A downturn in China's economic growth has been 'imminent' for much of the past decade, according to many experts. However, the country keeps on posting impressive figures. Peter McGill looks at the possible impact of its current challenges, including US tariffs, ballooning debt and shadow banking.

China steel

In the past decade, China has weathered four real or potential financial crises, each one of which led analysts to predict – incorrectly – that the country's economic ascent would stall.

The financial crisis of 2008 triggered a global recession which China was spared, largely through massive infrastructure investment. The strategy worked, although it left behind a mountain of debt and surplus capacity.

In June 2015, a crash on the Shanghai and Shenzhen stock exchanges ended 12 months of speculative frenzy in which prices had increased by more than 150%. Stability returned, at a much lower plateau, in early 2016.

Stock market turbulence in 2016 added to doubts about the Chinese economy and sparked capital flight, with an unprecedented fall in the renminbi. Strict capital controls, and exemplary punishment of Chinese conglomerates that wasted money on trophy foreign acquisitions, finally stemmed the outflow in 2017.

Steeled for a slump?

The latest challenge to China is of an entirely different order. A protectionist barrage from the US administration of president Donald Trump is aimed squarely at China’s productive base, of both its old and new industries.

Mr Trump claims that imports of cheap steel and aluminium are a risk to the US's national security. Blanket tariffs of 25% on steel and 10% on aluminium are mainly targeted against China, which the US accuses of dumping, but US allies are also affected, on the grounds that China ships steel to the US through other countries.

China’s steel mills account for half of the world’s supply. Output of steel, aluminium, coal, glass and solar panels rocketed during a construction boom, but when demand cooled China was saddled with vast oversupply. In 2017, China shut down 30 million tonnes of steel capacity but total steel output still rose 5.7% to a record 831 million tonnes.

Low-price Chinese steel and aluminium has flooded overseas markets, including the new ones that China is busy carving out. As well as extending China’s global reach and influence, the Belt and Road Initiative of president Xi Jinping, which is designed to create new trade routes, has boosted foreign demand for Chinese infrastructure, built with surplus Chinese steel and aluminium and funded largely through state-backed Chinese loans.

In with the new

While the metal tariffs have drawn the most international attention, they concern China’s old economy, centred on state-owned behemoths of heavy industry. An epic restructuring is under way in the country to shift the centre of gravity towards consumption, services and the new industries of the knowledge-based economy. This will involve huge shifts in employment; brokerage CLSA estimates that the 1.5 million Chinese workers who lost their jobs in the coal and steel sectors between 2015 and 2017 have quietly been reabsorbed into the labour market.

By 2006, state-owned telecoms company China Mobile was already covering 97% of China’s population, and smartphone penetration provided the backbone for the astonishing rise of Chinese online giants such as Baidu, Alibaba (and affiliate Ant Financial) and Tencent. 

Indeed, there is increasing concern in Washington that American global pre-eminence in technology is under threat from China, and at the core of Mr Trump's trade approach is an attack on Chinese industrial policy. A particular bête-noire of the Americans is the ‘Made in China 2025’ programme, which aims at putting China on an equal footing with the US, at the very least, in such advanced technologies as artificial intelligence, automated machine tools and robotics, new-energy vehicles, new materials, bio-pharma and aerospace.

China's vulnerable side

On the same day in March that $60bn in new tariffs on Chinese technology goods was announced, the Office of the US Trade Representative released the report of its Section 301 investigation into Chinese unfair trade practices. The nearly 200-page report mentioned 'Made in China 2025' 116 times.

There is a technological arms race between China and the developed world that will last 10 or 20 years

Bo Zhuang

In April, the Trump administration enacted a seven-year ban on US sales to ZTE Corp, China’s number two telecommunications company, in retaliation for breaking an agreement not to ship goods to Iran and North Korea. The ban amounted to a potential death sentence for ZTE, as US companies such as Qualcomm and Intel provide between one-quarter and one-third of components in ZTE equipment.

China offered to import an extra $70bn-worth of American goods over a year, and Trump responded by granting ZTE a reprieve. ZTE agreed to pay an additional $1bn fine plus $400m in escrow to cover any future violations, and the ban was lifted.

Mr Trump was criticised in the US Congress for showing leniency towards ZTE but the near-death experience of a national champion underscored for China its technological vulnerability.

Room for manoeuvre?

China is the world’s largest market for semiconductors, with the lion’s share supplied by US, South Korean, Japanese and Taiwanese chip-makers.

Bo Zhuang, chief China economist for research firm TS Lombard, believes China can afford concessions to the US with regard to protecting intellectual property, enlarging market access and reducing the US merchandise trade deficit, but will baulk at changing its industrial policy.

“There is a technological arms race between China and the developed world that will last 10 or 20 years. China won't give up. It’s more likely China will double up or triple up on investment in technology,” said Mr Zhuang.

Hostility in the US, France and Germany to further Chinese acquisitions in strategically sensitive sectors may prompt China to buy Japanese or South Korean technology instead, according to Mr Zhuang.

Tokyo-based SoftBank’s pending sale of a majority stake in the China operations of its UK semiconductor subsidiary Arm Holdings may be a portent. SoftBank said in June 2018 that it will sell 51% of Arm’s China unit for $775m to investors backed by the Chinese government. In 2016, SoftBank paid £24.3bn ($32.4bn) to acquire Arm, regarded as a ‘crown jewel’ of British technology.

Christopher Wood, chief strategist for CLSA, says that automation is a response to the decline in China’s working-age population, from 941 million in 2011 to 916 million in 2017, that has pushed up wages of unskilled workers for the past five quarters.

Assuming that China “does not lose control of its capital account”, Mr Wood sees an ageing population as “probably the major risk facing the Chinese economy”. It explains “the determination to upgrade the economy” embodied in the Made in China 2025 policy, and China’s refusal to “negotiate on any targeted American attempt” to undermine it.

The debt time bomb

Recent trade jousting with the US has pushed into the background concerns about a Chinese debt ‘time bomb’ but the issue has not gone away.

The Chinese authorities regard excess leverage as a threat to financial, economic and social stability, and since 2017 there has been a significant tightening of credit. “The Chinese investment story remains all about whether the authorities can continue to manage this delicate balancing act in terms of securing the necessary deleveraging without inflicting too great a collateral damage on the real economy,” notes Mr Wood in his client letter, Greed & Fear.

Before the global financial crisis, Chinese growth was more externally driven. The contribution of net exports to growth averaged 0.7 percentage points during the five years prior to the financial crisis. Productivity also surged following China’s entry to the World Trade Organisation in 2001.

Since the financial crisis, both productivity and the contribution of net exports have fallen in China, while credit has consistently grown at a faster rate than nominal gross domestic product (GDP). "China’s debt metrics have ballooned and the country has moved from being low-credit country to a high-credit country," said Standard & Poor’s in a report.

Political pressure to support employment by keeping non-viable firms going, especially state-owned enterprises, is one factor that has led to higher indebtedness and the blunting of credit effectiveness in generating GDP growth.

In the shadows

Demand for high-yield investment products and the increasing oversight of banks has also given rise to the mushrooming of risky ‘wealth management products’ sold by more lightly supervised non-bank financial institutions, especially asset managers and insurance companies. Money invested in wealth management products has then been lent by these ‘shadow banks’ to marginal borrowers with poor cashflows, such as property developers and local government financing vehicles, as well as home buyers unable to access bank mortgages. In 2017, the International Monetary Fund estimated the balance of wealth management products in 2016 was equivalent to 39% of China’s GDP.

A government clampdown on shadow banking and wealth management products has been accompanied by a selective targeting of high-flying companies that binged on buying foreign trophy assets.

Chinese regulators took control of Anbang Insurance in February and one month later its founder and former head, Wu Xiaohui, was jailed for 18 years for fraud, and had Rmb10.5bn ($1.66bn) confiscated. Anbang’s most celebrated acquisition was the Waldorf Astoria hotel in New York for $1.95bn in 2014. Mr Wu said at the time that Anbang would hold onto it for 100 years. The hotel is now up for sale.

Disposals so far in 2018 by another private sector conglomerate, HNA Group, founded in 2000 as a four-plane domestic airline connecting Hainan Island with the mainland, have topped $14.5bn, according to Bloomberg. HNA’s debts had reached about $94bn in 2017 and its borrowing costs were the highest of any non-financial company in Asia, according to Bloomberg.

Other telling signs of the campaign to deleverage and highlight financial risk can be seen in China’s Rmb76,000bn bond market. As of late May 2018, 59 borrowers had delayed or cancelled debt issuance within the year, and there had been 17 defaults by 10 issuers. In addition to tolerating corporate defaults, the government has also signalled a willingness to let local government financing vehicles default.

Mr Wood of CLSA considers it “a positive and healthy development that China’s bond market is starting to price credit risk” as a result of these defaults. He also praises China’s authorities for taking pre-emptive action to avoid a potentially devastating wholesale banking crisis, as at a time when China is gradually opening its capital markets such measures are needed to build confidence among foreign investors.

Bond surge

The partial inclusion in June 2018 of 226 China large-cap A-shares (mainland China-based companies listed on the Shanghai and Shenzhen exchanges) into the benchmark MSCI Emerging Markets Index was greeted with much fanfare, but so far there not been significant inflows into China’s domestic equity market. TS Lombard believes full inclusion of A-shares in MSCI indices for emerging markets, China and Asia (excluding Japan) will be drawn out between five and seven years, citing previous cases for South Korea and Taiwan.

More dramatic is the surge of buying into China’s bond market. Foreign holdings of domestic yuan renminbi paper rose from about Rmb19bn as of June 2017 to Rmb220bn at the end of May 2018. In part, this was the result of mid-2017’s opening of the ‘Bond Connect’ pipeline from Hong Kong but it also reflects foreign appetite for Chinese debt.

Goldman Sachs predicts that foreign ownership could rise to $1300bn or 6% of Chinese bonds outstanding by the end of 2022 (up from 2% currently), while foreign holdings in Chinese government bonds could rise to $900bn or 22% of outstanding (from 6% currently). This would spur the internationalisation of the renminbi, lessen the credit burden on the balance sheets of domestic financial institutions, fill domestic gaps in the bond market and catalyse needed reforms, according to Goldman Sachs.

China economy property and construction

Safe as houses?

The risk of an overheated property market imploding and wreaking havoc on the wider economy is often foretold but carries little weight with most financial analysts specialising in China.

Moody’s points out that at about 13% of GDP from 2013 to 2017, the exposure of China’s economy to property and construction is far less than that of Japan, the US or Ireland prior to their property crashes. Fixed-asset investment in property and construction has been on a downward – albeit bumpy – trajectory from China’s supercharged response to the global financial crisis in 2008 to 2011. Still, when all the supply chain linkages are taken into account, the sector still accounts for 25% to 30% of Chinese GDP.

Housing cost is the main factor behind a rise in household leverage, but affordability is supported by robust growth in household income, according to Moody’s.

Mr Zhuang of TS Lombard says that China’s urban housing market has been distorted by the one-child policy and urban household registration. “More than 60% of Chinese people are born in rural areas, and when they come to work in the cities, they rent. But to qualify for public healthcare and pensions, to send your children to school, and if you are male, to find a wife, you need to own an apartment,” he says.

The standard ratio of household income to housing price as an index of affordability does not apply to urban China, as parents and grandparents also contribute toward the cost. “So, the price of one apartment is a function of the income and savings of three households, not one. Otherwise your son cannot get married. That’s how the system works here,” says Mr Zhuang.

A downturn in China cannot be ruled out, whether caused by problems in the property sector or due to another factor, but so far the economy has a remarkable record of defying its critics.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter