China – Financial Year 2015 Review


  • China’s GDP growth met its CY15 target, but it keeps on slowing down. It would be a lot lower if the authorities weren’t pumping up the money supply, applying fiscal stimulus to key sectors, and fudging some of the statistics.
  • China’s wealthiest citizens are continuing to ship their money off to safer jurisdictions. This is one of the main reasons why the China’s currency is weak even though its trade surplus and its incoming direct investment are both rising.
  • We don't see any likelihood of a hard landing in China this year, but the downward drift of the Chinese economy is negative for resources exporters in general and for Australian resource stocks in particular.

One of the constant themes in our commentary on China since 2011 is that Chinese economic growth is slowing down. Global share markets had an attack of nervous tremors in early January before the 2015 Chinese GDP data came out, but their fears seem to have subsided again. We take this opportunity to review the Chinese economy, summarize the near term outlook, and assess the implications for Australian investors.

In 2015 Chinese GDP grew by 6.9% in real terms, i.e. after adjusting for inflation during the year. This was not only below the 2014 figure of 7.3%, it was also China’s slowest growth rate since 1990. It was, however, in line with consensus forecasts and the government’s official target. A negative indicator was that growth appeared to be decelerating over the year, because growth in the December quarter was only 6.8%, but this figure is acceptable because the government’s official target for CY16 is only 6.5%. So we can conclude that the Chinese economy is slowing as expected.

The composition of the 2015 national accounts suggests that the economy is responding to the government’s efforts to re-balance it away from investment-led growth and towards consumption-led growth. The main cause of the slowdown was secondary industry, which grew at 6.1% real during 2015, whereas the services (tertiary) sector grew at 8.2% real. This trend is consistent with a slowing in the growth rate of fixed asset investment (FAI) to 10.0% year on year, its slowest rate since 2000. The rise of the services sector is evident in the fact that, for the first time ever, it made up more than half of GDP – 50.5% compared to 48.1% in 2014.

The high growth rate of the services sector is in part a consequence of government policy, but also due to the fact that the services sector does not rely on external inputs as much as secondary industry. In particular, the small businesses which are common in the services sector have very modest capital needs, so they are not dependent on credit growth. The services sector also uses less energy and less materials, so that its growth is better aligned with the government’s policies to reduce environmental pollution, given the rising public concern over many obvious examples of pollution of food, water, soil, and urban air. As the services sector is labour intensive, its rapid growth will help absorb the labour made redundant by factory closures in secondary industry.

Most importantly, the average citizen is enjoying a higher income: average income per capita rose by 7.4% year on year, faster than GDP. Consumption accounted for 66.4% of GDP growth in 2015, up from 51% in 2014. China’s household consumption spending, however, was only 38% of GDP in 2015, compared to the typical level of about 65% in developed countries.

The slowdown in secondary industry has been a major factor in the collapse in global commodity prices. Steel output fell 2.3% and electricity generation fell 0.2%, so it is hardly surprising that China’s imports of industrial commodities also fell, e.g. coal imports were down 30%. This is the explanation for the slide in coal prices which has been killing Australian miners.

Falling prices are a key feature of the Chinese economy. China’s nominal GDP grew by only 6.4% in 2015, which was less than its real GDP growth rate of 6.9% because of the effect of deflation. Lower commodity prices are the main reason why China’s Producer Price Index (PPI) has been falling for the last four years, although the Consumer Price Index remains positive. Another deflationary factor is the over-capacity which has built up in many sectors, such as steel production, mining, and oil refining.

Although deflation is not intrinsically bad, it does have the unpleasant effect of increasing the real value of any nominal debts. As China’s debt to GDP is one of the highest in the world at 209%, continuing deflation will represent a problem for Chinese companies unless they have the active support of a local, provincial or national government. The four-year decline in the PPI has pushed corporate revenues down, making it harder for companies to service their interest and principal obligations unless they have some form of state support, e.g. subsidies or government contracts. This is one of the main reasons why the central government continues to provide fiscal stimulus, such as building more infrastructure, and monetary stimulus, such as interest rate cuts and reserve ratio cuts. A recent change to tax levels on new cars sparked an 18% increase in car sales in December alone.

The most urgent policy problem facing the Chinese government is capital flight. In the decade from 2003 to 2013, the Chinese yuan rose steadily against most major currencies, so investors and speculators got used to treating the yuan as a one-way bet. China steadily built up its foreign exchange reserves, reaching a peak of USD 3.99 trillion in June 2014. The gentle decline which began in 2014 accelerated in the second half of 2015, reducing the foreign exchange reserve level to USD 3.33 trillion at December 2015. The problem is not one of declining investment, as foreign direct investment (FDI) reached a record USD 124 billion in 2015. The 2015 capital outflow of USD 676 billion represents the decision of portfolio investors, currency speculators and Chinese residents to reduce their exposure to China.

Considering the whole picture of China’s national accounts, it is clear that growth is continuing at rates which the rest of the world would envy. There are a number of problem areas – such as the rapid rate of credit growth – but it is unlikely that China faces a hard landing in the near future. In the wake of the CY2015 figures, the consensus forecast for GDP growth is 6.5% in CY2016 and 6.0% in CY2017. It is, however, far from assured that China’s growth rate will reach the average of 6.5% which is forecast for the period of the Thirteenth Five Year Plan, from 2016 to 2020. Nor is it likely that the Chinese yuan will remain as stable as it has been under the last two decades of tightly managed exchange rates.

The implications for Australian investors are clear. Exports to China represent 5.1% of Australia’s GDP, which is by far the highest exposure among developed economies. The continuing slowdown in China is a negative for Australian resources companies, and – apart from tourism and education – the Australian services sector has been slow to engage with the growing Chinese services sector. Accordingly, we remain cautious on the prospects for Australian economic growth and the Australian dollar. Although the Australian resources sector will bounce from time to time in sync with commodity prices, we regard it a long term value trap.

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