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The paradox of China's growth story

December 11, 2015 17:26 IST
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There is uncertainty in most investors' minds as to whether China is transitioning to a new growth model or simply collapsing, notes Akash Prakash.

When one discusses the outlook for China with both bulls and bears, the crux of the debate is the outlook for the Chinese consumer and for the services sector.

There is very little difference in either side's outlook for industrial production and commodity demand: both the bull and the bear believe that manufacturing and commodities demand will remain weak in China.

The bears believe this weakness is due to China hitting the middle-income trap and being unable to continue dominating low-cost manufacturing while not moving up the chain with more value-added products.

The bulls believe this weakness can be traced to China making the transition to a more services-oriented economy.

Both sides of the debate believe that China has hit peak steel and coal, with coal demand already dropping in absolute terms, and steel also unlikely to show growth from its current levels of 800 million tonnes.

No country has invested as much as China, with an investment share of GDP over 40 per cent for decades. 

So the real debate is around the health of the services sector and the consumer.

Is there enough growth in services and consumption to save the Chinese economy from a hard landing and a credit bust?

Or will the doomsayers be proved right - is China is on the verge of its own credit bust and Minsky moment?

If there was sufficient belief in Chinese government statistics, then there would be no debate at all.

As per official statistics, nominal growth in the tertiary sector (services) was 12 per cent in the second quarter of this year. Services are now about 50 per cent of the Chinese economy.

If services were really growing at 12 per cent (even in nominal terms), there is no way the Chinese economy could be contracting like some bears seem to think.

Wage growth according to the government numbers is supposed to be eight per cent - again, no sign of any stress.

You can't really have a hard landing with that level of wage growth. 

While the bears may still be right, to believe in their scenario, you have to implicitly assume Chinese government data is rubbish.

While there have always been question marks around Chinese economic data, it has been more about degree; to assume it is just totally wrong seems to be a bit of a stretch.

Given all the concerns around official data, many market observers have built their own data sets, tracking various proxies for consumption and consumer sentiment.

The data on airline passenger volumes, 4G mobile subscribers, Alibaba gross merchandise value, property prices and so on are all uniformly positive and do not indicate any slowdown.

Even car sales, once you adjust the data for licence plate restrictions in the larger cities and consumer expectations of falling prices, are back in positive territory.

Consumers do seem to have both the confidence and income to consume. Consumption growth also seems broad-based and across sectors.

The bears always come back to trade data. Chinese imports in September fell by 20 per cent. An open and shut case surely:

How can an economy the size of China, with its global linkages, grow by seven per cent with this type of decline in trade?

The answer lies in the composition of Chinese imports. Commodity imports fell by 27 per cent, and China is the world's largest commodity importer.

This decline is a huge positive for China and reflects the collapse in commodity prices, not a collapse in import volumes.

Accompanying this is a decline of 21 per cent in capital goods imports as China has slowed investments and also indigenised certain technologies.

If one were to take out commodity and capital goods imports, then what remains is largely consumer goods - which have actually grown by nine per cent year on year.

This much growth in consumer goods imports in no way indicates a consumption slowdown or economic recession.

The bears also point to the weak commentary coming out of many foreign companies operating in China.

Given the ambiguity and lack of confidence in macroeconomic data, on-the-ground corporate feedback may be the best dip-stick test of what is really happening to consumer China.

Here the picture is mixed. You have companies like Apple, Nike, Disney and Starbucks reporting strong numbers, while others like Yum, Caterpillar and the luxury players have lowered guidance entirely due to China weakness. 

This dispersion seems to be related more to company-specific execution issues; we are starting to see more of a market share battle in various sectors as local Chinese companies gain share and the law of large numbers impacts growth rates.

Those companies executing well seem to be doing fine. We do not see commentary typical of a recession wherein noone is growing, there is rampant price cutting, and all companies are complaining.

There remains uncertainty in most investors' minds as to whether China is transitioning to a new growth model or simply collapsing.

In either case, fixed asset investment is clearly slowing - a necessity given how low China's return on assets are both on a stock and incremental basis.

China should be slowing investments to improve the utilisation of existing assets and enable economy-wide returns to meet the cost of capital.

This is an unambiguous negative for global commodities.

Further drops in global commodity prices combined with a strengthening dollar can create havoc for stressed commodity producers.

We may see further stress in high yield and EM corporate debt markets - sectors where spreads have begun to widen.

Combine this with fears around the Fed hiking rates and we may see a toxic brew developing for emerging market assets.

While one is tempted to be contrarian and look at EM assets given the pervasive bearishness, there may still be short-term pain ahead for the asset class.

It probably makes sense to gradually raise exposure to EM assets over the coming few months and not jump in all at once.

Weak commodity prices and a poor outlook for most EM economies will ensure that India will continue to be seen as attractive by most EM investors.

Despite being a consensus overweight, in a weak EM environment India may not see much by way of outflows as it benefits from the TINA factor.

But it will not always be so, and thus we must use what time we have to try and kick-start the economy.

Green shoots are starting to appear; let us hope we can maintain the momentum.

The writer is at Amansa Capital. These views are his own.

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