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However, China is stuck on the horns of a policy “tri-lemma”. While the laws of economic thermodynamics don’t forbid rapidly rising consumption per se, they do rule it out simultaneous with high GDP growth and a current account surplus. One element has to fall by the wayside for the math to work. Here are the unfortunate tradeoffs:
• High growth, external surplus, low consumption to GDP — This was China’s historical path until 2008 when the wheels came off. Producing and exporting cheap goods to a credit-binging world is no longer seen as sustainable. For those of you saying “Go Figure”, see the first chart below.
• Much slower growth, external surplus, fast-rising consumption to GDP — Bumping up consumption growth to 10% per year would entail some combination of the following: interest rate liberalization, a stronger currency, much higher wages or a depletion of savings. Understandably, none of these options are very palatable to policy makers in China.
• Moderately slower growth, external deficit, moderately-rising consumption to GDP — The prospect of a current account deficit is an idea not entirely out of left field. In the first quarter of 2014 China’s current account surplus narrowed to $7 billion, the smallest in 3 years.
For developing economies, the first option (surplus, low consumption, high growth) has been a tried and true method for growing GDP-per-capita at an elevated rate. For many Asian tigers of yesteryear, investment spending as a percentage of GDP remained elevated long after they navigated the middle income trap (see graphic below).
However, this choice is largely predicated on robust demand from trade partners willing to take on the deficits required to balance the trade equation, a “demand-ing” role that fewer and fewer developed economies can adopt without negative debt consequences. Extraordinarily large consumption growth rates of around 12% are required in order to realize a scenario of both high GDP growth (6-8%) and expanding consumption share of growth. It’s not impertinent to ask where the per-capita increase in disposable income is supposed to come from to fuel this growth. Given China’s poor healthcare and pension system, as well as its unreformed hukou, Chinese consumers are unlikely to tap savings in any appreciable way. Household income therefore would have to rise by roughly the same amount as the projected consumption expansion, which would mean some combination of higher wages, interest rates or currency strengthening. Paradoxically, all these factors actually serve to dampen GDP growth over time! With glacial adjustments to the currency and negative real interest rates a fixture of current Chinese policy, moving the needle on consumption growth might be left to rising wages alone, which of course reduces company profitability and potentially creates inflation in agricultural staples as well. Another potential brake on growth! These are tough, tough policy options.
So what’s the solution for China? Well, thus far the answer has been… more of the same! Interestingly, in the years 2010-2013 consumption growth contributed an average of 4.5 percentage points to growth while investment contributed 4.4 percentage points, essentially equal, with no real shift between consumption and investment over the period! Data thus far in 2014 is consistent with this pattern, with investment growth set to dictate overall growth after the first quarter, as it has for the last three years (Q1 frequently shows consumption strength due to the holidays and then drops). The untold story here is that China has actually been growing consumption at roughly 8% per year for the last ten years and that seems to be close to the top end for its economy.
If investment continues to be significant going forward, regardless of whether there is a downshift from high to moderate growth, the issue of productivity and debt become increasingly critical (party targets are at 17.5% growth in fixed asset investment in 2014, over 19.6% in 2013). China has experienced declining efficiency in its investment capital, with double the amount of investment required today to generate the same unit of output as the early 1990s (the inverse of ICOR, incremental capital-output ratio, which stood at 2.6 twenty years ago). This has contributed to substantial overcapacity in numerous industries, including: steel, cement, shipping and solar panels. In addition, debt has exploded. Between 2007 and 2012 credit to GDP climbed 190% (60 percentage points)! With the majority of debt backed by inflated real estate, concerns only mount as the downturn in housing prices continues in 2014.
De facto credit liberalization has led to rough parity in the share of lending between traditional banks and the shadow banking system (where Chinese banks held 92% share a decade ago), creating tremendous concern about risk management in these institutions. With local authorities and SOEs tapped out, China has announced the opening of major industries to greater private investment (Third Plenum, Nov. 2013). In theory, this would allow investment to be maintained through more productive entities and without additional accumulation of debt, however, this policy must overcome entrenched interests and general market skepticism.
The dirty little secret of consumption-led growth is that it’s largely predicated on urbanization, which in-turn requires increasing investment. Barring political or economic collapse, urbanization will continue to be the main thrust of economic policy in China for the foreseeable future (current goals are to move 60% of the population into the cities from the current level of 53%). Not only because moving workers from marginal jobs on the land to more productive industrial jobs is good for growth but also urbanization increases consumption, as Premier Li Keqiang characterized it “urbanization has the greatest potential for boosting domestic demand… every rural resident who becomes an urban dweller will increase consumption by more than 10,000 Yuan”. The question for China-watchers is how long can this type of growth continue given the debt explosion? Here, it’s important to keep in mind the inherent risk-return distortions in China’s economy when invoking “comparable” country growth or macroeconomic theory (from bank rate and currency interventions to local government and SOE shenanigans). This has tripped up the analysis of panda huggers and dragon slayers alike. The Chinese market is not inordinately cheap and there are simply too many distortions that jam the “normal” risk-reward signaling, rendering data ambiguous in the extreme. Currently, there are more attractively priced emerging markets where value gaps are greater and corporate governance better aligned with shareholder interest.
Caglar Somek has fifteen years of equity research and portfolio management experience with a focus on emerging and frontier markets. Caglar is formerly the CIO of Caravel Management LLC and has also worked for Goldman Sachs Asset Management, Salomon Brothers Asset Management and Credit Suisse First Boston.
Caglar is fluent in Turkish and French, is a CFA charterholder and holds an MA in International Economics and Finance from Brandeis University as well as a BS in Economics from Universite de Paris Dauphine.
Alexander Schay is a Managing Director at Ultima Thule, an equity research company focused on developing markets and an equity partner at WK Associates, a boutique energy consulting firm with a specialization in emerging market oil and gas.
Alex holds both an MS in Risk Management and an MBA from the Stern School of Business at New York University.