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A detailed analysis of the Chinese economy suggests pessimism is misplaced.

Photo of Paul Zwi By Paul Zwi, MyClime

China has lowered its forecast and targeted economic rate from 8.0 per cent to 7.5 per cent. This has implications for commodity demand, Australia's resource sector and the Australian sharemarket given that its performance is more closely linked with China's sharemarket these days.

MyClime believes talk of a hard landing (a sharp fall in economic growth) is unduly pessimistic, at least for the next five years or so, but beware the dangers of extrapolating past China growth figures forever into the future.

It is worth reminding ourselves that although Chinese growth is slowing, the world's second-largest economy is still growing at a huge rate.

In terms of an absolute increase in economic activity, growth of 7.5 per cent in China is equivalent to the US growing at 3.5 per cent. In reality, the US will struggle to grow by just 2 per cent this year.

Furthermore, over-reliance on the statistics emanating from Beijing, especially to the first decimal point, is fraught with risk. But there is no doubt that China is still the most dynamic of the G8 economies and its growth underwrites world growth.

China Share of World GDP Increased Substantially
Share of World GDP (PPP Basis)

China share of world GDP chart - 1985 to 2010

Source: IMF

From an Australian exporter's perspective, the projected growth means that in 2012 China will need more iron ore, coal and copper than it did in 2011.And it will need  more again in 2013 and very likely in each year of its next five-year plans.

Doomsayers who predict a dire Chinese economic outcome continue to ignore reality.

Surprise trade deficit

China reported its biggest monthly trade deficit in at least a decade in February as imports rebounded after the New Year holiday slowdown. Exports grew 18.4 per cent over a year earlier to $114.5 billion, but imports jumped 39.6 per cent to $145.9 billion.

China's global trade deficit was $31.5 billion, its biggest since at least the 1990s and a rare exception to the pattern of multibillion-dollar surpluses. Seasonal factors played a role, but there is a larger trend being highlighted here.

January's trade declines were the sharpest since the 2008 GFC. China's relatively strong growth amid Europe's debt crisis and US economic troubles meant exports to those regions decelerating markedly.

On the other side of the ledger, imports were strong in February partly because of restocking by manufacturers in anticipation of rising commodity prices. Import growth from China's two biggest trading partners, the EU and the US, give a sense of how Chinese demand is helping underpin recovery. Imports from the EU grew at their fastest pace in two years, and those from the US were the strongest for 13 months, although China stayed in surplus against both.

Inflation lower than expected

Inflation in China slowed dramatically in February as temporary price rises related to the New Year faded. Consumer prices rose 3.2 per cent from a year previously, a significant decline from 4.5 per cent in January and more than 6 per cent in mid-2011. Food, which accounts for roughly a third of the government's official inflation measure, tends to be one of the most volatile items for consumers.

In his annual report to the National People's Congress, Premier Wen Jiabao said the government's goal is to maintain inflation at around 4 per cent a year. The goal takes into account risks from imported inflation and rising costs of land, labour and capital. It will leave room to change the way prices of resources, including electricity and oil, are set.

Slowing inflation is a welcome sign for the government, giving it the flexibility to focus more on stimulating the economy if required.

Growth in perspective

Putting expectations of future growth in perspective, China's economy expanded 10.4 per cent annually in the past 10 years, about five times the US rate, as the government boosted spending on roads, railways, ports and bridges, and manufacturers exported everything from toys to trains to the rest of the world. The economy has grown by around 9 per cent annually over the past 30 years, and by 9.2 per cent in 2011.

Even assuming a significant moderation in growth, over the next three years China is likely to grow from around 46 per cent of the size of the US economy (China at $6.9 trillion, the US $15 trillion) to 52 per cent by 2015 (China up to $8.5 trillion, the US up to $16.2 trillion). This assumes Chinese growth of 7.2 per cent (with below 6 per cent regarded as a hard landing) and US growth of 2.6 per cent.

China still needs to rebalance its economy away from building productive capacity and towards growing internal consumption. Figures are notoriously rubbery, but a best guess is that consumption in China accounts for about 35 per cent of GDP, roughly half the ratio in the US.

Recent growth in China has been built on the surge in investment, rising from 42 per cent of GDP in 2007 to 48 per cent in 2011. This raises sustainability questions. China is exposed to Europe and other countries through trade: its global exposure has risen, with its share of global exports in 2011 rising to 10.5 per cent, up from 8.8 per cent in 2007.

Urbanisation will continue

As in the past decade, a key driver of economic growth over the next decade will be urbanisation as millions more people move to the cities in search of higher-paying jobs. China recently announced that the population in towns and cities now outnumbers that in the countryside, making it a predominantly urban nation for the first time in history.

City dwellers were just 11 per cent of China's population in 1949, when the Communist Party took power, and 19 per cent in 1979, when Deng Xiaoping launched market reforms. Today, urban dwellers account for 51.3 per cent of China's total population of 1.3 billion.

We expect the trend to endure for some time, albeit at a somewhat reduced pace. McKinsey, the consulting firm, forecast last year that the country would have one billion urban residents by 2030 - its urban population growing by more than that of the entire US in just two decades.

Mass migration creates problems

The downside to urbanisation is that this mass migration places an increasing strain on housing, transport and welfare. Mass migration to cities creates pollution as well as encouraging social unrest and demands for political reform. Finding a balance between GDP growth, urbanisation and farmers' rights will be a big challenge for a new generation of party leaders.

Moreover, urbanisation is hardly the only demographic trend sweeping China. As more workers move into the cities, the size of the workforce, those aged 15 to 64, is peaking as it gets older. More than 30 per cent of the population is expected to be over 60 by 2050, producing an increasingly heavy economic burden on those in the workforce.

However, unlike most other countries, China has the policy space to contain the negative spillover should such risks materialise. A fiscal stimulus package in the order of 3 per cent of GDP could hold growth above 7 per cent, much as China's pre-emptive policy action in 2008 eased domestic vulnerabilities.

China could use any significant slowdown in the coming year or two as an opportunity to boost consumption, including through helping the most vulnerable, strengthening household income, and social services. This would also help reduce reliance on investment and support a more sustainable internally balanced economy.

The long-term future

Growth at around 7 per cent is secure for the next five years or so because of China's ability to stimulate growth through fiscal measures if required.

The changing pattern of China's current account surplus (consisting mainly of exports minus imports) in the next five years will be a key determinant for the global economy. China's highly competitive manufacturing sector will continue to power ahead, to expand exports and to gain global market share. At the same time, China's domestic economy should continue to grow fairly rapidly, thereby drawing in imports.

How this plays out will largely depend on how much progress is made with rebalancing the economy, from the single-minded focus on exports to growing internal consumption.

China's quarterly economic growth is widely forecast by analysts to slow to just over 8 per cent in the first quarter from 8.9 per cent in the previous quarter, marking the fifth consecutive quarterly slowdown and likely to put the economy on track for its slowest full year of growth in at least a decade.

Nevertheless, that slowdown is on course to be a 'soft landing', with recent indicators easing investor fears of a sharp deterioration and revealing ample room for Beijing to loosen fiscal policy further to support economic growth. 

About the author

Paul Zwi is an analyst at Clime Investment Management. Clime's online valuation and research service, MyClime, assists investors in identifying companies with attractive dividends and yield. Register for a free 14-day trial.

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