Is China heading towards a downturn?

Xi Jinping, China's president, during a visit to India welcomed by Narendra Modi, IndiaÕs prime minister,at a ceremonial reception at Hyderabad House in New Delhi, India, on Thursday, Sept. 18, 2014. ***. Photographer Graham Crouch/ Bloomberg *** Local Caption *** Xi Jinping;

Xi Jinping, China's president, during a visit to India welcomed by Narendra Modi, IndiaÕs prime minister,at a ceremonial reception at Hyderabad House in New Delhi, India, on Thursday, Sept. 18, 2014. ***. Photographer Graham Crouch/ Bloomberg *** Local Caption *** Xi Jinping;

Published Nov 25, 2014

Share

CHINA is in transition. That the country has achieved spectacular levels of growth over the past three decades is irrefutable, but the law of large numbers, overinvestment and decelerating growth is culminating in a sharper economic downturn than many expected.

There is growing belief that the structural issues facing the country (gross capital misallocation, unsustainable levels of debt and the associated declining efficiency of capital) are leading to diminishing returns across a plethora of industries and bringing forward China’s own ‘Minsky moment’.

Within the country, debate has intensified over how much stimulus should be applied, whether monetary policy should be eased more aggressively and the need to meet the growth target. President Xi Jinping has publicly embraced reform and must now engage in a delicate balancing act to ensure the ambitious agenda laid out in the 2013 Decisions Document is pursued, while maintaining a politically and socially acceptable level of growth.

If history is any guide, the bears have good reason to be sceptical; the evolutionary path to becoming a developed economy has been a bumpy one. Why should China be any different? In addition, the delayed launch of the Hong Kong-Shanghai stock connect and relatively muted outcome to the recently held Fourth Plenum has caused some to question whether the Emperor is wearing no clothes. While we have a degree of sympathy with both views, much has been achieved in laying the platform for the two main policy objectives: strengthening the Communist Party and making the path of economic growth more predictable and sustainable.

As the strongest leader to emerge since Deng Xiaoping, success or failure of the reform agenda is intrinsically linked to Xi’s personal efforts to consolidate power. Since taking over, Xi has placed great emphasis on ‘party strengthening’, notably in his pursuit of the anti-corruption campaign that has convicted several hundred thousand officials and included ‘tigers’ such as princeling Bo Xilai and the former internal security boss Zhou Yongkang, the former Politburo Standing Committee member.

Xi has assumed control of an unprecedented number of leadership positions. He chairs the National Security Council, which deals with internal and external security and is designed to integrate different strands of policymaking and implementation, ensure cohesion with the People’s Liberation Army (which Xi also heads as chairman of the Military Commission), and co-ordinate the actions of ministries involved in international affairs. This gives him a dominant position in the party structure to a degree not apparent under his two predecessors.

At the state level, progress has been made to enhance the effectiveness of policy execution. First, the idea of recentralisation has been proposed by streamlining the existing five levels of government into three (central, provincial and a combined city/country/town government).

Second, legal reform promised by the Fourth Plenum will reduce the influence of vested interests at the local level.

Third, the introduction of a new budget law gives the central government more control over local government debt, introduces debt ceilings and the removal of state-backed implicit guarantees.

Fourth, Xi is also reputedly pressing ahead with efforts to limit the size of the party (80 million members) in order to facilitate a more efficient movement of cadres.

A recentralisation agenda marks significant progress towards setting rules for local government funding and debt issuance and for a more transparent and accountable budgetary system overall. It also demonstrates progress towards authorising provincial governments to issue bonds within quotas approved by the State Council.

The initiative is also certain to disrupt the status quo via a widespread loss of official jobs and the quelling of influential and connected party members. It is reasonable to assume that this could only have been achieved through a combination of savvy political manoeuvring, strong leadership and party unity.

After ten years of consensus leadership under Hu Jintao, Xi’s crusade, both personally and in party terms, is proving popular. But having moved swiftly to consolidate his power base, tangible results beyond the anti-corruption campaign are called for. Significant moves have been made on the economic reform front, but in keeping with China’s ingrained gradualist characteristics, the rebalancing from dependence on fixed asset investment and exports to domestic consumption was always going to be a slow process. The big question is whether the market will allow Xi time to deliver on his promises.

Much like the local government financing vehicle issue that Beijing is moving to address, there is an inherent duration mismatch between the long-term reforms that China needs and the speed at which the economy is slowing in the short term.

Progress will be difficult given the need to maintain growth and the systemic issues in a state where economic and political interests are so closely interconnected. In the coming year, as the cost of slowing growth is felt and social problems continue to rise, Xi will probably face his greatest test.

With China’s path to global power status likely to be a bumpier one, our focus within the funds is to concentrate on the key bottom-up task of identifying China’s best firms. In this respect, we continue to focus on strategic policy response beneficiaries (agriculture, clean energy, health care, e-commerce and mobile) where visibility and the prospect of positive structural change are greatest within the practical constraints posed by the political system.

Craig Farley is a portfolio manager at Ashburton Investments.

Related Topics: