- China recently adjusted its GDP growth target from 8% to 7.5%, but we think the downward adjustment partly reflects the government’s efforts to manage the markets’ expectations
- A slower growth rate also reflects a transformational year as China strives to become a consumption-driven economy, focusing on quality not quantity
- The pro-consumption policies will boost imports, while external demand will weigh on exports; these two diverging factors may lead to net exports contributing negatively to China’s economy this year
- Nonetheless, the adjustment, along with other topics addressed by the government during the NPC, assures us that there will be continued progress towards boosting domestic consumption and stabilising the Chinese economy
- We do not see this event to be detrimental to the market’s long-term outlook, we remain positive on the Chinese equity markets
At China’s first National People’s Congress (NPC) meeting this year, held on 5 March 2012, Premier Wen Jiabao announced that the nation’s gross domestic product (GDP) growth target will be adjusted downwards from 8% to 7.5% for 2012. The announcement shook markets, temporarily halting the Chinese equity markets’ year-to-date market rally, leading it to decline for three consecutive days. Even though this was the first downwards adjustment after holding it at 8% for 7 years, given the actual implications of the 7.5% GDP growth rate target, we think the market’s initial reaction was overplayed. In this article, we will discuss the implications of the 7.5% revision of GDP growth rate target and our expectations for the economy in the coming years.
First, we by no means think that the growth rate target revision reflects the government’s expectation of a dramatic slowdown to the 7.5% growth level. China has almost always been able to surpass its growth targets; in fact, looking at Chart 1, we can see that in the past 10 years, the economy has successfully grown at a rate which exceeded the official target every year, sometimes even by a substantial amount, such as that seen in 2007. But another way to look at this is that the government typically adopts a rather conservative growth target, so that it can be surpassed, minimising the occurrences of negative surprises.
If we consider the market’s expectations for the nation’s economic growth, we can see that estimates are above both the new and old growth targets. According to Bloomberg estimates, China is expected to grow at 8.5% and 8.4% in 2012 and 2013 respectively.
Chart 1: China Gross Domestic Product (GDP) Growth Rate vs. Target
However, the downwards adjustment in GDP growth rate does reflect expectations of a slowdown to some extent. But this should be nothing new to investors, given the evident signs of a sluggish global economy for at least half a year now. Since China would not be immune to a weak global economy, part of the underlying motivation to lower the growth target is to skillfully manage the markets’ expectations for the coming year.
Quality not Quantity
Apart from managing expectations however, a slower growth rate also reflects a transformational year for China as the economy embarks on some major steps towards becoming a consumption-driven economy, as outlined under the 12th Five Year Plan (FYP). The government’s focus is now on quality not quantity.
Referring to Chart 2, we can see two of China’s GDP drivers, according to the GDP expenditure approach. We can see that in the past decade, the economy has become increasingly reliant on investments as a contributor to GDP, while consumption’s contribution has been steadily declining. What’s worth noting is that in the past 10 years, investments’ contribution to the economy has increased from 36.5% (in 2001) to 48.6% (in 2010). In 2003, investments’ contribution even started to exceed private consumption’s contribution. Part of this can be attributed to the rapid growth in investments, which was largely motivated by the objective to expand infrastructure development as part of the 11th FYP, which spanned from 2006 to 2010. Then the massive 4 trillion yuan post-financial crisis fiscal stimulus, which infamously lead to overcapacity and overinvestments across the nation, led to a sudden spike in investment’s contribution between 2008 and 2009, the year in which investments’ contribution rose from 43.9% to 47.7%.
Chart 2: Private Consumption and Investments’ Contribution to China’s GDP
A high level of investment is a typical feature of a high-growth emerging economy. But as China’s investments start climbing towards the 50%-of-GDP level, it’s hard to imagine the continuance of such large investments; in other words, it is unsustainable. Furthermore, such heavy reliance also means that even a minor shock to investments would have a substantial impact to the overall economy. This is why the government has put particular emphasis on pushing "quality" drivers of the economy, rather than pumping out "quantity" (i.e. large amounts of investments), in order to transform China’s economic growth model into a more sustainable one.
Encouraging growth in domestic consumption to find quality drivers for the economy was one of the main focuses of the 12th FYP. China boasts a 1.3 billion population which means that there is huge potential for domestic consumption to surge if it can just tap deeper into the population pool. The basic idea under the 12th FYP is to increase the population’s propensity to consume. Some of the ways China hopes to achieve this is by expanding the services sector and value-added products to create jobs, raising minimum wages and to strengthen the social safety net so that the people will save less, spend more.
|Table 1: Ways to Boost Consumption under the 12th Five Year Plan
- Expand labour-intensive industries which create more jobs per unit of GDP
- Increase services industry’s proportion to GDP from 43% to 47% by 2015
|Increase Minimum Wages
- Boost rural-urban migration by continuing to relax the "Hukou" residential registration system
- Boost rural incomes by increasing agricultural efficiency and productivity
|Strengthen Social Safety Net
- Expand social safety net coverage
- Improve social security, private pensions and medical insurance
|Individual Income Tax Reform
- Increase the lower taxable income bracket
- Decrease tax burden for low-to-middle income earners
- Increase tax burden born by higher income earners
|Source: iFAST Compilations
Another major way China hopes to increase consumption is through income redistribution via the Individual Income Tax (IIT) system reform. The reform will provide relief for the low and middle income earners by increasing the lower taxable income bracket threshold, at the same time the tax burden for higher income earners will increase. Local Chinese employees earning below the RMB19,000 threshold will benefit from this reform, increasing the low-to-middle income earners’ propensity to consume.
As mentioned in our previous articles, 2012 will be a fundamental year for China to implement these plans. One of the obstacles it has been facing is inflationary pressures, which will inevitably weigh on consumer’s propensity to consume. But as inflation seems to be under control, after declining meaningfully in recent months, we think the pro-consumption goals will be made just slightly easier to achieve. In particular, it will give the government more space to increase minimum wages, something that should only be done when inflation is controlled.
These goals are important for our analysis because Premier Wen, at the same time, emphasised that the government would be committed to finding quality growth. The transformation of the economy may put a slight drag on economic growth, especially at its early stages. But this is also partly why we view the downwards revision as a positive sign as it demonstrates that the government is willing to walk the talk, and sacrifice quantity for quality. This marks an effort to stabilise China’s economy in the long run, which is of utmost importance for the nation.
Net Exports May Contribute Negatively
A secondary source of unsustainability in the Chinese economy is its reliance on exports. Referring to Table 2, we can see that during the periods of 1993 – 2001 and 2002 – 2007, exports growth had surpassed retail sales growth by a startling amount. Subsequently, net exports’ (exports minus imports) contribution to China’s economy started to climb, until it reached 8% in 2007. Heavy reliance on exports can make an economy extremely sensitive and volatile to changes in external demand. Looking at Chart 3, it is evident that the spectacular double-digit growth rates seen from 2005 to 2007 had been driven by rapid growth in net exports, which contributed over 2 percentage points in each of those years. But as soon as the financial crisis hit the global economy, net exports slumped and put a huge drag on the Chinese economy, pulling down the GDP growth rate by 3.6 percentage points in 2009, contributing negatively to economic growth. It’s also worth noting that in that same year, the economy was only able to grow at 9.2% because investments growth contributed a massive 8.4 percentage points to GDP growth, offsetting the exports’ drag. Now that the global economic outlook is not all that positive right now, weak exports as a result of weak external demand may lead China to record negative net exports this year. This means that we may witness trade contributing negatively to China’s GDP, another consideration that explains the lowered 7.5% GDP growth rate target.
|Table 2: Exports and Retail Sales Growth Trends
|Retail Sales Growth
|Source: World Bank, National Bureau of Statistics and iFAST Compilations
*Growth in table is calculated as a compounded annual rate
Chart 3: Components’ Contribution to GDP Growth Rate
In February, China recorded its largest trade deficit in years, amounting to USD31.5 billion. For a country that has been known for its huge trade surpluses, this economic figure indicates the shifting dynamics between external and internal demand in China. In the first two months of the year (aggregated to reduce distortions from the Lunar New Year holiday), imports grew 8.2% while exports grew only 6.9% year-on-year; the figures highlight the relative weakness in external demand.
Moreover, it is not hard to see that this trend may persist this year. If we look at China’s main exports destinations in Chart 4, we can see that Europe is the largest contributor to Chinese exports, making up 19% of China’s total exports. In addition, we can also see that exports to Japan makes up 8% of total Chinese exports. Both of these economies’ outlooks for this year are relatively weak, leading us to believe that they will continue to weigh on Chinese exports.
Chart 4: China’s Exports Destinations
On the other hand, the pro-consumption policies mentioned earlier will continue to stimulate domestic demand, which will at the same time boost imports growth, further amplifying the divergence in growth rates of exports and imports. Therefore, continued weakness in external demand coupled with strengthening domestic demand means that net exports may not deliver any exciting (upside) results this year. Not only does this help explain the lowered GDP growth rate target of 7.5%, it also demonstrates that the shift from exports (and investments) to domestic consumption has become more urgent than ever before.
Unhealthy Competition Partially Subdued
Lastly, one of the drawbacks of a high GDP growth rate target is that it promotes local governments to engage in aggressive tactics to "compete" in boosting its province’s own GDP growth rate. Last year some provinces had GDP growth rate targets far above the official 7% set under the 12th FYP, some provinces such as Chongqing had set its target as high as 16.4%. Many economies did manage to grow at phenomenal growth rates in 2011, provinces such as Tianjin and Chongqing managed to grow at a rate of over 16%. In fact, even the larger provinces shown in Table 3 were growing at an annual rate of over 10% in 2011.
This sort of unhealthy competition is what induced local governments to borrow excessive amounts after the financial crisis to invest into suboptimal infrastructure projects. These were the investment projects which have subsequently enlarged the potential risks of a spike in non-performing loans in China.
|Table 3: Top 10 Provinces’ (by GDP) Growth Rates in 2011
|Source: Yearly Economic Reports of Local Governments, iFAST Compilations
We believe a lowering of the GDP growth rate target will also ease pressure on local governments, softening their need to compete for unsustainably high economic growth, coming from risky sources or projects.
Implications for Investors
In conclusion, we were not too surprised to see the moderate adjustment in GDP growth rate targets by the Chinese government and find that markets had initially overreacted. The GDP growth rate merely represents the weakening external demand, an effort to manage expectations of slower growth and the probable results from a transformation in economic growth model to find quality. In fact, the implications of the downwards adjustment along with the other topics addressed by the government during the National People’s Congress meetings, assures us that there will be continued progress towards boosting domestic consumption and stabilising the Chinese economy.
Thus, as we do not see this event to be detrimental to the market’s long-term outlook, we remain positive on the Chinese equity markets. Investors can read more on our outlook for the Chinese equity markets in these articles: Prepare for a Chinese Rally and China Market on Track to Achieve 17.7% Earnings Growth in 2011.
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