China’s Slowing; So What? May 2016

By this time there is not a business person in the western world who doesn’t know that the Chinese economy is not moving ahead at the torrid pace of five years ago. China has grown to become the second largest economy in the world and the law of large numbers is in its way. In the first quarter, it reported 4.5% real GDP growth, the lowest since 2010. In order to reach the annualized rate of 6.7%, growth in the next two quarters would need to be 7.4%, which seems hard to achieve. I have been projecting (guessing) overall Chinese real growth of 4.5% and arguing with clients and analysts about whether I am too low or too high. The real question is, how much does this matter? If you are an agricultural or industrial commodity exporter like Brazil or Australia, the Chinese growth rate means a lot. If you are a Hong Kong businessman/ entrepreneur looking for deals, there is plenty to keep you busy.

I have just returned from a trip to Singapore, Hong Kong, Beijing, Shanghai and Tokyo, meeting with sovereign wealth funds, other clients, policy officials and business people. While everyone is aware of the slowdown in China, very few expect a hard landing caused by a real estate bubble, a banking collapse related to non-performing loans or other factors. There is a general recognition that Xi Jinping is centralizing his leadership and taking control of the media and the military, but he is also accomplishing a necessary goal. Official corruption had reached a level where it was causing the general population to lose confidence in the central government. The average person had enjoyed more economic opportunity in the last fifty years, but they were angered by local and national officials accumulating considerable assets and flaunting their wealth (or their children doing so). In addition, growth was accompanied by an excessively restrictive regulatory environment in the view of most observers.

Xi realized this situation had to change. He began a vigorous anti-corruption campaign to re-establish the legitimacy of the Communist Party and its leadership and to restore the confidence of the general population. I attended a small dinner with Dr. Henry Kissinger a few weeks ago and asked him about the anti-corruption program. (Kissinger is a hero of mine because he is still well-connected and relevant at 93.) He told me Xi’s goal was to eliminate the corruption that resulted in wealth creation, not the corruption that facilitated the ease of doing business. If you want to get building materials delivered to your site during the day, rather than at night in accordance with the rules, you can still make a payment to someone to do that, but major gifts allowing many officials to build fortunes were stopped. Even the distribution of gift cards to ordinary employees to establish good will is over. As a result, gambling travel to Macau is down and luxury goods sales in Hong Kong have declined.

But business in China goes on. The consumer sector continues to grow in importance in the overall economy. The government is still engaged in fiscal spending and monetary accommodation but the economic planning officials recognize that the future depends on consumers becoming an increasingly larger portion of GDP. The Chinese consumer is currently a smaller part of its economy than the consumer in any major industrialized nation, and rebalancing has a long way to go. As for government expenditures on infrastructure, there is also much to be done. Most visitors to China are aware of the dazzling roads and buildings in Beijing and Shanghai, but China has more than 100 cities with a population of one million or more. Many of these are in the western and northern parts of the country and need infrastructure improvements of all types. This should provide many jobs for some time to come, increasing the overall wealth of the more remote parts of the country. If growth in China were closer to 5% than 7%, is that so bad? China will still be able to create ten million or more jobs annually. The United States, Japan or Europe would be thrilled to grow at that rate. Why should we all be wringing our hands because growth has slowed to the mid-single-digit level? As Jon Gray, who runs Blackstone’s Real Estate division told me, “Our malls in China had annual sales increases of 18% a few years ago; then that went down to 12% and now it’s 8% – but 8% is still pretty good.”

China is not, however, without serious problems. It has too much capacity in many basic industries and some of it is obsolete. It has a large number of non-performing loans on the books of its banks and many of these will never be paid back. Because the banking system is integrated into the People’s Bank of China, the assumption is that there won’t be a banking meltdown, but that may not be right. While to the outside world China does not seem to be under financial stress, Chinese debt has escalated more than 50% since the recession of 2008-9 and its foreign exchange reserves have been drawn down sharply by 20% to maintain the value of the renminbi.

We also know that the social safety net needs a lot of work. China has weak retirement support for its aging population and has no universal healthcare. As a result, consumers save as much as 50% of their income so they have the resources to deal with unexpected circumstances. This affects growth, and few involved in China expect these conditions to change in the near term.

Real estate is key to financial stability in China. The combination of monetary accommodation and relaxed rules relating to owning more than one residence have propped up the market and prices are rising in many of the 100 largest cities, but observers are worried that this won’t last. Consequently, one of China’s major problems is capital flight. Wealthy Chinese have been trying to move assets out of the country for several years. I think it is fair to ask, “If there are so many investment opportunities in China, why are many people trying to get their money out?”

The answer is that China is filled with uncertainties as well. The extreme volatility of the Chinese stock market made domestic investors apprehensive about investing in financial assets at home. Apartment prices in the top tier markets like Beijing and Shanghai are clearly expensive and have been rising yet higher. In second tier cities there are still good values, but future economic opportunity is less clear there. Young people want to live in Beijing or Shanghai just as they want to live in New York or San Francisco in the United States or London and Paris in Europe and the real estate values reflect the popularity of these places. Talk about unintended consequences: the hope behind the high-speed rail system was that young people could live and work in smaller cities near their families and travel by train to Beijing and Shanghai on weekends. What happened was that the millennials chose to live in the big cities and travel to visit their families on weekends. Still, in a country with continued growth and 1.3 billion people, many other cities will emerge as attractive places to live over time. The major cities are so built up and dense that the logistics of living in those places is making them less desirable.

The Chinese practice of buying multiple apartments to store personal wealth points out one of the true tragedies of the country’s financial planning. Perhaps because the stock market was viewed as the quintessential manifestation of the capitalist experience, the Chinese leadership never took it seriously enough or saw its opportunities. It should have demanded more transparency through regulation and required more responsible accounting. Their dilatory attitude resulted in extreme volatility in the “A” share market, especially after the financial crisis of 2008. Because of this, there was a period when the stock market was closed down and investors lost access to their assets.

While only about 10%–20% of the Chinese population participated in the market before the closure and few institutions were involved, this action dealt a serious blow to confidence. Before the closure, the government participated in the market aggressively to boost prices. This intervention hurt confidence as well, and it will take a long time to repair the damage. This is sad because the Chinese are natural entrepreneurs and investors and if the financial markets were properly regulated, equities could have become an important and constructive part of the business culture. Had that happened, the problems with capital flight could have been severely reduced.

In several of my meetings, Chinese innovation was a subject of debate. Given that Chinese immigrants often do extremely well in American high schools and universities, why are we not seeing more technology breakthroughs coming out of the country? One reason is that the Chinese higher education system is teaching-oriented and research plays a smaller role than it does in American universities. A second reason is that there is little government money for research. Finally, the venture capital market is just getting going in China, so while the talent is there, the money isn’t. This is changing and we will see more new products coming out of China in the coming years. Drones and animation are on the planning boards. The Chinese are also working to advance healthcare and education practices.

While China has relaxed its “one child” policy, this change may be slow in having an impact. Raising a child is expensive in China and apartments are small. 2015 was the year of the sheep – a bad time to have a child. 2016 is the year of the monkey – a much better time for giving birth. The authorities expect a surge. The change in the one child policy may get more traction in non-urban areas. Over time, larger families will surely contribute to growth.

Xi Jinping has focused on corruption, but he needs to pay more attention to the operation of state-owned enterprises. Because these companies are extensions of the government, they are not held accountable in the same way as western companies. While profits are a goal, the employment of a maximum number of people is also an objective. This has to change in order to sustain productivity and growth, but labor efficiencies were given lower priority on the list of planned reforms. Banks also need to become more profit-oriented. One of the reasons there are so many non-performing loans on their books is that the managers know that big or small, they can’t fail: the government will bail them out.

The key government objective is to maintain stability, not profitability. and the Chinese seem to accept that. One official told me that Xi is highly focused on the need to retain the approval of the people. Civil unrest is to be avoided at almost any cost. One of the reasons the Internet is so tightly controlled is to prevent those inside China from communicating with terrorist groups or having access to information that may lead to radical behavior. The Western press focuses on these restrictions on the freedom of Chinese individuals, but the average citizen is thinking more about his or her job and the quality of life, and that is still improving. First Amendment–type policy issues are less important.

The situation in Japan is very different. The combination of negative interest rates and the failure of Shinzo Abe’s “Three Arrow” policy to stimulate growth with modest inflation has left the people disheartened. In conversations with investors there, I got the feeling that many had lost hope that stronger growth and opportunities for wealth creation were ahead. Japan’s decision not to provide further economic stimulus at the end of April was a sign of leadership confusion. Investors expected vigorous monetary expansion to weaken the yen but, instead, the currency strengthened and hurt exports. Officials don’t know why. They have chosen not to initiate further policy moves until they understand the situation better. The market reaction to this indecision was negative.

Investors throughout Asia were concerned about the usual global issues that are on everyone’s mind: interest rates, monetary policy, oil prices and sovereign debt levels. The most frequently asked question was, “In a slow-growth world economic environment is there any way for an institution to earn a reasonable return for its clients?” In the past 25 years, high-single-digit returns or more were possible, but now with interest rates low and the markets choppy it may be hard to achieve half of that rate of portfolio appreciation. In addition to that near-term concern, very few have an answer to the question of what will change the outlook.

The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Services L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.

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