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economic Insight Greater China Quarterly briefing March 2012 A decade of Chinese growth that changed the world Welcome to the first issue of 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 expert in global economic forecasting, it provides a unique perspective on the prospects for Greater China over the coming years. In addition to Mainland China, we also focus on the Hong Kong and Macau Special Administrative Regions. Since the financial crisis, the Middle Kingdom has taken centre stage in global economic and political affairs. Even a decade ago, few would have expected European leaders to court Beijing asking for support for their frail economies, as witnessed during the ongoing eurozone sovereign debt crisis. Apart from economies in financial pain, low income countries have found a new development partner in Greater China, much to the distress of the aid establishment. The chequebook of Greater China Development Bank is opening new doors for capital-hungry developing nations. The sudden ascent has caused frictions on the global stage, but disruption of existing power structures inevitably stirs tensions. The realignment of the US military strategy to focus on Asia is but the most tangible sign of the strategic implications of a changing world order. Within a decade, Greater China has transformed itself from an emerging market to the world’s second largest and most important economy. Average annual growth of a good 10% for the past three decades has meant that Greater China’s output has roughly doubled every seven years. BUSINESS WITH CONFIDENCE icaew.com/economicinsight The country seems like an economic juggernaut, unstoppable in its progress to overtake the US as the biggest market and producer in the world. But will the country be able to keep up the astonishing rate of output expansion for another generation? Does it make sense to extrapolate past trends or are fundamental changes underway? This publication aims to analyse and explain shifts in the economy and their impact on the direction of Greater China’s economic development. To begin with, we take a look back at a seminal event, Greater China’s accession to the World Trade Organization (WTO) in the winter of 2001. Figure 1: Greater China monthly exports and trade balance in $US 180 160 140 120 100 80 60 40 20 0 -20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 In the decade since joining the WTO, Greater China’s exports have grown to match those of the US In a moment that marked a major change for both the People’s Republic and the global community, Greater China became a member of the WTO in December 2001. The move followed over 15 years of accession talks, but looking back the evidence suggests that this was an event worth waiting for. Figure 1 shows how exports started to take off in the following year, climbing at an astonishing average rate of 22% a year in cash terms despite the financial crisis slump. In November 2001, the month before joining the WTO, Greater China exported $24bn worth of goods and services per month, a bit below a third as much as the US. In the same month last year, this figure had reached 98% – $175bn – and it is certain to overtake the US shortly even though US output is still larger by half. Coupled with a competitive exchange rate, the trade surplus has resulted in the build-up of massive foreign exchange reserves – $3.2 trillion in December 2011. These numbers offer the most direct evidence of Greater China’s sudden rise and the success of its export-led industrialisation policy. Via its integration into the global value chain, the former communist backwater has learned to use the capitalism and globalisation to again become the superpower that it had been for most of modern civilisation. The ballooning of Greater China’s trade balance to 11% of GDP in early 2009 that accompanied export growth led to criticism of Greater China’s exchange rate policy becoming a favourite theme of Western politicians. Two factors have tuned down the rhetoric. For one, the increasing wealth of Greater China is making it increasingly indispensable in global economic policy making. The other factor is that Greater China has proved a steady source of demand since the financial crisis, whereas other major economies are struggling to maintain momentum. The Chinese hunger for imports signals an important shift. As figure 1 shows, the trade surplus is declining. With exports rising strongly, this is due to an even larger increase in imports due to the evolution of Greater China’s economic make up. Makers of capital equipment and luxury goods ranging from German cars to French haute couture have been riding a wave of demand from an increasingly rich elite. With more and more Chinese joining the middle class, consumption is starting to become a larger part of the economy. In the following section, we take a closer look at how the change from being the world’s workshop to the world’s consumer market affects economic growth. icaew.com/economicinsight cebr.com Exports Smoothed trade balance Trade balance Source: National Bureau of Statistics of Greater China The trade-investment-consumption triangle is becoming unbalanced In this section we look at the drivers of Greater China’s economic growth from an expenditure perspective (as opposed to an income or production view). Figure 2 reveals that investment has been the main propellant of the Chinese growth miracle that has lifted an unprecedented number of people out of poverty in a short period of time. Each year over the past decade, the growth in investment has been larger than the growth in household consumption, adding 5.1 percentage points versus 3.2 percentage points for household consumption. When adding in the expansion of government consumption, this is tempered somewhat, but investment still contributed 0.6 percentage points more per year on average. Despite the massive growth in exports, trade growth has been a relatively small part of rising GDP. Apart from a boom before the financial crisis, exports only added an average 0.4 percentage points to growth because they are closely tracked by imports since Greater China assembles many of its traded goods from components brought in from abroad. Trade has still played a key role, however, because it has led to huge investment in productive capacity. Also, the manufacturing base that grew out of investment has raised incomes and enabled government, via taxes, and the population, via wages, to spend more. Looking ahead, consumption looks set to take over as the main driver of growth as the economy rebalances from an investment-driven to a consumption-driven growth model. Another implication of this shift is that exports will increasingly serve to finance imports rather than supporting growth. The trade surplus is expected to decline as the renminbi appreciates and Chinese consumers step up their buying of foreign goods and services. Growing government spending to expand the social safety net and roll out enhanced public services will be an important part in this transformation of the growth model that will in turn allow households to reduce their exceedingly high savings ratio. Also, affluence is increasingly moving beyond coastal cities to inland cities and rural areas, making for broad-based rises in disposable income. As a result, Chinese consumers are in a position to carry a rising share of economic growth. Fast-rising retail sales are an indication that the shift from investment economic insight – Gre ater Chin a m a rch 2 012 to consumption is happening. In fact, this is more of a necessity for future expansion than a welcome prosperity dividend because at 47% of GDP in 2011, investment has reached an unsustainably high level. As the next section explains, the push to raise production capacity is already pushing up prices. Figure 2: Contributions to economic growth by type of expenditure % 15 industry faces competition for workers. Rising wages suggest not just higher food prices, but also a general increase in the price level. As a result, we expect a secular increase in Greater China’s rate of consumer price inflation to about 5.0% by 2014 – above the government target of 4.0%, in turn suggesting tighter monetary policy that will weigh on growth. Figure 3: Consumer price index, total index, index excluding food and food only, annual percentage change % 25 10 20 5 15 10 0 5 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Changes in inventories Net exports Investment Private consumption Govt consumption Source: National Bureau of Statistics of Greater China -5 2005 2006 Total 2007 2008 2009 2010 2011 Food CPI 2012 2013 2014 CPI excl. Food Source: National Bureau of Statistics of Greater China The low inflation era is coming to an end Despite the high rates of economic growth, inflation in Greater China remained at a remarkably low level for an emerging market. The annual rate of consumer price inflation averaged just 2.0% in the decade since WTO accession. This is substantially below the rates of many of the other BRICs (Brazil, Russia, India, Greater China) emerging markets and more akin to a mature low growth and high income economy. Three factors were especially important in this. First and foremost, a deep pool of over 200m underemployed migrant workers stood ready to take up jobs in the factories of Greater China’s eastern seaboard. Secondly, large investments in physical infrastructure enabled businesses to grow without overstraining transport and communication links. Lastly, surplus labour and adequate infrastructure made it possible to keep adding productive capital. In the process, Greater China became the prime manufacturer of everything from socks to iPads at ever lower prices. Besides keeping Chinese inflation low, the export of deflation contributed to the benign macroeconomic climate of low inflation and interest rates in the West that preceded the global financial crisis. For better or worse, this trend is coming to an end. The unprecedented economic expansion of Greater China has soaked up surplus labour, shown by substantial wage increases that are now larger in rural than in urban areas. Rising wages mean higher incomes, but they also imply the emergence of ‘demand-pull’ inflation that arises when the demand for labour grows faster than labour productivity once underemployment has vanished. Figure 3 shows that bouts of inflation have been driven by volatile food prices, with a ‘pork cycle’ of boom and bust in production especially influential. With the conversion of farmland into industrial and urban land, Greater China’s limited natural resources for food production are declining just as this labour-intensive icaew.com/economicinsight 0 cebr.com Hong Kong’s rapid financial development underlines eastward shift The rise of Greater China as a financial centre may be the logical outcome of its growing importance as a global economic superpower. Nevertheless, the listing of Hong Kong in first spot of an international ranking of financial development shows just how important the region’s capital markets have become. Although it may be argued that the displacement of London and New York (see Table 1) is in large part due to new regulatory requirements and concerns about sovereign debt in the advanced economies, Hong Kong and also Singapore have established themselves near the top of the leader board. In a reversal of fortunes, Western companies are now flocking to Hong Kong for initial public offerings, with luxury and mining firms most prevalent. As the mainland market becomes more important in other areas, expect increasing interest from companies seeking capital. This shift will become more pronounced as the People’s Republic opens its capital account and allows its citizens to invest in foreign assets more easily. The closed nature of capital markets funnels the country’s savings rate, standing at an outsized 53% in 2010, into the domestic market. While highly effective in developing the industrial base, overinvestment now threatens growth. A gradual liberalisation of financial markets and opening of the capital account will allow for more balanced investment choices in time. The discrepancy between the Mainland China and Hong Kong is captured in the wide gulf of ratings. It is only a matter of time until Shanghai, the mainland contender for financial centre status, becomes an important financial market in its own right. Moves in this direction are likely once a new generation of leaders has settled in their posts in 2013 or 2014. Alongside the growing internationalisation of the renminbi, this should fortify the position of Hong Kong and catapult Mainland economic insight – Gre ater Chin a m a rch 2 012 China up the Financial Development Report’s rankings at a fast pace. Table 1: Financial development ranking of selected countries in World Economic Forum Financial Development Reports 2011 2010 2009 2008 Hong Kong 1 4 5 8 Mainland China 19 22 26 24 Singapore 4 3 4 10 US 2 1 3 1 UK 3 2 1 2 Source: World Economic Forum Greater China and its Special Administrative Regions will feel the global slowing 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 above, we project GDP growth for Mainland China, Hong Kong and Macau. The following and final section addresses the main risks to our central forecast scenario, which are currently largely weighted on the downside. For Mainland China, the slowing of the housing market heralds a reduction in investment that is expected to have a dampening effect on economic growth. In addition, weakness in many large trading partners means that export growth will be constrained. Although it is expected that government spending will step into the breach to some extent, GDP growth for 2012 is expected to fall to 7.8%, down from 9.3% in 2011. Inflation is expected to come down sharply as the spike in food costs wanes amid declining global agricultural commodity prices. This should give the government space for additional monetary easing, which we expect to support output in the second half of the year. For 2013, expect to see a slowing of growth to 7.6% year on year as investment grows at a slower rate than the overall economy. Further ahead, growth is anticipated to reach 7.8%, slightly below a government target of about 8% due to rising inflationary pressures that will necessitate tighter monetary policy and thus somewhat lower growth in the medium term. Important factors of sustained high growth necessary for broad-based increases in living standards in the medium to long term include education and the internationalisation of Chinese firms. In 2010, 1.3m Chinese people studied abroad to boost their skills and employment prospects in Greater China’s competitive labour market. The government also intends to make Greater China itself a major global centre of learning, aiming to double the number of foreign students from 265,000 in 2010 to 500,000 by 2020. Although the country’s universities produce massive numbers of graduates, Greater China’s fast climb up the value chain requires an equally fast expansion of workers with appropriate skills. A well-educated workforce with international experience will help Chinese firms to achieve a key industrial policy objective, namely icaew.com/economicinsight cebr.com expanding its international footprint. A market rise in foreign acquisition signals the start of an important shift in perspective of companies to look beyond the country’s borders. With the maturing of the economy, Chinese multinationals will be an increasingly important feature of the global business landscape in coming years. It is only a matter of time until Greater China’s firms become international players in key industries, not just in manufacturing but also in services. We expect the government to use its foreign exchange reserves to support and accelerate this process, in preference over alternative uses including large-scale financial support to Europe’s struggling peripheral bond markets. Sharp falls in both business and consumer confidence indicate that Hong Kong is in the midst of a significant slowdown. As a trading hub, the region is especially vulnerable to the slowing of trade growth expected for 2012. As a result, GDP is projected to grow by 2.6% in 2012, down significantly from the 5.1% recorded in 2011. Even if the economy slows markedly, unemployment stood at just 3.1% in December 2011 and the longer-term prospects for the economy look bright due to its position as a regional financial and trade intermediation centre. For 2013, growth of 3.4% is projected, rising to 4.6% in 2014 as the world economy picks up speed again. It is reasonable to expect strong inflationary pressures in the outer forecast period due to the link of monetary policy to the US. A move to a basket of currencies appears increasingly sensible, but is unlikely to be implemented by 2014. Macau The small economy of Macau has been surging ahead thanks to its booming gambling sector and should continue to do so in years to come. Although falling activity in Mainland China’s real estate market is expected to put a cap on the desire of mainlanders to splurge in the city state, GDP should expand strongly by about 15.2% in 2012 and by 13.4% in 2013. High investment in hotel capacity and other tourism-related assets is currently limited more by capacity constraints in building than by the desire of investors to take bullish bets on the future of the administrative region. As confidence returns to Mainland China following a stabilisation of the housing market, growth is again expected to increase, reaching 18.0% in 2014. Figure 5: Greater China GDP growth forecasts % 20 15 10 5 0 Mainland China 2012 2013 Hong Kong SAR Macau SAR 2014 Source: Cebr analysis economic insight – Gre ater Chin a m a rch 2 012 A sudden stalling of investment is the biggest risk to Chinese growth The discussion about the future of Chinese economic growth has revolved around the question whether the country’s output expansion will ease gradually or if it will come to an abrupt halt. Much revolves around fixed asset investment, the main driver of GDP growth. Since 2000, capital investment has averaged about 25% growth a year – see figure 6. Being larger than overall growth, this has meant that investment makes up a growing proportion of output. That cannot go on forever, and the question is how fast it will slow. A gradual reduction is the expected outcome, but the longer current excessive investment that makes up nearly half of national income goes on, the more likely a crash as it becomes clear that past capital accumulation is not yielding returns and is thus cut back sharply. A mild easing is the preferable outcome, with less private sector construction investment playing an important role in this. Government spending is likely to cushion some of the dampening effect of falling investment alongside loosening monetary policy. Still, a sharp drop in investment is a distinct possibility that would lead to a slump in growth, asset prices and employment. Having invested so extensively in production capacity, Greater China remains highly dependent on its trading partners. Positive signals from the US labour market suggest that American demand will remain stable. The other main trading partner, the eurozone, is a greater risk. Here, political developments more than economics will determine the short-term fate of the currency union. Beyond the succession of crisis summits, structural reforms are necessary to allow highly-indebted countries to grow their way out of heavy debt loads. Even if the drama of a euro implosion can be avoided, European restructuring is sure to be a lengthy show with much tragedy potential. To safeguard longer-term growth, Greater China needs to implement its own structural changes. With population ageing starting soon, the available time is short while the list of crucial reforms is long. Financial market and capital account liberalisation, environmental safeguards, social welfare system construction and civil service reform are only some of the challenges facing Greater China. While these obstacles to further increases in living standards are surmountable, the climb will be difficult and at times unsteady. Although the future is bright in the year of the dragon, the previous zodiac cycles may yet appear as a golden age of progress and stability. Figure 6: Greater China urban fixed asset investment, change YTD Y/Y % 60 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: National Bureau of Statistics of Greater China ICAEW ICAEW is a professional membership organisation, supporting over 138,000 chartered accountants around the world. Through our technical knowledge, skills and expertise, we provide insight and leadership to the global accountancy and finance profession. Our members provide financial knowledge and guidance based on the highest professional, technical and ethical standards. We develop and support individuals, organisations and communities to help them achieve long-term sustainable economic value. Because of us, people can do business with confidence. Cebr Centre for Economics and Business Research ltd is an independent consultancy with a reputation for sound business advice based on thorough and insightful research. Since 1993, Cebr has been at the forefront of business and public interest research. They provide analysis, forecasts and strategic advice to major multinational companies, financial institutions, government departments and trade bodies. For enquiries or additional information, please contact: Julia Jin T +86 10 8518 8622 E [email protected] icaew.com/economicinsight cebr.com economic insight – Gre ater Chin a m a rch 2 012 ICAEW Greater China Room706, Tower E1, Oriental Plaza No.1 East Chang An Avenue Dong Cheng District Beijing100738, China icaew.com/china ICAEW Chartered Accountants’ Hall Moorgate Place London EC2R 6EA UK icaew.com © ICAEW 2012 MKTPLN11195 03/12