Don't Worry About China

The AMP's Chief Economist and Strategist, Dr Shane Oliver looks at the key issues with China.

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China remains on track for strong long term growth

China is being propelled by very strong structural forces that have decades to run.

These include:

• Strong productivity growth on the back of privatisation, deregulation and the application of new technology.

• Rapid urbanisation which is sustaining investment, contributing to productivity growth and keeping labour costs down via the supply of cheap labour. The argument that China has run out of cheap labour seems weak – its urbanisation rate is still only 40%.

• Huge competitive advantages built around low unit labour costs, scale advantages and good infrastructure.

Average salaries of manufacturing employees are 5% of US and European levels. Unit labour costs are a fraction of those in developed countries. Manufacturing unit labour costs are falling despite rising wages.

Consumer demand is growing strongly and will be boosted by Government policy to re-establish a social safety net (with plans to double the percentage of the workforce covered by pension plans and medical insurance by 2010 to just below 70%).

Consumer spending is coming from a low base. E.g., there are less than 20 cars for every 1000 people which is where the US was in 1918 and this compares to about one car for every two people in Australia and the US. Living space per person is 10% of US and Australian levels.

• China's rate of investment is likely to remain strong on the back of urbanisation, the low level of capital relative to the population, strong profit growth and a high level of retained earnings and policies to narrow the income gap between the eastern and inland provinces.

With per capita income levels in China still way below rich country levels China's rapid growth phase has decades to go. This means China's export penetration into developed country consumer – & increasingly capital goods - markets has a lot further to go and so does the resources boom.

Growth is very strong, but no sign of overheating

There is no doubt that Chinese economic growth, running above 11% so far this year, is a bit too strong.

As a result we are likely to see more attempts to slow it down to 9% to 10%. It is also the case that monetary policy in China is unnecessarily stimulative with the one year benchmark borrowing rate of 7.29% extremely low relative to nominal GDP growth of around 15%. Keeping the Renminbi cheap is leading to economic distortions and adding to the difficulties of monetary management.

Rapid growth is also creating social and environmental tensions. However, there are several points to note about all this. Firstly, the normal signs of overheating are not present.

• Non-food inflation is just 1.1%.

The current account is in surplus and as such China is not reliant on foreign capital inflow.

• While property prices are rising strongly, in aggregate Chinese property prices have been rising at a slower pace than nominal GDP (which is running around 15%).

• Investment running at 26% year on year remains too strong, but retail spending has been accelerating and recent strength in investment growth reflects strength in the inland provinces, both targets of Government policy.

These considerations suggest that while further measures are likely to slow growth down a bit, there is no need to crunch it so policy tightening is likely to remain measured.

Secondly, while Chinese interest rates are low relative to nominal GDP growth it should be borne in mind that China is not yet a fully developed laissez faire economy.

Unlike in most developed countries where interest rates are the key policy lever, China also actively uses a range of approaches including the use of administrative controls (such as restrictions on investment projects or putting pressure on banks to slow loan growth like now).

• In this regard, it should also be borne in mind that loan growth of 18% per annum is not strong in relation to nominal GDP growth of 15%. It has been running at much higher levels relative to GDP growth in rich countries recently including Australia.

Thirdly, while China may speed up the appreciation of the Renminbi, it is unlikely to go too fast given the authorities' fears that it could stifle exports and make it hard to absorb rural workers. Their approach is likely to remain gradual.

Finally, while China has big environmental problems and problems with product standards (such as the recent furore with product recalls from toxic tooth paste to excessive lead in kid's toys) this is arguably just a stage in its economic development. Industrial revolution London did not look too flash either and the US had similarly lax product and intellectual property standards in the 1800s -

Charles Dickens was extremely annoyed at seeing pirated copies of his books in Boston book stores!

Will China withstand a US downturn?

The impact of the downturn in the US on China depends on how far the US economy slides. China is well placed to handle a slowdown in US growth to around 1-2%, which is our base case.

China's export growth to the US has been slowing and now amounts to only 19% of total exports whereas exports to Europe (23%), Asia (47%) and other developing markets have been rising. Similarly consumer exports to the US have been declining in importance relative to capital goods.

Of course, if the US has a hard landing then China will be much more vulnerable.

Is China still a force for global disinflation?

With US import prices from China starting to rise there has been much debate whether China's dampening impact on global inflation is over. Our assessment is that this is unlikely. While Chinese wages are rising, unit labour costs remain very low and are still falling thanks to productivity gains.

The rise in US import prices from China partly reflects a fall in the $US versus the Renminbi and better quality Chinese exports.

The level of Chinese prices remains well below competitors forcing export prices from the rest of Asia down & as China moves into higher value adding production it will push prices down in these areas.

The Chinese share market

So far this year the Citic/S&P index of the 300 largest Shanghai and Shenzhen listed companies is up 145% and over the last two years has risen 477%. This rate of increase is unsustainable and over the last few weeks we have seen Chinese shares embark on another correction falling around 18%. Several points are worth noting:

• Firstly, much of the rise since 2005 reflects a reallocation away from bank deposits by individual Chinese investors. It doesn't reflect gearing into shares.

• Secondly, profit growth for listed companies over the last year has been a very strong 70% (or around 60% if share market related investment gains are excluded).

• Thirdly, while the price earnings ratio for Chinese shares is high it is still way below the peak levels reached during previous share market bubbles, eg, Nasdaq shares reached a PE of 160 in 2000.

Fourthly, the regulatory restrictions on Chinese investors putting their money abroad means that the share market has been benefiting from a captive market. This is likely to change only gradually.

For a market that rises so rapidly big corrections are inevitable and healthy. Volatility is likely to remain high.

However, the longer term trend is likely to remain up reflecting China's strong growth prospects, although probably at a more moderate pace.

What's the risk of economic damage from shares?

A collapse in Chinese shares is unlikely to have a major economic impact.

Over the last decade the Chinese economy and shares have moved in different directions.

The relationship between the Chinese share market and economy is loose because the equity market only accounts for 12% of capital raisings and only a small proportion of Chinese households have a significant share market exposure with most shares held by state authorities.

Conclusion

China faces risks and speed bumps that make for an occasional volatile ride, including for its share market.

However, there is no sign of a major disruption to China's strong growth any time soon and the long term outlook remains strong.

This should be positive for Chinese shares as well as indirect plays such as commodities. The key risks are a US recession, a rise in non-food inflation and the adoption of too heavy handed tightening measures.

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