For many years the ease of development of already advanced industrial methods meant high levels of output led growth. Many anticipated this growth path would continue, but recent events have significantly reined in expectations. This has been reflected by what we have seen across global markets in the past few months and most notably on 24 August, which has now been labelled as ‘Black Monday’.
When investing in the Chinese market, it is important to consider volatility. In the last 25 years the Shanghai composite closed within 1% of the previous day’s close just 56% of the time compared with 74% in other more developed countries over the same time period. It’s worth noting that within this period its average movement was three times larger then any other economy of its size. This highlights the ongoing growth pains China’s economy has been faced with and the sensitivity of market sentiment to economic shocks.
China’s heavy growth led model is one which seemed to be unsustainable with a number of issues that have been continually ignored. Over-reliance on fixed investment and exports has held back the transition to a consumer led economy. China has had a history of holding its currency down, so any dip in its export market highlights concerns over whether China’s high level of growth can be sustained. Unsurprisingly, recent export figures have been below expectations and, as a result, forecasters have downgraded industrial output and GDP predictions. Some expect GDP growth to be as low as 5%, which is 2% below official figures released by China.
Five interest rate cuts by the bank of China since November 2014 and planned state spending have done little to support the slowing economy. In fact the surprise devaluations and monetary easing have only emphasized the worries of the economic slowdown. As a result, Chinese equity funds fell by as much as 44% at the end of August, collapsing 8.4% in just one day on 24 August, wiping hundreds of billions worth of capital off the stock market. The government has been spending around 40 billion dollars a month to alleviate further volatility, however, as a result, they have been accused of artificially trying to boost the stock market.
Considering there are 258 million stock trading accounts in China with a projected 90 million retail investors, you would expect the domestic market to be relatively buoyant. However, the issue was that many ordinary people put their life savings and even mortgaged their houses in order to invest in the stock market, so the wealth of families relied on prices to keep going up, but eventually the stock market bubble burst. Firms relied on shareholders’ capital to cover their losses, however more and more capital was being wiped off balance sheets as domestic investors fled from the market.
The question being asked now is where China goes from here. You might argue that the government is perfectly capable of supporting its banks, and providing all the currency liquidity they require. What appears to be the problem in the transition is a lack of demand from China itself. China is saving rather than spending, preventing the transition to a consumer led model. A number of problems have to be addressed in order to refuel domestic demand and market sentiment.
The slide in the markets has exposed the flaws in government reforms. China’s banking policies and lack of adequate social safety net are often blamed for the lackluster domestic market. The most significant problem is the imbalance between savings, investment and consumption, whereby gross savings and gross fixed investment as a percent of GDP are the highest among any of the world’s largest economies, whilst private consumption as a share of GDP is among the lowest.
Considering China places restrictions on the export of capital, Chinese households put savings into domestic banks instead of foreign banks. This is highlighted by the fact savings saw a rise from 12% to 32% between 1982 and 2012. The Chinese have been encouraged to save due to poor pensions, health care, unemployment benefits and education. The government has often set interest rates on deposits below inflation to stimulate spending, however it has instead encouraged firms to invest. While this isn’t particularly unusual in growing economies, it is when considering the poor social safety net China provides.
Clearly China has significant long term growth potential with a middle class predicted to be larger then the population of the USA within the next couple of decades. However, while China undertakes its transition to a consumer led economy, we might expect continued ‘growing pains’.
We see recent events as short term damage to market sentiment, providing a headwind for global growth. However, we remain relatively optimistic over the long term health of the global economy. Investors will just have to start accepting more normalised levels of growth in China going forward. It is hard to bet against China’s long term economic development, after all, its economy is still likely to be growing far more rapidly than more developed nations like the US and UK. However, greater transparency and more honest economic projections from China are needed to alleviate continued volatility and uncertainty in both its domestic market, as well as globally.