China slowdown likely to be brief, says Edmond de Rothschild AM

But the country faces challenges in the form of an overheating property market, renminbi internationalisation and the need to reform a hybrid economic model, argues Pierre Ciret.

Pierre Ciret is an economist at Edmond de Rothschild Asset Management.

Do you believe that regulating China’s real-estate market will be too complex a task in the months ahead?
The dreaded overheating of the economy is most evident in speculative rises in real estate prices. Retail prices reached 3.3% year-on-year in July, above the alert threshold of 3% set by the government, but the rise ex-food (30% of the index) was still a modest 1.6%. In fact, prices in China have been stable since March. Given the base effect (July 2009 marked a trough), we should return to below 3% over a one-year rolling period. The much-talked about increase in labour costs is offset by productivity growth. 

The rapid urbanisation that characterised the country for several years has created significant housing needs. The government, therefore, wants to increase the amount of social welfare housing. The opinions of the provinces and cities that own the land and benefit very directly from the bull market must be taken into account. Demand on the open-market residential sector, which is in fact still subject to official controls, exceeds supply. Moreover, real estate is perceived by households as the core element in their personal wealth. The speculation mostly concerns the high-end segment (15% of the market). 

Administrative restrictions that were introduced (access to credit for a second apartment) curbed demand for mortgages, which has been declining since the spring (the volume of transactions fell 30% in July compared to June). Prices in July still rose by an annualised 10.3%, down from 12.8% in April. The current policy will be maintained, but the risk of a severe correction looks limited. In terms of construction activity, the increase in social housing should offset the decline in the high and medium-range housing brackets. 

Fearing overheating, the Chinese central bank adopted the usual measures to curb credit by increasing reserve requirements, but also took direct administrative control of credit distribution. Do you think this was a necessary step? 
The central bank, the People's Bank of China (PBoC), did not need to raise its benchmark rates, but interbank rates came under pressure in May and are still higher than they were at beginning of the year (2.4% against 1.7%). At the same time, the PBoC has required banks to meet their capital ratios, forcing them to be more disciplined. To reinforce proper industry practices, the banking regulator now requires banks to reintegrate into their balance sheets credit corresponding to certain securitisation transactions.

These new provisions will take effect at the end of next year, but in the meantime banks will be forced to increase their capital in due proportion or revise their credit distribution policy. Major Chinese banks have already announced new share issues. In July, new loans totalled around Rmb533 billion. Even though it marks a drop from the average monthly level (Rmb750 billion) in the first half of the year, the credit growth is still deemed robust. 

What about China's interior and agriculture? How do you see them developing?
Rising real estate prices in most of the developed parts of China (coastal provinces – the centre point of growth so far), and accelerating costs for companies, means that the latter must turn to the inland provinces (Henan and Sichuan in the case of Foxconn), which are less affected by the effects of the reform. This is why transport infrastructure is such a priority. This year $120 billion will be invested in the railways alone. 

Agriculture has also been lagging behind industry in terms of investment and infrastructure. However, China needs to improve its crop yields to avoid pushing world prices up, ultimately impacting its own price index (where food represents 30%). Improving farmers’ incomes (still 60% of the population) will be a positive factor for demand in general and will help the country to develop in a more balanced way. 

Do you think the government is ready to liberalise the renminbi?
The Chinese government has repeatedly expressed its wish to turn Shanghai into a major international financial centre. This goal cannot be achieved, however, without the convertibility of the renminbi. Technical measures have already been taken, and there is a burgeoning offshore centre for RMB transactions in Hong Kong, but exchange control restrictions remain largely in place. There have been some international RMB-denominated issues (McDonald’s), but the amounts in question are still minimal. 

The liberalisation of foreign exchange will inevitably strengthen the RMB with an obvious threat to export competitiveness. A real effort has been undertaken to make products more competitive, regardless of their price, by offering higher value-added products. The process is far from complete, even though there have already been some undeniable successes. In other words, the strengthening of the RMB must happen gradually. The reaction of China’s trading partners when faced with a growth in surpluses will be interesting, especially as some segments of the Chinese market appear insulated from competition, or closed to foreign companies. There is a genuine risk of targeted retaliatory measures (see Hua Wei and their difficulties in the US).

Finally, the accumulation of official reserves ($2.45 trillion) poses the problem of breakdown by currency as well as their management. After two years of stability, the announcement in June of a change to the PBoC’s intervention level on the foreign exchange market is important in principle but doesn’t change the prospects much for coming months. The RMB has risen less than 1% against the US dollar (6.78 against 6.83). 

Do you see the Chinese model as a great success? And what do you believe the future holds for the country?
Since 1978 and Deng Xiaoping’s first reforms, the economy has undergone an in-depth transformation which has proved to be a great success in terms of growth and development. China’s growth rate has regularly exceeded 9%, and its GDP now exceeds that of Japan. This expansion has benefited all emerging Asian economies and represents a major source of imports. Further reform is nonetheless necessary to exit the current hybrid model, which has probably reached its limits. On the eve of important political events (a new president and a new prime minister will be appointed in 2012), there is a risk that the authorities will simply manage policy over the short term, deferring long-term decisions. 

As one might expect in a standard development pattern, China’s growth has depended for over 20 years on investment and exports (in itself a generator of investments). This approach has been a great success (the country has become the world’s leading exporter), but it is increasingly triggering reactions that could threaten the model’s sustainability. Domestic investment is not in itself an issue, but persistent trade surpluses ($28.7 billion in July) due to a very controversial exchange rate can only lead to tensions with trading partners, and at times even to protectionism. 

What model do you see the Chinese economy migrating to?
The increase in Chinese consumption is a real source of growth. The automobile sector in China has, for example, become the world’s largest market. However, household spending has not increased in proportion to investment and exports. As a result, the share of consumption in GDP has declined steadily over recent years. This share is now at just 35% and it can be estimated at 47% if we add in residential investment.

One anomaly of the Chinese economic and financial system lies in the excessive weight of savings due to the absence of a genuine welfare system until recently. Meanwhile, wage increases, the result of higher qualifications, have helped to increase the population’s standard of living (per capita income exceeds $6,000, an average that masks wide regional disparities). The continuation of this trend will underpin rising consumption (annual growth of retail sales in July was 17.9%), but a real change in household behaviour is essential. 

Do you have any concluding thoughts on the future of China’s economy?
The Chinese economy is experiencing the short-term slowdown sought by the authorities. After growing 11.1% in the first half the year, the second half will see a drop as a result of restrictions on real estate. The slowdown should, however, be brief. Pending signs of their success, the measures introduced should not be changed for a few months. In determining economic policy, Chinese officials are still attentive to the growth outlook of external economies.

In the longer term, the growth potential of the Chinese economy has never been stronger because sector diversification is higher. However, sustaining growth will depend on the ability of China’s leaders to pursue the transformation of the Chinese economy and to accept the development of a true private sector.

The private sector that has emerged in the past few years has created more value than most public companies that dominate market indices, more worried about state interests than about those of smaller shareholders. Despite strong economic growth, Chinese indices have shown a disappointing development compared with other emerging markets. The private sector is where investors should focus through a rigorous stock selection in order to enjoy its strong middle-term growth potential.

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