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EmergingMarketsResearch March2013 China: Beyond the miracle YipingHuang,JianChang,StevenLingxiuYang PLEASEREFERTOTHELASTPAGEFORANALYSTCERTIFICATION(S)ANDIMPORTANTDISCLOSURES. Barclays | China: Beyond the Miracle FOREWORD China has become a key locomotive for global growth, in many ways taking over the role traditionally played by the United States in business cycles. It is now the world’s second largest economy, and has grown much faster than any other major economy over the past couple of decades. China’s role as a key driver of global growth brings with it increased scrutiny by investors and economists: a significant slowdown in China – never mind a collapse - would have significant implications for economies and financial markets around the world. This was most recently seen in 2012, when slower economic growth – fostered in large part by policy tightening to alleviate inflation pressures and structural imbalances – generated fears of a “hard landing” that served as a headwind to financial market performance for much of last year. The extremely rapid growth in China – as welcome as it has been during an otherwise disappointing recovery from the Great Recession – represents the first stage of development in the evolution of the economy from closed to open, from fully controlled to market, and from agrarian to industrial. This initial stage is already giving way to a new phase of slower, more sustainable growth, with different drivers. It is critical for the global economy and financial markets that China’s transition is managed in a way that allows the necessary adjustments to happen gradually and without de-stabilizing effects. The Beyond the Miracle series - written by Yiping Huang, Jian Chang and Steven Lingxiu Yang and launched in September 2011 - carefully analyzes the transition that China is undergoing from various perspectives, and also discusses the economic and financial market implications. It argues that China will successfully make the transition from ‘economic miracle’ to normal development in the next decade (Chapter 1). But there is an important caveat: China must embark on a multi-pronged set of reforms if the country is to move to a slower, more sustainable growth rate that deemphasizes trade, construction and investment and instead places a greater weight on consumer spending as a source of growth. Each chapter provides an in-depth analysis of the task at hand – from financial reform (Chapter 2), to housing reform (Chapter 3), to the pivotal role of consumption in rebalancing China’s economy (Chapter 4). For China to avoid becoming a source of inflation in the future, its monetary policy-making, too, will need to be reformed (Chapter 5). China’s ageing population will also mean an end to its surplus of cheap labor, heralding a new era of rapidly rising wages (Chapter 6). In turn, this could put additional pressure on the country’s fiscal outlook, as it seeks to meet growing pension liabilities (Chapter 8). March 2013 1 Barclays | China: Beyond the Miracle These challenges notwithstanding, the Beyond the Miracle series is optimistic on the outlook for China. It argues that the Chinese economy is in the middle of a major and broad-based structural transformation that will lead the country to a more sustainable growth potential of 6-8%, from a double-digit pace previously. As China continues to grow and upgrade, its outward direct investment should rise quickly (Chapter 7). And by narrowing the technological gap with the advanced economies, China should be able to avoid the “middle income trap” and graduate to the global high-income group within the next decade (Chapter 9). China’s Beyond the Miracle series is ambitious, both in scope and depth. Given the critical role now played by China in the world economy and financial markets, I highly recommend it as essential reading for investors, as well as anyone interested in current and future economic and market trends. Larry Kantor Head of Research, Barclays March 2013 2 Barclays | China: Beyond the Miracle CONTENTS Chapter 1: China’s next transition ......................................................... 5 Emerging economic trends ............................................................................................................ 6 The making of an economic miracle .......................................................................................... 10 Distortions in factor markets ....................................................................................................... 17 Remarkable successes and growing risks ................................................................................. 25 Why the next five years might be different ............................................................................... 29 The great rebalancing .................................................................................................................... 33 Chapter 2: The coming financial revolution ...................................... 36 The revolution that needs to happen ......................................................................................... 37 How has the financial system evolved? ..................................................................................... 41 Repressive policies are now retarding growth in China ......................................................... 46 Growing financial and economic risks ....................................................................................... 49 The needed financial reforms ...................................................................................................... 53 Policy and market implications ................................................................................................... 63 Chapter 3: Bubble deflation, Chinese style ........................................ 67 Policy-induced correction ............................................................................................................. 67 Making of property bubbles ......................................................................................................... 71 How serious are property bubbles in China? ............................................................................ 75 Why hasn’t the Chinese ‘bubble’ burst? .................................................................................... 78 These favourable conditions could turn negative soon ......................................................... 82 How might bubble deflation play out in China? ...................................................................... 86 Policy and market implications ................................................................................................... 99 Chapter 4: The great wave of consumption upgrading .............. 101 Weak consumption in a strong economy ...............................................................................102 Common explanations for China’s weak consumption .......................................................104 Controversies surrounding consumption statistics ..............................................................108 Recalculating China’s consumption share of GDP ................................................................112 Will consumption improvement be sustained? .....................................................................119 A strong case for consumption upgrades ...............................................................................122 Policy and market implications .................................................................................................126 March 2013 3 Barclays | China: Beyond the Miracle Chapter 5: Understanding Chinese inflation .................................. 130 Has inflation really peaked? ........................................................................................................132 Reliability of Chinese inflation statistics ...................................................................................134 What determines Chinese inflation? .........................................................................................138 The making of monetary policy .................................................................................................150 Rising inflation risks for China and the world.........................................................................162 Chapter 6: The consequences of demographic change ............. 165 The one-child policy .....................................................................................................................166 Gender imbalance might stimulate growth? ..........................................................................170 Will China grow old before it gets rich? ...................................................................................176 The Lewis turning point – end of surplus labour? .................................................................193 Demographics pose new challenges, but unlikely to derail growth .................................205 Chapter 7: Will China buy up the world? ........................................ 210 A new giant investor on the global stage ................................................................................211 Some “stylised” facts about Chinese ODI ...............................................................................214 Economic literature on ODI motivation ...................................................................................219 Why Chinese companies invest overseas? ..............................................................................223 American, Japanese and Chinese models of ODI ..................................................................230 Outlooks, challenges and policies .............................................................................................234 Chapter 8: Can China manage its fiscal risks? ............................... 240 Mixed picture for China’s fiscal outlook ..................................................................................242 Fiscal decentralisation, Chinese style .......................................................................................245 Local government debt the biggest medium-term risk .......................................................254 Pension liability the biggest long-term risk.............................................................................266 Overall assessment and investment implications .................................................................271 Chapter 9: Can China avoid the middle-income trap? ................ 278 China’s new growth challenge ..................................................................................................280 Lessons from the other countries .............................................................................................283 Underappreciated structural improvement ............................................................................286 Political and economic reforms .................................................................................................293 Early takeoff of science & technology ......................................................................................298 What could derail the growth train? .........................................................................................304 Toward a high-income economy ..............................................................................................306 March 2013 4 Barclays | China: Beyond the Miracle CHAPTER 1 China’s next transition • This is the first in a series of reports titled China: Beyond the Miracle that will analyse the major structural issues facing the Chinese economy. • We think China is about to experience a transition from ‘economic miracle’ to what can be considered normal development in the next five to ten years. This process will not only transform the Chinese economy, but will also have significant implications for the rest of the world. • The key to the upcoming transition lies in the anticipated reform of factor markets, including rapid wage growth, interest rate and exchange rate liberalisation, and market-based resource prices. • We identify a number of important trends that will emerge during the transition process. Growth is likely to moderate steadily, economic cycles will probably become more violent, and inflation pressures could escalate, as a result of widespread increases in factor costs. • Industrial upgrading is likely to accelerate, with a rapid move into high value- added manufacturing and service sectors, and faster development of inland provinces. We also expect income distribution to improve. • The economy should see the beginning of great rebalancing, which is likely to mean an end to investment-led growth but much stronger consumption. As a result, demand for commodities could slow. • China will likely achieve basic convertibility of the capital account over the next five years, and its capital outflows are likely to primarily take the form of direct and portfolio investment. This article was originally published on 5 September 2011. March 2013 5 Barclays | China: Beyond the Miracle Emerging economic trends As economies show visible signs of weakening trends around the world, market participants, economists and policymakers are again looking for likely policy actions by the Chinese government. We think China probably would respond quickly if global economic conditions deteriorated sharply. However, it probably will not be able to repeat the action it took three years ago at the height of the global financial crisis, given elevated inflation, large local government borrowing, an expected deterioration in the quality of banking assets, worsened structural imbalances and the upcoming leadership transition. Beyond short-term cyclical considerations, the biggest challenge facing Chinese policymakers is how to transform the economic development pattern, as identified by the 12th Five-Year Program (FYP). Some market participants are sceptical that China can ever achieve this policy objective. Since the government failed to improve the growth model during the 11th FYP, why should it be different this time? The current economic development pattern, however, is no longer sustainable. Despite China’s great success in achieving rapid growth during the past decades, its economy has developed a number of structural problems, including a high investment ratio, large current account surplus, unequal income distribution, high resource intensity, serious environmental degradation and widespread corruption. The Politburo meeting in late- July 2011 also reiterated its concerns about China’s uncoordinated, unbalanced and unsustainable development pattern. Many of these structural problems have worsened sharply since the global financial crisis as a result of the aggressive fiscal and monetary expansion implemented to support economic growth. Investment’s share of GDP, for instance, rose from 41.7% in 2007 to 48.5% in 2010 (see Figure 1). Asset bubbles and excess capacity have become more serious and widespread (see Figure 2), and prompted many predictions of a hard landing. For instance, James Chanos, founder of Kynikos Associates, a New York-based investment company, has predicted a slump due to excessive property investment in China. Similarly, James Rikards, former General Counsel of hedge fund Long-Term Capital Management, warned that China was in the midst of “the greatest bubble in history”. March 2013 6 Barclays | China: Beyond the Miracle FIGURE 1 FIGURE 2 GDP: Unsustainable investment-led Continued build-up of a property bubble growth 100 25 House price/household income 80 20 60 15 40 10 20 5 0 Investment Private consumption 0 -20 Government consumption Net export Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 1980 1985 1990 1995 2000 2005 2010 Shang hai Beijing Guang zhou Source: CEIC, Barclays Research Note: We assume an average house size of 70 sqm. Source: CEIC, Wind, Barclays Research While acknowledging these serious – and even worsening – structural risks, we do not see a high probability of a hard landing or a fiscal/financial crisis in the near term. In our view, the pessimists are wrong on at least two fronts. One, they often underestimate the flexibility and resilience of the policy regime. Chinese policymakers have proved their ability to respond and adjust in the face of crisis risks, as evidenced by their decision to adopt the household farming system at the beginning of the 1980s, to privatise loss- making state-owned enterprises (SOEs) in the mid-1990s and to enter the WTO at the beginning of the century, despite strong political resistance to these changes. Secondly, in predicting a hard landing, the pessimists ignore the still-healthy balance sheets of households, corporates, banks in China, and the external economy and government. For instance, mortgage loans in early 2011 amounted to only c.13% of banks’ total outstanding loans. These loans are also equivalent to less than 20% of GDP and less than total household savings (see Figure 3). This implies that, even if house prices decline, we are unlikely to see forced and widespread deleveraging that could lead to a meltdown of the financial system and economic activity. Again, public debts are equivalent to only c.18% of GDP. Even after including local government debt (27% of GDP reported by NAO), it remains below the 60% international warning line (see Figure 4). Fiscal revenues have been growing at a rate of 20-30% pa for years. The government also has massive assets, including state-owned ones totalling CNY207.8trn, equivalent to more than six times annual GDP (CNY33.7trn). Clearly, this suggests that government solvency is not at risk in the near term. March 2013 7 Barclays | China: Beyond the Miracle FIGURE 3 FIGURE 4 Chinese households, not that leveraged Chinese government debt, still manageable 20 250 Public Debt/GDP, as end of 2010 (%) 18 200 16 14 150 12 10 100 8 6 50 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Mortgage/total outstanding loan (%) 0 Mortgage/GDP (%) CHN IND JPN USA DEU FRA GBR ITA Note: Majority of household debt is mortgages. Note: China’s figure includes both official public debt Source: CEIC, Barclays Research and local government debt. Source: IMF, National Audit Office (NAO), Barclays Research But that does not mean the structural problems can continue for a long time. If China fails to transform its development pattern over the next five years, then the risks of a major crisis could increase exponentially. In the past, the government always stretched the financial and fiscal systems to contain near-term downside risks. But there is a limit to how much longer this approach can be employed. After the Asian financial crisis, for instance, it took years for China to reduce nonperforming loan levels and contingent fiscal liabilities. But China may not always have the luxury of a long ‘adjustment period’ to deal with such problems. Whether or not China is able to transform its development pattern is critical for growth sustainability. There are many economies in the world, most notably in Latin America, that achieved a successful takeoff in the immediate post-war period but then failed to sustain growth, falling into the so-called ‘middle-income trap’. This is not our base-case scenario for China. We believe China will be able to gradually change its growth model, rebalance its economy and reduce inefficiency over the next 5-10 years. The key will be the reform of factor markets. By providing extra incentives for producers, investors and exporters, factor cost distortions have been an important force driving China’s strong economic growth in past decades. These same forces have also created serious structural problems, such as economic imbalances, huge commodity consumption and various types of inefficiencies. March 2013 8 Barclays | China: Beyond the Miracle FIGURE 5 FIGURE 6 Migrant workers salaries have been The still distorted energy price signal rising rapidly 350 Migrant workers' monthly salary (CNY, 1978p) 60 60 300 RPoealyln soamlairnyal trend 5568 5505 54 250 45 52 40 50 200 35 48 150 46 30 44 25 100 42 20 Jun-01 Jun-03 Jun-05 Jun-07 Jun-09 Jun-11 50 Electricity price for resident (CNY/100kwh) 1980 1985 1990 1995 2000 2005 2010 Coal price for resident, 1st grade (CNY/100kg, RHS) Source: Lu Feng, "Employment expansion and wage Source: CEIC, Barclays Research growth (2001-2010)", China Macroeconomic Research Center, Peking University, Beijing, 12 June 2011 Fortunately, we have already started to see changes in the factor markets. Wages have been rising rapidly due to emerging labour shortages (see Figure 5). The government has begun to adjust the prices of resources, including electricity, oil, gas and water (see Figure 6). The authorities also plan to introduce market-based interest rates and increase exchange rate flexibility during the 12th FYP. These changes should gradually remove distortions to the incentive structure for economic entities, and eventually drive the transition of the Chinese economy – from economic miracle to normal development. Assuming this transition takes place, we are likely to witness a sea change in China. If the transition is smooth, then we think the Chinese economy should be able to avoid the ‘middle-income trap’ and move to the next level of economic development. During this process, there is likely to be a series of important changes that could have significant implications for market participants, both at home and abroad. We identify the most important emerging economic trends as: Growth is likely to moderate, although steady growth should continue; 1. Inflation pressures to rise; 2. Income distribution will likely improve; 3. Industrial upgrading to accelerate; 4. The economy will start to rebalance; March 2013 9