With the recent change to China’s leadership the following article entitled “China’s Growing Pains” gives an excellent overview to help understand what its position currently is.

“China has experienced a decline in its GDP growth rate from 11.5% to 7.5% over the past four years, yet its continued urbanisation and industrialisation will foster moderate growth for decades.

The decline in China's growth rate has become a major media issue and topic of conjecture for economists the world over.  The reality is both cyclical and structural forces are at play in the Chinese economy. The cyclical decline in growth has been caused by the following:

  1. The global economic and financial recession reducing trade flows and China's exports
  2. Government intervention to cool the property market (restricting speculation) and lower inflation (limiting social unrest)
  3. A more cautious investment policy created by the upcoming leadership transition following the 12th Central Party Congress

The first two causes are well known, with the reduction in exports subtracting 1.5% from China's growth rate and the slowdown in the property market having a significant impact on construction spending.   Housing investment shifted from 8% to 12% of China's GDP over the past decade, and the excesses created by the residential construction boom must be worked out.

The third cyclical cause receives less attention but is very important given China's investment-driven growth model.  Over the past 30 years, the Chinese political and business cycles have been interwoven. A pattern exists whereby capital formation* increases dramatically after a Central Party Congress and drops sharply before the next - a period through which we are transitioning now. Quite simply, new provincial leaders wish to position themselves more favourably for the next Party Congress by demonstrating their investment and job creation credentials.

However, the investment they undertake inevitably creates inflation, requiring the Central Government to step in and slow growth, something we have witnessed over the past 18 months.

The structural decline in China's growth rate has occurred due to overinvestment, which has crowded out productivity growth. From 2001 until 2007, following China's entry into the World Trade Organisation, productivity growth averaged 4.7% and was driven by the mass relocation of labour from low productivity agriculture to high productivity manufacturing. However, from 2008 until 2011 the economy managed productivity growth of only 2.8%  (although no reported numbers from China can be assumed accurate).

Capital efficiency diminished with the impact of RMB4-trillion stimulus being pumped into the economy in response to the financial crisis and declining exports.  Much of this stimulus went to state-owned enterprises that operate in protected sectors of the economy. While the state sector is an important employer, it creates distortions and discourages private sector investment, further detracting from growth.

It is this structural decline in growth rates that caused many investors to question the sustainability of China's growth model and its reliance on high fixed asset investment.  They argue that sustainable growth now requires a much higher level of consumption and a lower level of investment going forward.

We agree; however, we believe that rebalancing China's growth will occur over a long period as the process of industrialisation and urbanisation continues to raise incomes and with them, the consumer and service sectors.

Industrialisation will remain the major driver of growth as the country needs to continue investing in its capital stock to improve its productivity.  While China's level of capital formation to GDP is the highest in the world at close to 46%, its formation per head of population is less than a third of the United States.

This means that China must continue to invest at a higher rate than Western economies if it is to achieve the same development and productivity levels.  The country simply does not have the capital stock (equipment, buildings and infrastructure) that the West has built over the past 200 years.

Productivity levels can also improve with market-orientated reforms that remove price distortions and lead to better deployment of capital.  While reforming the state-owned enterprises and banking sectors is easier said than done, we should not forget that China has managed substantial structural reforms in the past - rural land reforms, creation of special economic zones, joining the WTO - all of which resulted in substantial increases in productivity.

Urbanisation will play a central part in driving growth going forward. There are still a large number of people to be housed in cities as the urbanisation rate moves from 51% today to 70%-75% in 2030. This is a multi-decade story, underpinning the housing investment (10% of GDP) and broader construction investment needed to service the new urbanites.

Importantly, urbanisation has the desired impact of rebalancing the economy towards greater consumption as urban per capita income and consumption are three times as high in the city as they are in rural areas.

We believe that China's growth rate has stepped down and consolidated at a sustainable level in the face of slower external demand and a more focused investment policy. We also believe that the investment-driven model will remain the primary driver of growth in the short to medium term, with a consumption model growing in importance as urbanisation increases and incomes grow.

Trying to predict a future growth rate for China's command economy is problematic, but we do not expect a hard landing as the Chinese government seeks to maintain a level of growth that ensures stable employment and limits social unrest. And, importantly, the government is in the fiscal position to do so.”

* Capital formation refers to the increase in capital stock (e.g., equipment, buildings and infrastructure) over an accounting period.  A nation uses capital stock in combination with labour to provide goods and services. Generally the higher the capital formation of an economy, the faster it can grow its aggregate income.  Thus, an increase in a country's capital stock increases its capacity for production and leads to higher national income levels.

SOURCE: Private Portfolio Managers- Andrew Beirne, Portfolio Manager