An episode from Vanguard’s Investment Commentary podcast series

For more in-depth analysis on the risks to China’s medium- and long-term economic outlook, read Navigating the transition: China’s future at a crossroads.


John Ameriks:
So while often thought of as the “world’s factory,” China’s going through a transformation as it strives to move away from an export-based economy to a more consumption-based one. This transition isn’t without its challenges, and policy actions could determine whether a downward trend in China’s economic growth will continue into the future.

Hi, I’m John Ameriks, and welcome to Vanguard’s Investment Commentary podcast series. In this month’s episode, which we’re recording on April 20, 2017, we’ll talk about our latest research paper, Navigating the transition: China’s future at a crossroads.

Joining us today from our offices in Hong Kong is Qian Wang, Vanguard’s senior economist for Asia and one of the paper’s authors. Thanks for joining us today, Qian.

Qian Wang: Thank you, John. I’m really happy to be here today.

John Ameriks: So let’s just jump right into it. So Vanguard recently released your paper on China’s economic future. Can you discuss some of the themes of that paper?

Qian Wang: After 30 years of impressive expansion, China’s growth has been slowing down quite sharply while financial risk is rising. During the past several years, China has often contributed to a sharp rise in global risk aversion. I think, at this moment, there are two key questions in investors’ minds. First, will there be a hard landing in China, or a collapse of the financial system? Second, will China be able to successfully rebalance its growth model to a more sustainable one?

John Ameriks: So let’s start with this first idea around the transition in terms of a rebalancing of orientation away from a manufacturing- and export-based economy into one that’s based more on services and consumption. Can you talk a little bit about how that’s happening and sort of what the implications are?

Qian Wang: Well, I think if you look at the China slowdown, right, the reasons for the slowdown [are] quite complicated. It’s both cyclical, secular, and structural. And the secular and structural problem cannot be cured by the cyclical policy, such as monetary and fiscal easing.

On the supply side, we do see the potential growth of China has been falling down. You know, the labor force is shrinking, the population is aging rapidly, and the catch-up effect is quickly fading.

John Ameriks: I’m just going to jump in on you real quick to see if maybe you can go back and explain that sort of catch-up effect for us. What do you mean by the catch-up effect?

Qian Wang: Well, you know, as emerging markets, right, when your GDP per capita level is low, then you can easily see faster growth when you get the maximum from other countries, the technology transfer from other countries, based on your comparative advantages, such as cheap labor. Then, in that case, actually, the growth can be very fast.

But when your wealth level, you know, GDP per capita, reaches to a certain level, then you become a middle-income country. Then the growth will gradually slow down.

John Ameriks: I see. That’s really an interesting idea, as it contrasts with the long-term sort of story about China that it’s all been about it being an emerging economy, really driven by cheap labor, and just the adoption of existing technology. I think what you guys seem to be saying, and writing about in the paper, is that that’s changing a bit and that now that China’s getting closer to that sort of middle-income level, they’re going to have to think about how to continue their progress in a very different way.

Qian Wang: You know, China was called the world’s factory. A key reason is because, 30 years ago, China had a huge supply of labor, cheap labor. And that’s why a lot of factories [were] moving into China.

But now, because of the demographic cycle, I would say the era of cheap labor in China is actually drawing to a close. So the competitiveness of China as an export hub, or the world factory, is no longer there. So then, in that case, you have to think about where else is the driver for China’s growth.

John Ameriks: So that’s where the service aspect and turning more internally to consumption-based sources of growth might be headed, right? So what does that look like?

Qian Wang: Well, we look at the growth parts of China. I mean, in the past, the exports and investment have been the two key drivers for the Chinese economy growth. Now, after the Greece financial crisis, what happened is that, well, the export sector is already shrinking. But, on the other hand, because of the 4 trillion [renminbi] fiscal package, the investment growth was really accelerating. So what we have seen is that the credit-fueled and investment-led growth model has become increasingly unsustainable.

Investment has been rising to nearly 50% of GDP, and nonfinancial sector debt has risen more than 100 percentage points of GDP in ten years.

In particular, the investment has been mostly concentrated in the heavy manufacturing sector and also the real estate sector.

Then we have to find a new growth driver in some other areas. So I think the question here is that when investment is slowing down more sharply, can service and consumption really pick up to offset the slowdown in investment?

John Ameriks: I think that leads right into this sort of next question here, which is around the scenarios that you mentioned covering in the paper. So which of those four—the smooth rebalancing; sort of hard landing; Japanese-style stagnation; or emerging markets, sort of classic emerging markets, instability—do you think we’re more headed to in China?

Qian Wang: At this moment, we still think that the smooth-rebalancing scenario is probably the most likely. To achieve the smooth rebalancing, we really need the government to provide enough macro policy cushion to avoid a hard landing, and we also need them to push forward a timely and effective structural reform to revive the productivity and, also, the potential growth in the long term.

Then we also see the risk is that if the government becomes overly protective, then they provide too much macro policy cushion, but instead, they didn’t really push forward the structural reforms in a timely manner. Then we could end up in a Japan-style stagnation.

There is also another scenario, called a hard landing. It’s like what happened in the late ‘90s in China. They had to push forward the structural reform, so, you know, no pain, no gain. You suffer, but then you find the way out.

The least likely scenario is that emerging markets instability, which means we didn’t have the structural reform, so we end up with no new growth model.

John Ameriks: That makes a lot of sense. It’s important, I think, for people to hear, too, that we refer to that as a hard landing and not a crash. And as you’ve mentioned, you know, it’s happened before in the past. So, again, this sort of dire scenario is very unlikely. Maybe I can get you to talk a little bit more about the government and the tools that they have available. You mentioned that the toolbox in China is pretty deep. You talked a little bit about the SOEs, the state-owned enterprises. But what type of tools does the Chinese government have at its disposal to try to deal with and manage this process of transition?

Qian Wang: Well, I think that’s exactly why we are advising our clients, say, not to panic about China in the near term. You don’t worry too much about a hard landing in the near term because China has abundant policy tools to cushion the economic slowdown. You know, so we look at the monetary policy, fiscal policy, and regulatory too.

Other than that, we also have reforms. We can reduce the tax and fees burden for corporations. So in case if there is a sharper slowdown in the private sector, the government can definitely come out and provide that kind of necessary cushion to avoid an economic hard landing.

John Ameriks: In your research, you state that it’s not China’s level of debt but rather the pace and concentration which are worrisome. So why is that?

Qian Wang: If you look at the level of the debt in China, well, first, it’s similar to those in the developed markets, and, second, China is really able to support a relatively high leverage level given its large growth [in] national savings.

But I think, on the other hand, it’s really that the high level of leverage was accumulated in a very short period. And the concentration of the debt is in the corporate sector, especially in those unproductive state sectors. That is somewhat concerning. So it’s not just that that level is high, it’s also that those debts are not efficient.

John Ameriks: Very interesting. Okay, so let’s start to bring this back toward how is this relevant to Vanguard investors, institutions, individuals, and the other clients that we serve? Folks just have a lot of concern about China being able to return to and continue to achieve, over long periods of time, sustained and healthy growth. Why should this matter to investors? Why should they care? Why should they be concerned?

Qian Wang: Well, the first thing, I think, is that China matters to the world, right? I mean, China is the world’s second-largest economy and deeply intertwined in the global market. So China right now is a very important contributor to the global economic growth. And if China slows down, there will be [a] spillover effect in trade and GDP. So the impact to the rest of the world really depends on which scenario will happen, right?

So we do see that if China slows down more significantly, it will affect the neighboring countries, especially like in Asia, and also commodity exporters, such as Brazil and Australia. And, also, I think the slowdown process of China matters for the global inflation pressure, matters for the exchange rate for many other emerging markets countries, and most importantly affects the confidence, the investor sentiment, in the global financial market.

John Ameriks: Qian, what advice would you give to investors as they think about the risks that you’ve discussed and the possibilities that we’ve talked about today as those investors think about how to build their portfolios?

Qian Wang: Well, I would say if you want to invest in China, I think the important thing is, remember, stay long term. China is the world’s second-largest economy. They have the third-largest bond market and second-largest equity market in the world. So this is a very important part of the global economy and the financial markets that you cannot afford to miss. So investing in China basically offers the investor the exposure to a growing share of world GDP, and it captures the associated diversification benefit in a global portfolio regardless of [the] future growth scenario.

So stay long term. Remember, China is still an emerging market, so it does have volatility. So don’t panic.

John Ameriks: I think that’s a great way to think about it. Thank you. Last question. What would China’s capital outflow mean to the global markets over the long term?

Qian Wang: In the short term, they have been tightening up the capital control because capital outflow can destabilize the financial system. So that is more of a near-term thing.

But from a long-term perspective, capital account liberalization is an effective way to have China more effectively allocate the capital both onshore and offshore. So I would say, in the future, when China liberalizes the capital account more and more, we will see rising outward investment as domestic, corporate, and households aim to diversify their investment portfolios. So this will have [a] significant implication for the global market.

John Ameriks: That’s been very helpful. Some great insight. Thank you so much, Qian.

Qian Wang: Thank you. Thank you, John, for the great questions.

John Ameriks: And thanks to our audience today for joining us on this Vanguard Investment Commentary.

To learn more about the issues we discussed today, please check our website and take a look at our new paper Navigating the transition: China’s future at a crossroads. And be sure to check back with us each month for more insights into the markets and investing. Remember, you can always follow us on LinkedIn and Twitter. Thanks to all for listening.


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