinese officials realize that something needs to
be done about intellectual property (IP) violations – a key issue
for the U.S. in the trade dispute – and recently released new rules
to protect IP. However, it remains to be seen how well these rules
will be enforced. It is in China’s interest to act soon, as domestic
companies continue to innovate and are increasingly developing
their own IP. Those companies will want to protect that IP, just
as U.S. companies are seeking protections.
Increasing income shapes consumer preferences; Shanghai is home to the
world’s largest Starbucks Reserve Roastery
Consumer culture continues to expand
Urbanization continues to increase in China. As more people
migrate from rural to urban areas, income and productivity
also increase. Per-capita income for urban residents in China
continues to rise at a rapid clip, with the latest data showing an
increase of nearly 8% in 2018. Rising disposable income brings
a change in buying preferences, with more consumers choosing
to spend on services or higher-quality goods versus basic
necessities. Despite the slower economy, this trend was apparent
when I was in China.
Credit availability has become a short-term headwind. Peer-topeer
(P2P) lending exploded in China over the last few years
and was a driver of consumption. Given the rapid development
in such lending and the lack of regulation, the government’s
concerns about rapid debt growth spread to the P2P industry.
There have been many instances of P2P companies defaulting
on loans, and individuals who depended upon financing
now find it more difficult to get credit. While I believe P2P
lending will continue to be constrained, the government is
working to lower the cost of, and increase the availability of,
credit for consumers.
Environmental issues come into focus
Environmental control has become a key focus of the central
government. The term “Beautiful China” was included in
the country’s 13th Five-Year Plan, introduced in late 2015.
President Xi has made it clear that officials now must consider
the environmental impact when making decisions. In other
words, political careers are now judged on their impact on the
environment as well as on economic growth.
Air pollution was the initial focus, with water pollution and soil
contamination quickly following as a concern. The government
has mandated shutdowns of heavy-polluting factories in the
winter. Air pollution in Tangshan, China’s steel-producing capital,
was better when I visited, but it still can be very bad at times in
many cities, including Beijing.
Air quality is a growing issue in major cities
The government’s mandates on pollution are important for health
reasons, but they are raising costs for companies. For example,
the central government has mandated steel companies must
move production outside the city limits of Tangshan. In addition,
companies must transport all raw materials from ports via rail
instead of truck by late 2020, which will require more rail lines
to be built. This type of environmental crackdown in one city is
being duplicated all over China.
China facing challenges ahead
China’s need to reduce the pace of debt accumulation must
be balanced with the downside risks to the economy, which
are coming from both domestic and external sources. China
is likely to temporarily stimulate domestic demand, but doing
so risks eroding progress made on the debt front. The country’s
aging population will continue to lead to slower GDP growth.
If China is unsuccessful in permanently slowing the pace of
debt growth, then the aging population will make the debt
load even more unsustainable.
Officials could strike a trade deal with the U.S., but longer-term
pressures from the U.S. and other countries are likely to remain,
especially as such countries try to slow China’s economic and
military rise. I believe the Chinese economy will begin to recover
in the second half of 2019, but the larger challenges will remain
for an extended period.
Photo credits: Derek Hamilton
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The opinions expressed are those of Derek Hamilton and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through January
2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not
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