Download ECONOMIC INSIGHT GREATER CHINA Quarterly briefing Q2 2012

ECONOMIC INSIGHT
GREATER CHINA
Quarterly briefing Q2 2012
CHINA ON COURSE FOR A SOFT
LANDING
Welcome to ICAEW’s Economic Insight: Greater
China, a quarterly forecast for the region prepared
directly for the finance profession. Produced by
Cebr, ICAEW’s partner and acknowledged experts
in global economic forecasting, it provides a unique
perspective on the prospects for China over the
coming years. In addition to Mainland China, we
also focus on the Hong Kong and Macau Special
Administrative Regions.
Despite a fall in export growth and other signs of a
slowing such as falling energy consumption growth in
the first half of 2012, the Mainland Chinese economy
continues to move ahead. Rising wages are feeding
through to more household expenditure, and while
business surveys differ in their evaluation of current
conditions, production figures show only a little let-up
in their pace of expansion. Despite concerns about the
sustainability of the investment boom gripping China,
capital continues to pour in. But how durable are these
growth drivers?
The rise in domestic spending, driven by rising
prosperity, appears to be a stable source of demand
as employers compete for workers by offering better
pay. In many cases though, the ability to pay wages
depends on foreign sales, making progress reliant
on the outside world. Meanwhile, as exports and
manufacturing production are still going strong, their
growth rates appear to be on a mild downward trend.
If foreign demand holds up reasonably well, there is
little cause for concern at the moment on these fronts.
The bigger question is about investment, which makes
up an increasingly large part of national output.
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In this edition we explore some issues surrounding China’s
fixed asset investment boom, which is the part of GDP most
prone to the much-feared hard landing.
A wave of outbound Chinese FDI is coming
One source of capital for China’s industry has been
the capacity expansion of foreign firms via foreign
direct investment (FDI). With over a billion consumers
commanding more and more resources, China looks like the
Promised Land to many a foreign corporation. For instance,
the country previously known for its hordes of cyclists has
become the world’s largest car market. With more and more
local technical know-how, foreign-owned factories are now
churning out anything from clothes to iPads. As a result, the
stock of foreign direct investment had grown to $1.6 trillion
dollars by 2011, an increase of 440% in FDI in just seven
years (see Figure 1). The compound annual growth rate of
23.7% is likely to decline in coming years because many
large investments in future capacity have already been made
and because the total FDI stock is already large. But even
with a rate of FDI growth five percentage points lower on
average each year, the stock of foreign capital would still rise
to $5.6 trillion another seven years on.
FDI in China has been a major source of headlines as
multinational firms have competed to build market share.
The coming years are likely to see a large increase in Chinese
investment abroad. The establishment of a Chinese car
factory in the EU heralds the start of a wave of Chinese
firms moving outside of their home market, a trend already
evident in the rising volume of acquisitions of foreign
companies and brands. Outbound FDI stood at just $52.7bn
in 2004, but rose to $339bn seven years later – compound
annual growth of 30.5%. At this rate of increase it will reach
$2.3 trillion by 2018, still much below the official currency
reserves of $3.2 trillion in Q4 2011, but certainly large
enough to change the global investment landscape. In other
words, outbound FDI could go from 14% of foreign FDI in
China to 41% in the space of just 14 years.
One reason why Chinese companies have not been
especially active abroad has been China’s exchange rate
policy. By intervening in the market to keep the yuan low in
the interest of export promotion, the government indirectly
made foreign acquisitions costly. This distortion is becoming
ever smaller as the currency moves towards its equilibrium
value, making foreign investment a more attractive use
of capital for Chinese firms – in particular those that have
moved up the value chain and acquired skills allowing them
to compete in the globalised economy. The world used to
come to China, now China will come to the world.
Figure 1: Stock of FDI in China and direct Chinese
investment abroad
52,700
369,000
339,050
2,284,049
1,634,900
2004
5,612,392
2011
2018
Direct investment abroad
Foreign direct investment
Source: State Administration of Foreign Exchange, Cebr
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Machinery trade illustrates China’s move
up the value chain
To enable the prodigious increase in industrial production
over the past decade, China has imported large amounts
of machinery. About one in three dollars imported was
spent on machinery and equipment imports in 1992. The
share of imports rose in the late 90s, rising to 43% by
2002. However, with a growing capacity to make capital
goods itself, the ratio of machinery and equipment to
other imports started declining again. Like in the early
90s it currently stands at about a third and looks set to fall
further as China imports more consumer products and
intermediate inputs while it prospers.
Another perspective on China’s growing technological
sophistication comes from the other side of machinery
trade: exports. From a low base of 15% in 1993, the share
of machinery and equipment in total exports rose steadily
for a decade, reaching 42% in 2004 and overtaking the
import ratio in the following year. Frequent complaints
by foreign competitors that Chinese firms don’t respect
intellectual property suggest that know-how gained from
importing machinery has been put to good use in turning
the import/export balance around. By 2009, a further
increase to a peak of 45% can be seen in Figure 2, but a
decline to 42% has followed. This may be preceded by
further falls as China sells more sophisticated and valuable
products, such as transport equipment, and eventually
starts to export more services as well.
The fluctuations in the import and export shares mask the
rising value of traded goods. As Figure 2 illustrates, the
value of machinery imports, measured in US dollars, has
gone up steadily since the turn of the millennium. Even a
drop of imports during the financial crisis left no lasting
mark as import values soon returned to their trend path.
In 2011, China exported an astonishing $800bn-worth of
machinery and equipment and imported $550bn. There
is a link here with the previous section because firms
have invested in factories in China to take advantage of
low production costs, meaning that part of the exports
are driven by FDI into China. The figures also show that
the country still relies heavily on foreign technology in
upgrading its industrial capacity. Nevertheless, the rise
in exports and recent success in products such as highspeed trains should serve as a warning to established
machinery makers like Germany that their important client
and manufacturing base is quickly becoming a fearsome
competitor in sophisticated products.
Figure 2: Machinery and equipment imports and
exports as a share of total exports (left-hand side) and
value of machinery and equipment imports, US$m
(right-hand side)
%
60
600,000
50
500,000
40
400,000
30
300,000
20
200,000
10
100,000
0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Import value
Import Share
0
Export Share
Source: National Bureau of Statistics of China
ECONOMIC INSIGHT – GRE ATER CHIN A
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Regional focus: Macau
The economy of Macau is becoming ever more focused
on the gaming industry. Economic prospects are
intertwined with the clutch of casinos that have made
the former Portuguese colony the gambling capital of the
world. With manufacturing in relative retreat, spending
in casinos and associated trades such as hospitality and
retailing now dominate the small economy.
Tourists from China make up the bulk of visitors and are
by far the highest spenders outside of the casinos. Day
trips by Hong Kong citizens are also popular, but the
large expansion in tourist volumes, gambling revenues
and thus the Macau economy is principally supported
by visitors from the neighbouring Chinese Mainland.
With tourism driving the economy, the number of nonresidents staying in Macau hotels is a good proxy of
economic prospects. In 2011, there were 216,000 fully
occupied rooms (calculated by multiplying the number
of available rooms with occupancy rates). This number
has quadrupled from just 53,000 in 1997, the moment
Macau reverted to the People’s Republic after Portugal’s
long-term ‘lease’ expired.
On the back of a burgeoning affluent class on the
Mainland – many of whom have a taste for the
occasional wager – visitor numbers are expected to
keep rising. Guest room capacity keeps growing to meet
demand and we expect a further increase in occupied
rooms of 58,000 over the next three years. Despite
lower growth in 2012 expected due to a weakening
in China, this implies an annual average growth rate
of 8.3% of occupied rooms. Unless a sharp slowing of
China’s economy hits Macau, the city state is set to do
very well indeed. Unemployment is at a record low and
the government is in a comfortable financial position
to mitigate some of the detrimental impact of the
gambling industry on non-gambling-related parts of
the economy. Although discontent may rise due to the
dominance of a sector linked with harmful social effects
and addiction, the economic benefits are just too great
to lead Macau to change focus – why kill the goose that
lays the golden eggs?
Figure 3: Fully occupied guest rooms in Macau (000s)
300
250
200
150
Also, investment in public infrastructure and commercial
real estate in line with the emergence of the country as an
economic superpower has led China to pour more than
half the world’s concrete and made it the major user of
industrial metals.
In conjunction with the housing boom, exorbitant
house prices have become a big social and economic
issue. Such prices put home ownership out of reach for
a large portion of the population and the preference for
male property ownership before marriage creates social
tensions. The main factor behind property speculation
has been the lack of outside investment options. Many
Chinese people have amassed considerable fortunes,
but the tight regulation of financial markets and a closed
capital account – ie, an inability to legally invest abroad –
leaves few safe investments. The Shanghai stock exchange
is very volatile and bank deposits have offered negative
real interest rates, pushing people to put their money into
bricks and mortar.
Government policies designed to limit property
speculation are widely thought to have curbed excessive
price rises. To stimulate growth, a relaxation of the
strict approach is likely if the sector slows much further:
official figures show property prices declining in most
large cities while incomes are rising faster than house
prices. Thus, the imbalance between prices and incomes
is slowly correcting. However, there is an alternative
interpretation of falling house prices; rather than being
driven by government regulation, Figure 4 indicates a link
between industrial profits and house prices in the capital
Beijing. Given a substantial grey economy in China, a
large amount of cash is probably being transformed
into legitimate funds via housing investment. As profits
dry up, the need to stash away additional money
disappears, undermining the housing market. Then, with
a return of industrial profits the market picks up again.
The correlation may be coincidental, but the graphical
evidence, as well as anecdotal accounts, suggests that
this may be an important factor in the residential housing
market.
Figure 4: Percentage change in industrial profits, year
to date (left-hand side) and index of Beijing secondary
home prices (right-hand side)
140
14
120
12
100
10
80
8
60
6
40
4
20
2
0
0
-20
-2
-40
-4
-60
100
-6
2006
50
2007
2008
Secondary home prices, Beijing
0
‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14
2009
2010
2011
Industrial profits
Source: National Bureau of Statistics of China
Source: Statistics and Census Service of Macau, Cebr
Are house prices driven by profits and
not by speculation?
The air is thinning as the investment share
of output climbs
Beyond the growth in industrial capacity driven by
trade, construction has played a major part in China’s
transformation. A massive urbanisation wave has fed
residential construction on an unprecedented scale.
Showing the importance of the aforementioned industrial
and housing sectors, manufacturing and real estate make
up 63.8% of China’s fixed asset investment, while other
components are all below the 10% level. With investment
growth running ahead of other parts of national output,
its share of GDP has increased steadily, rising from
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ECONOMIC INSIGHT – GRE ATER CHIN A
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JUNE 2 012
29.8% in 1978 to 46.2% last year. That level is very high,
illustrating the country’s dependence on building assets
to maintain output. With such dependence comes fragility
– a decline in this component of GDP would have an
unusually strong knock-on effect on the general economy.
Although heavily reliant on investment, China is in good
company in developing its economy by ramping up
productive capacity. Several highly successful ‘miracle’
East and South East Asian economies followed the path
of Japan in state-directed economic development with a
focused industrial policy. Rising productivity accompanied
a gradual move from developing country status towards
industrialised economies within the space of a generation.
However, later research showed that it was an increase
in the amount of capital per unit of labour that allowed
these countries to attain high levels
of income.
Figure 5 compares China’s gross fixed capital formation1
(GFCF) with that of selected ‘miracle’ economies that had
exceptionally high investment to output shares. The figures
are smoothed to eliminate fluctuations and bring out the
thrust of what happened. We can see that even for these
countries heavily reliant on capital investment, the peak
levels of GFCF as a share of output remained below that of
China’s current level in the smoothed graphs. The actual
(unsmoothed) peaks were 42.4% for South Korea, 47.7%
for Singapore, 43.6% for Malaysia and 41.6% for Thailand,
showing that, at 46.2%, Mainland China is already more
dependent than most other countries in the region with a
similar focus on industrial development ever were. If other
countries’ experience is a guide to what is a feasible level
of investment, China has to rebalance its economy towards
other sources of demand.
It is not necessarily the case that a maximum level has
already been reached though, even if a rebalancing will
eventually be required. Some observers maintain that
the amount of capital per worker in China is still lower
than that of the other countries mentioned, meaning that
further investment will still yield development benefits.
However, just adding capital will not be enough as the
economy requires supporting institutions to guarantee
efficient use of resources. These include the rule of law,
secure property rights, expert regulation and capital
markets that allocate resources to the best use. In sum,
China can probably still invest more, but will eventually
need to change its focus to domestic consumption, while
at the same time developing an environment conducive
to an increasingly complex social and industrial structure.
Figure 5: Gross fixed capital formation as a share of
output, HP-filtered
0.5
0.4
0.3
0.2
South Korea
Singapore
China
2011
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
0.0
1960
0.1
Malaysia
Thailand
Source: International Monetary Fund, Macrobond
1Equal to the fixed asset investment figures from China’s National Bureau of Statistics referenced
before but excluding land purchases as well as machinery and building maintenance
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Western economies’ weakness set to slow
Greater China, but not stop it
In this section we weave together many of the threads
spun above by taking a view on their combined effect
on economic growth. Based on the trends identified, we
project GDP growth for the People’s Republic, Hong Kong
and Macau. The final section addresses the main risks to
our central forecast scenario, which remain weighted on
the downside.
The economy of Mainland China slowed considerably
in the first quarter of 2012, and for the year as a whole
growth of 7.8% is expected – a marginal downward
revision from last quarter’s outlook. The cooling trend of
the economy is proceeding as expected as exports slow
and industrial production growth comes down. A gradual
rather than a sudden reduction in growth still looks likely,
with stimulus from higher government spending and a
further loosening of monetary policy to be expected if
growth falls much below the 8% mark.
With both the US and Europe stuck in first gear, muted
export demand looks likely to constrain China’s progress
over the next two years as well. That may in turn feed
through to lower investment at the same time as rising
domestic consumption reduces the trade surplus and
weighs on growth. As a result, a growth reduction to
7.6% is projected for 2013, followed by a further slowing
to 7.5% in 2014.
In the Special Administrative Region (SAR) of Hong
Kong, its function as business and financial hub for the
Mainland provides plentiful employment opportunities
for the local population. The job market is at full
employment level, boosting incomes and allowing for an
increase in household spending that will make the major
contribution to raising the SAR’s GDP by 2.9% in 2012.
That is substantially less than in 2011, partly due to lower
exports and also to a slowing economy next door. Further
ahead though, strong investment supported by large
infrastructure projects and a healthy private sector should
join private consumption in raising output to 3.8% in
2013 and 4.2% in 2014.
Controversy surrounding the recent election of a new
chief executive and corruption allegations against
prominent tycoons suggest a degree of fragility in Hong
Kong’s ruling class. However, with a diversified economy,
a wide skill set of the population and strong public
institutions, Hong Kong should not be overly affected by
such tussles. Its economic risks mainly emanate from the
big neighbour’s outlook.
The 557,400 inhabitants of Macau can look forward to
strong growth over the next years. For 2012 a slowing
of the SAR’s growth to 10.3% is expected as the number
of visitors increases more slowly than in 2011 and the
deceleration of the mainland economy somewhat puts
the brakes on expansion in the second half of the year.
The swelling ranks of affluent Chinese should, however,
provide a steady stream of visitors to the territory and
provide growing gaming revenues over time, easily
outweighing the shrivelling of manufacturing exports,
whose producers are set to be priced out of the market for
factors of production by the gaming industry.
Another source of output expansion comes from the
growing largesse of the government that is swimming in
gambling tax receipts. A steady share of over one third of
gross gaming revenues flows to the exchequer, opening
fiscal space for transfers to citizens that are facing rising
ECONOMIC INSIGHT – GRE ATER CHIN A
JUNE 2 012
prices. Gross gaming revenues have reached nearly 100%
of national value added and will keep soaring, offering
the prospect of a welfare state for the boom town’s small
population. This should give impetus to GDP, helping it
expand 14.2% in 2013 and 13.5% in 2014.
Figure 6: Greater China GDP growth forecasts
%
16
14
12
10
8
6
4
2
0
China
2012
Hong Kong SAR
2013
Macau SAR
2014
Source: Cebr
Public debate will increasingly affect
economic policy
Although the rates of growth projected here are
somewhat lower than the consensus, the central scenario
remains one of growth of a good 7% a year. If sustained
until the end of the decade, China’s economy would
roughly double in size. It has done so about every seven
years for three decades now and the question is not if this
rate of expansion will slow, only when.
The massive amounts of money pouring into productive
capacity, buildings and infrastructure that we looked at
above may be the Achilles heel of the Chinese economy,
but it’s not the only weak spot. Bank credit has been
financing the boom and a souring of investment projects
amid a serious economic slump would hit the banking
system hard when borrowers become unable to pay their
dues. The central government has the fiscal space to
support the banking sector, but growth would be hurt.
China’s ‘offshore’ financial centre Hong Kong would feel
the effects, while the playground Macau would also see
business suffer.
China is also indirectly vulnerable to another banking crisis
which could originate in the eurozone. Many national
electorates are already losing patience with the austerity
agenda of their governments and the resulting change
in policies may destabilise markets again. The Spanish
banking sector is a main worry, but the list goes on and
thus the uncertainty will be with us for many months.
Since the last edition of Economic Insight, an economically
important domestic issue has emerged. The internet is
making information available across China, loosening
the state’s tight grip of the media and raising pressure
for transparency and accountability in government. The
highly successful system of governance that has brought
prosperity to many will have to adapt quickly to operating
in open view rather than behind the scenes. China’s
economic policy mandarins have been good at doing their
job in the absence of much public scrutiny. It remains
to be seen how they will fare once fiscal, monetary and
regulatory policies become topics of open public debate.
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