November 2015
Schroders
Talking Point
China: Facing collapse or slow decline?
Craig Botham, Emerging Market Economist
Our recent visit to China reassured us that things are not so much worse than the data is telling us. Corporates,
analysts and officials were candid about many of the challenges faced, but there is little evidence of a crisis at
present. While current activity seems to be holding up, we remain concerned about the years ahead given
some of what we heard.
Prospects of reform
Sentiment has soured on the prospect of China becoming more market-oriented. Market reforms will be
tolerated only where they serve the purposes of the state and the goal of enhancing social stability. In addition
to this, reform is meeting strong resistance from senior management at state owned enterprises (SOEs), who
have obvious vested interests in not being merged with one another. Optimism is muted at best that the Fifth
Plenum will make substantial changes in this regard.
One-child policy scrapped
Perhaps the banner policy so far has been the ending of the one child policy, but this is likely to have limited
impact.
Boosting the fertility rate would definitely help, but it is not certain that ending the one-child policy will be
effective. Previous relaxations, such as in 2014 when 11 million couples were eligible for a second child, only 1
million applied to do so. It may be that after so long, the one child norm will take time to reverse. In addition,
anecdotally many young Chinese cite the cost of children, particularly education, as a major barrier to
considering large families.
Reform of state-owned enterprises (SOEs)
SOE reform, including mergers, would be a key part of reducing spare capacity in China. Some large SOEs
have been employing almost twice as many people as they actually needed. Of course, this is the problem for
the government; how to reduce spare capacity without causing massive unemployment, which would call into
question the Party’s legitimacy and threaten social stability. The realpolitik of the situation provides further
grounds for gloom. SOEs in overcapacity sectors have begun expanding into “emerging industry” areas, but it
is questionable how quickly existing staff can be retrained for these new industries.
Property divergence
Overcapacity in the property market remains a problem but the divergence between Tier 1 cities and the rest is
widening. Though it is unsurprising that central Shanghai property should be more resilient than property in a
small city in the Western provinces, it creates problems for smaller developers concentrated in the less
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salubrious regions. All the same, sector consolidation is proceeding at what could best be described as a
stately pace. More failures are likely among the market minnows.
Financial liberalisation
One area of reform that has proceeded reasonably smoothly and rapidly is financial liberalisation, with deposit
rates now fully liberalised and the local government debt swap doing much to reduce debt costs, even if it is
squeezing bank margins. Local government bonds are seeing buyers other than banks strong armed into it by
the state. However, this has much to do with the bond market bubble which has seen a remarkable
compression of spreads across the credit space. Local government bonds themselves are still trading at very
tight spreads to the sovereign – in no small part due to the assumption of central government support.
Currency devaluation
Of course, not all financial reforms have been without problems. The devaluation of the renminbi (RMB) in
August caught everyone by surprise, including well connected SOEs. In the wake of the policy shock,
somewhat panicky firms showed a marked increase in their desire to hedge currency exposure and also began
paying off dollar debt. At the same time, wealthy clients of asset managers have also reportedly become keen
to diversify their portfolios away from RMB-denominated assets. While the hedging and debt repayment
activity has seen a peak and will now wind down, reducing pressure on the currency, the desire for
diversification will mean that any relaxation of currency controls will likely see further depreciation.
Prospect of hard landing?
Our expectation remains that Chinese growth will avoid a calamitous collapse and instead slowly drift lower.
But without successful reform, the risk of a hard landing rises. Vested interests will have to be challenged if the
misallocation of resources is to be addressed, itself key to transitioning to service led growth. If inefficient
SOEs are allowed to continue to dominate, productivity will be hurt and growth will slow much sooner – the
next five years will be vital.
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