How China deals with the challenges of rising debt, a transition to a consumer economy and the technological ‘arms race’ with the West will have big implications for investors.
12 minute read
As world leaders prepared to descend on the Japanese city of Osaka for the G-20 meeting in late June, one topic dominated debate: the US-China trade war. Speculation swirled around a possible one-on-one meeting between President Trump and his Chinese counterpart Xi Jinping. Would the two men agree a truce or let the tariff dispute escalate yet further?
The focus on trade is obscuring deeper shifts in the Chinese economy. As China grows richer and more technologically advanced it will play an ever more prominent role in global markets and geopolitics, whatever the outcome of trade talks. But the rising Asian power faces big challenges, and the road ahead may not be entirely smooth.
In this article we consider three factors that will play a determining role in China’s future. From dealing with a growing debt burden while attempting to transition from investment-led to consumer-led growth to its world-leading tech aspirations, how China manages its maturing economy and growing political power will have consequences far beyond its own borders.
1. Balancing debt and growth
Having sagged to a three-decade low in 2018, China is stepping up efforts to stabilise its economic growth rate. However, by piling more debt on an already highly leveraged economy, Beijing could be storing up problems for the future.
The government has been forced to lower its growth target for 2019 to a range of six to 6.5 per cent – it had a harder target of “around 6.5 per cent” in the previous year. While activity has been weighed down by a decline in confidence due to rising trade tensions with the US, the bulk of the slowdown has been caused by China’s earlier drive to deleverage its economy and eliminate risky lending practices.
Shaken by the stock market boom and bust of 2015, and subsequent outflow of capital, Chinese policymakers’ initial response was to try to stimulate the economy. But by the middle of 2017 they applied the brakes once again in an effort to reduce financial risks.
Perhaps most significantly, policymakers launched an aggressive campaign to crack down on the country’s shadow banking sector, long viewed by the International Monetary Fund and others as the biggest risk to China’s financial stability.
Partly because deposit rates offered by China’s mainstream banks are suppressed by the state to help ensure a cheap source of funding for inefficient state-owned enterprises, the shadow banking system has attracted billions of dollars from savers who were attracted by the comparatively high returns on offer.
Rapid growth in shadow banking created two main problems. First, since the industry is largely unregulated, it lured less scrupulous operators. In some cases, savers were wrongly led to believe the products they were investing in were guaranteed by the government. A spate of failures in 2015 led to a series of noisy street protests and prompted Chinese President Xi Jinping in April 2017 to declare “financial security is an important part of national security”.
Second, the boom in shadow banking was among the most important factors in driving total debt to a dangerous level. Since the financial crisis, debt has grown significantly faster than gross domestic product (GDP). The Institute of International Finance recently estimated China’s total debt-to-GDP ratio at 300 per cent, which is high even by the standards of most advanced economies.2
As a result of the crackdown, outstanding loans in China's shadow banking sector shrank 6.5 per cent to 61.3 trillion renminbi ($9.1 trillion) in 2018, following an even bigger fall the previous year, data from ratings agency Moody's show.
However, the downside of this contraction is that many small firms in the private sector were starved of credit and borrowing costs for the remainder rose. Given the private sector is estimated to account for upwards of 60 per cent of China’s GDP growth and 90 per cent of new jobs, that took a heavy toll on the economy.2
China’s property market is a microcosm of China’s debt problem, with mega developers potentially becoming ‘too big to fail’. While returns have been strong and selective opportunities can still be found, investor caution is deepening as the authorities tackle systemic weakness.
As an example of the conundrum China faces in solving its debt problems, the property market is racking up a potentially unsustainable amount of borrowing, which impacts several other crucial parts of the economy.
“How the government manages the transition of the real estate industry to a more stable footing – without causing a property crash – will be one of its biggest challenges in the coming years,” says William Malcolm, portfolio manager in emerging markets and Asia-Pacific equities at Aviva Investors.
“It doesn’t mean it’s not manageable, and there is a realisation at the highest level of the government of the systemic financial risks that exist in the property market,” he adds. “Nevertheless, they need to be careful to reduce stress in a gradual, controlled way.”
These structural issues are worsening just as China is experiencing a host of cyclical problems, such as slowing growth amid global trade tensions. In an industry already heavily distorted by state intervention, any misstep by policymakers could be destabilising, not only to the domestic economy but also globally, given China’s growing importance. The government’s efforts to stabilise the property market could also create investment opportunities, however, at least for companies that are best able to adapt.
Storing up trouble?
While China is much bigger and its economy more state-dominated, its economic development is arguably following a similar path to the one trodden by Japan and South Korea. They both recorded annual growth of ten per cent or more in the 1960s and 1970s before the pace of expansion inevitably began to slow.
“If their experience is anything to go by, annual growth of four per cent could well be a good result for China a decade from now,” argues David Nowakowski, senior multi-asset and macro strategist at Aviva Investors.
Much as that may seem perfectly respectable relative to other nations, such a slowdown in growth, when combined with China’s high debt, could be a potentially lethal mix for companies, especially banks. After all, last year’s economic slowdown helped push Chinese commercial banks’ non-performing loan (NPL) ratio to a ten-year high of 1.89 percent.1 Worryingly, those numbers do not include other problematic and risky loans.
Joanna Davies, senior China economist at Fathom Consulting, reckoned the true amount of impaired lending was just shy of 30 per cent in 2017, and rising.
According to Davies, Chinese banks’ non-performing loan ratio is high largely because funds are so often channelled into unproductive assets that do not earn enough to pay back the debt interest, let alone the principal.
There is little doubt China’s banks are weak and need recapitalising. And while its state apparatus gives the country more ability to shape events than is the case elsewhere, a banking crisis would not be straightforward to fix. Unlike the banking crisis of the late 1990s, China would not be able to grow its way out of the problem, while its banks have since been partially privatised.
However, although a banking crisis would undoubtedly be painful, China is different to most other countries. Not only does it not depend on foreign capital, its debt is mainly owned by its banks, which are in turn majority owned by the state. That makes it less vulnerable to the type of external funding pressures to have plagued other emerging economies in recent years.
According to Nowakowski, the easing of credit conditions, although typical of the stop-start manner in which Beijing has managed the economy in recent years, marks a dramatic about-turn in policy. It also illustrates the increasingly perilous tightrope policymakers are treading as they try to reduce leverage without badly harming the economy.
Nowakowski says it is almost inconceivable China will not meet its GDP objectives, since the government will find a way to engineer extra growth if it looks set to fall short of target. But it is necessary to recognise, with debt so high and the banking sector weak, Beijing has little margin of error.
2. Consumer to the rescue?
Given China’s growing importance on the global stage, it is important to understand the true health of the Chinese consumer and any requisite implications for domestic and global growth. Investors are particularly eager to understand and position themselves to benefit from several fast-changing retail trends. Despite a recent softening in consumption growth, innovation in areas such as e-commerce and ‘experiential’ retail continue to offer up opportunities.
With household consumption accounting for 40 per cent of Chinese GDP growth and 68 per cent in the US (according to Oxford Economics and the Bureau of Economic Analysis respectively), the relative importance of the Chinese consumer to its economy is far below that of advanced economies. However, that static snapshot ignores the maturing direction of travel and investors are right to be cautious.
The slowdown in Chinese consumer spending growth began in the second half of 2018 and continued into early 2019. Spending over the Lunar New Year holiday in January totalled just over RMB 1 trillion (US$149 billion), 8.5 per cent higher than the same period in 2018 but the slowest rate of annual growth since 2005, the year official data on consumption first became available.
“The slump in car sales, profit warning by Apple and slowing housing sales all attracted international attention and led to concerns about China’s consumption running out of steam [in 2018] . But the slowdown in overall consumption – looking at the quarterly household survey data – has been gradual and contained,” says Tianjie He, senior economist at Oxford Economics in Hong Kong.
She cites various factors behind the slowdown, including the government’s crackdown on peer-to-peer lending in 2018, which had knock on effects on the availability of consumer credit. Then there was the economic uncertainty surrounding the ongoing trade spat between China and the US, which has made consumers more reluctant to spend.
The automobile sector has been particularly hard hit. Year-on-year car sales were down six per cent to 22 million in 2018, according to the government-backed China Passenger Car Association – the first decline in two decades.5
There are structural reasons behind the decline in car sales that illustrate wider consumer trends. Over the past decade, 200 million cars have been sold in China. Many middle-class families who want a car and can afford it have already purchased their first one; hence the industry driver is transforming to more of a replacement cycle with naturally slower growth. And a similar effect is being observed in other sectors: purchases of expensive items such as smartphones and washing machines have begun to moderate as the consumer market matures.
This may cause a drag on the government’s efforts to rebalance the economy away from unsustainable debt-fuelled state investment to consumer-led growth, even if retail spending is now outstripping gross fixed capital formation as a contributor to GDP.
Over the longer term, the government needs to expand its social safety net to encourage citizens to spend more of their savings and continue lifting rural communities out of poverty and into urban affluence. This should allow China to sustain consumer spending growth as a result, albeit at a more modest level than over the past decade.
“We still have a long-term consumption-driven play in China,” says Alistair Way, head of emerging market equities at Aviva Investors. “I’d interpret the recent slowdown as a natural maturing of the market, rather than anything more severe. The underlying trends are still strong: household incomes look good and Chinese consumers have been able to sustain spending without accumulating debt to the extent of their counterparts in the West.”
As the breakneck consumption of the past decade begins to slow, Chinese retail is becoming more fragmented and unpredictable. But one overarching trend looks to be unstoppable: the rise of e-commerce. Online retail sales grew 24 per cent last year, according to the official statistics bureau. By the end of 2018, the internet accounted for 18.4 per cent of total retail sales in China, compared with 9.7 per cent in the US.6
One consequence of this is that traditional retailers are having to become more creative; in a market where customers can now use virtual-reality apps to browse the shelves from the comfort of their homes, high-street chains rely on technology to tempt customers into shops. At the Shanghai branch of Sephora, a cosmetics chain, sales teams on the make-up counters are equipped with tablets that can show customers how different shades of lipstick would look like on their face without trying each one.7
The need to offer ‘last-mile’ delivery options is also a dominant factor. For example, Alibaba decided to move into bricks-and-mortar retail with its Hema supermarkets, which are designed to act as last-mile logistics hubs as well as attractive shopping locations. Hema brings many of China’s recent consumer trends together, including a blend of online convenience and in-store customer experience, along with sophisticated digital targeting and tracking of purchases through mobile payment systems.
On- or offline, everything at Hema is paid for using Alibaba’s Alipay platform, enabling the company to add to the data it owns on customers’ behaviour and preferences. Its figures show Hema shops are almost twice as profitable as traditional supermarkets. Alibaba has even started to monetise the technology that underpins the model by leasing it to other chains: RT-Mart, a supermarket chain, has seen sales rise ten per cent since bringing in new retail tech.8
Nevertheless, like Amazon in the West, China’s e-commerce giants are increasingly ploughing their profits into new investments far from their core expertise; from cloud computing to artificial intelligence to fast-food delivery. This restricts the amount of money they can return to shareholders. Jonathan Toub, emerging market equities portfolio manager at Aviva Investors, argues these firms should consider reining in some of their more ambitious new projects to concentrate on their central internet businesses, which remain strongly positioned amid the flux of Chinese retail.
“The big e-commerce companies want to have a finger in every pie – they’re buying into all kinds of companies, from Indonesian e-commerce to domestic food services companies – so investors are not receiving much cashflow back right now,” he says. “But if these companies focus on what they’re good at, the opportunities are there – growth rates of 20-25 per cent for the e-commerce sector are plausible over the coming years.”
3. Could technology save the day?
The e-commerce trend within retail is indicative of a wider Chinese ambition to become a global leader in technology and innovation. Heavy investment in areas such as artificial intelligence and 5G are clear examples of this. But it is not without problems, not least a fierce debate over whether China is a pirate or innovator in what has been framed as a tech arms race with the West.
As long ago as 1992, the George H.W. Bush administration persuaded the Chinese government to create laws to protect US companies’ intellectual property. But copyright piracy remained rife and over the last two decades Chinese appropriation of Western innovations has become a major geopolitical issue. It is one of the key sticking points in the current trade negotiations between Washington and Beijing.
The issue is not clear-cut. Many foreign firms have been able to thrive in the lucrative Chinese market without giving up their most prized technology. In areas such as 5G networks and artificial intelligence, Chinese technology is already superior to the Western equivalents.
“As China is such a powerful economy, the extent to which it can dominate every technological sector is a germane concern for companies, governments and investors,” says Way. “There are some things China is very good at and there are others where it is going to struggle without technology transfer. As investors, we have to treat it very much on a case-by-case basis.”
Forced tech transfer
The US government has become more vociferous in its criticisms of China in recent years. Under the foreign policy of President Obama, the US ‘pivoted’ towards the Asia-Pacific region to contain China’s rise. In 2015, Chinese President Xi Jinping agreed to clamp down on commercial cyber-hacking after Obama threatened sanctions.7
Nevertheless, Chinese companies are still regularly accused of taking Western technology.8 More often than overt theft, appropriation of foreign ideas occurs via the officially sanctioned practice of ‘forced technology transfer’ (FTT).
Dan Prud’homme, associate professor at EMLV Business School in Paris and the co-author of a forthcoming book on China’s intellectual property regime, says FTT takes various forms. ‘Lose the market’ policies, for example, effectively outline a quid pro quo – foreign firms must agree to transfer technology or give up access to the Chinese market – while others leave foreign companies active in China with no choice but to relinquish their IP.9
Needless to say, FTT is unpopular among foreign businesses and policymakers. A 2018 report by US trade representative Robert Lighthizer, which looked into FTT, cyber-hacking and state-directed acquisitions of US firms by Chinese rivals, formed the basis for a round of sanctions imposed on Chinese goods by the Trump administration last summer.
Beijing has already ceded some ground. IP courts and tribunals have been established across China in recent years, providing both domestic and foreign companies with a way of seeking redress for IP theft. And China’s foreign investment law was revised in March 2019: it now requires Chinese government officials to keep confidential any trade secrets they learn during regulatory approvals, under the threat of criminal proceedings.
The complaints over technology transfer have a sharper edge in industries such as IT, robotics and semiconductors, which have been prioritised by the Chinese government. In particular, China wants to curb its reliance on foreign technology such as computer chips; it currently spends more on importing semiconductors than it does on oil.10 It has been unable to close the gap through foreign acquisitions, which tend to be blocked by wary Western governments. The US, along with South Korea, enjoys a commanding lead in chip technology and is fiercely resisting China’s attempts to buy expertise to catch up.
Faced with these political obstacles, China may have to develop the requisite semiconductor expertise the hard way, through long-term investments in training and R&D (it has reportedly earmarked US$100-150 billion of public and private funds for this goal).11 Creating market-leading semiconductors has become harder as chips get physically smaller, which is slowing the progress of the leaders and may yet give China an opportunity to catch up.
Where there’s a will, there’s Huawei
At the epicentre of this geopolitical tech-tussle is Huawei, which is accused of stealing technology and violating US sanctions on Iran. Washington has banned domestic purchases of Huawei’s equipment, but has not yet moved to prevent US suppliers from doing business with it.
Huawei is a genuine innovator. Its AI-powered smartphones are considered best-in-class and it is the world leader in 5G infrastructure. Its R&D spending topped US$15 billion last year and it filed some 5,400 international patent applications (its Finnish competitor Nokia filed 550 over the same period).12 13 But the US considers Huawei’s involvement of telecoms infrastructure a potential security threat, because in theory it gives the company – and by proxy, the Chinese government – access to secure data flows.
Huawei has already been banned by US allies such as Australia and New Zealand from operating 5G networks, although the UK may allow it to supply ‘non-core’ 5G.14 The European Commission is also considering limiting Huawei’s involvement in mobile infrastructure, despite the company’s efforts to reassure European politicians by opening cybersecurity labs in Brussels and Bonn.17
“Huawei’s phones are impressive, and they are selling well in European markets, but the concerns around national security may prevent it from offering 5G in Europe,” says Federico Forlini, TMT credit analyst at Aviva Investors. “This could benefit rivals such as Nokia and Ericsson, along with Samsung, which is developing new 5G technology. But as Huawei’s technology is both cheaper and more advanced than its competitors, it should find opportunities in emerging markets.”
Governments and investors alike are keeping a close eye on the trade talks between US and Chinese representatives, which could result in further agreements on FTT. But while it may make some concessions, Beijing tends to bristle at the suggestion that it merely steals all its ideas – and with good reason.
Chinese tech companies tend to be much more efficient than their Western rivals at building on existing discoveries and bringing new products to market, from mobile phones to LCD-screen televisions to consumer drones. This is partly because they have access to a vast population of tech-savvy consumers who are comparatively more willing to try out products and services compared with their peers in the West.
With US companies increasingly looking to China for inspiration – dockless bicycle sharing is just one idea that has crossed the Pacific from Guangzhou’s bustling tech scene to the start-ups of Silicon Valley – Chinese companies are beginning to defend their own IP as vigorously as their Western rivals, at home and overseas. The legal framework is improving, although work still needs to be done.
“The Chinese state has made an incredible number of commendable reforms in recent years in an attempt to make its IP regime more conducive to R&D and technological innovation for both foreign and domestic companies. Nonetheless, China’s IP regime could benefit from further reforms,” Prud’homme says, pointing to the need to expand IP enforcement and administration infrastructure and strengthen deterrents against IP infringement, among other policies.
Reducing debt, managing the transition to a consumer economy and strengthening IP law – these things will not be easy, especially if the trade war rumbles on. But if China successfully achieves them, it will not be the only country to benefit. When China sneezes the whole world catches a cold, as the old adage has it. Then again, the reverse is also true: if China takes its medicine, the global economy could face the future with a new spring in its step.
- Global Debt Monitor, Institute of International Finance, 15 January 2019.
- ‘China's private sector contributes greatly to economic growth: federation leader,’ Xinhua, 6 March 2018. http://www.xinhuanet.com/english/2018-03/06/c_137020127.htm
- ‘China banks' bad loan ratio climbs to 10-year high at end-2018,’ Reuters, 11 January 2019. https://www.reuters.com/article/us-china-banks-regulations/china-banks-bad-loan-ratio-climbs-to-10-year-high-at-end-2018-idUSKCN1P50XR
- ‘China’s lunar new year spending growth slowest since 2005,’ Financial Times, February 2019. https://www.ft.com/content/67b9203c-2dd3-11e9-8744-e7016697f225
- ‘Why are the Chinese buying fewer cars?,’ BBC, January 2019. https://www.bbc.co.uk/news/business-46887984
- Official figures from the National Bureau of Statistics of China and the US Census Bureau, as of March 2019.
- ‘China e-commerce boom fires up logistics sector,’ Financial Times, August 2018. https://www.ft.com/content/c3d9495c-9943-11e8-9702-5946bae86e6d
- ‘Alibaba says New Retail strategy is paying off as Hema shopper data shows bigger average spending,’ South China Morning Post, September 2018. https://www.scmp.com/tech/enterprises/article/2164651/alibaba-says-new-retail-strategy-paying-hema-shopper-data-shows
- ‘China announces understanding with China’s Xi on cyber theft,’ Reuters, April 2019. https://www.reuters.com/article/us-usa-china-idUSKCN0RO2HQ20150925
- ‘One in five companies say China stole their IP within the last year,’ CNBC, March 2019. https://www.cnbc.com/2019/02/28/1-in-5-companies-say-china-stole-their-ip-within-the-last-year-cnbc.html
- See Dan Prud’homme and Taolue Zhang, China’s Intellectual Property Regime for Innovation, forthcoming July 2019.
- ‘Chip wars,’ The Economist, December 2018. https://www.economist.com/leaders/2018/12/01/chip-wars-china-america-and-silicon-supremacy
- ‘Chips on their shoulders’, The Economist, January 2016. https://www.economist.com/business/2016/01/23/chips-on-their-shoulders
- ‘Innovators file record number of international patent applications, with Asia now leading,’ World Intellectual Property Organization, March 2019. https://www.wipo.int/pressroom/en/articles/2019/article_0004.html
- ‘May to ban Huawei from providing 'core' parts of UK 5G network,’ The Guardian, April 2019.
- ‘EU goes softly-softly on pushing out Huawei,’ Financial Times, March 2019. https://www.ft.com/content/4bdd7a08-5168-11e9-b401-8d9ef1626294