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Beijing looks West in search of economic stability

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China’s current growth model is unsustainable, according to Ewan Markson-Brown, a portfolio manager with Newton’s Asian equity team.

 

In a period when headlines, which have been dominated by China’s high-profile sparring with the US, have centered mainly on the Chinese stance in relation to the value of the renmibi, Markson-Brown believes that domestically, China is faced with some major decisions this year that will influence its growth over the next year or so.
 
“At present, the Chinese economy is rife with distortions which have slowly gestated since its currency was effectively pegged to the US dollar back in 1995, while interest rates have been continuously held significantly below nominal GDP growth,’ explains Markson-Brown. “This low interest cost has led to an excess demand for capital, especially within the export sector, necessitating government intervention in the allocation of loans, and a controlled banking system. This, in turn, has led to the over-availability of credit, hence over-investment in the export sectors and within state-owned enterprises and local governments, to the competitive detriment of the private sector. 
 
“The consequence of the fixed currency has been that export growth has led to a vast current account surplus, the wholesale purchase of US Treasuries – estimated to be just under 50% of its foreign exchange reserves – and the effective financing of the US consumer rather than boosting its own domestic infrastructure and economy,” he adds. “As shown by China’s consumption as a proportion of GDP which has fallen for the past decade – although this finally bottomed out in 2009 – much of China’s economic growth over this period has been capital rather than labour intensive,” he continues. “In effect, this is because not as many jobs were created than would have been within a free market as capital has remained underpriced versus labour, while profits have been going to capital rather than wages – which have grown below GDP growth.”
 
However, the past decade or so has still been a bumper period for Chinese economic growth, relative to its Western and Asian peers. Markson-Brown continues: “The period has also seen widespread urbanisation and infrastructure spending, while the utilisation of previously employed labour and capital has increased substantially. As such, returns on capital have been strong, despite these economic and governmental headwinds.
 
“It is clear that the government realises that this model of growth is not sustainable if it wants to continue to grow and challenge the US as the world’s largest economy,” he adds. “The problem it is faced with is how to make these shifts away from investment and towards consumption, without destabilising the economy? Further urbanisation of the vast rural areas of Western China and the subsidisation of consumption – such as tax breaks on new car purchases – should help, but the latter really can’t be viewed as a viable long-term option. 
 
“What is becoming evermore real as a possible move is a controlled appreciation of the renminbi,” explains Markson-Brown, “While the verbal sparring of recent weeks might make China reluctant to revalue, the fact is that it wouldn’t be revaluing in order to appease Washington, it can and should do so in order to boost its own economic prospects. With export data soaring 45% in February, expectations are that export growth could potentially surprise on the upside this year. Given that China is only likely to allow a gradual appreciation of the currency from a position of strength,” he adds, “this seems like the perfect opportunity to boost its domestic economy and in so doing ease tensions with the US without losing face.
 

“If it is successful in its shift towards consumption, then the subsequent fall in the Chinese savings rate will lead to a reduced current account surplus and provide upward pressure on domestic interest rates and price inflation. The result would be a stronger currency, along with stable and balanced economic growth. That said, there is no doubt that this will take some time,” he concludes, “but for an economy as rich in potential as China’s, it is the only feasible means of ironing out its economic distortions and paving the way for sustainable long-term growth. Evidently, such a period of change comes with much volatility as the Chinese economy shifts slowly towards being a free market, but with such change comes real investment opportunities. These will abound over the next decade or so.”

 

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