No other economy attracts as much awe and skepticism as China. What China has achieved in last 20 years is almost unparalleled for a large country. India and China had similar GDP in 1990 and today China at nearly USD 11 trillion in GDP is nearly 5x India when India ‘s nominal GDP has grown in excess of 10% for much of last decade.

The inflexion point in China’s growth trajectory came post its entry in WTO in late 2001 when its share of world’s exports moved from 3% to 12% in 2015 as companies’ world over discovered a new competitive location for sourcing their goods.

The much talked about export growth model faced its serious challenge post 2008/09 financial crises as demand from developed world plummeted. Faced with stagnating wages and high debt, households in developed countries embarked on a multi-year deleveraging.

The single minded growth focus which worked wonderfully in 1990s-2000s became a handicap for China as export gave way to infrastructure as a growth driver. Though the leadership was wise not to repeat the huge 2009 infrastructure stimulus, yet mini investment stimulus every now and then has led to a situation where capital output ratio has worsened to 6.5 in 2015 from an average of 3 in 2007 and Debt/GDP is up nearly 70% to 260% over the same period. The overcapacity looms large in heavy industries like steel, cement, aluminum and coal where provincial governments prioritized output, employment over stability.

2017/2018 would be when China would face its real litmus test. The rise of Trumpism aka protectionism is symptomatic of problems besetting all political leaders – how to create jobs domestically and keep the restless population satisfied. Even PM Modi despite his huge win in 2014 is under tremendous pressure for not having been able to do much on creating 10mn jobs that India requires annually. In years to come, globally tariff barriers are likely to go up not down and economies like China having benefited the most in recent decades, would face the most pressure. Moreover, the investment led growth model in China is also reaching its limits. Though higher spends on metros, environmental projects would be useful, same can’t be said about much touted PPP (Public private partnership) projects in social sector where revenue streams are less clear.

The challenge for the leadership in China is to realize out of 3 factors of GDP growth, 2 factors i.e. labor, because of fall in working population and capital due to overinvestment have been nearly exhausted. Rise in productivity is the way to emerge stronger out of this challenging situation. The supply side reforms which started in 2016 are a welcome step, however supply cuts need to be more meaningful and go beyond steel and coal. Debt for equity swaps though good in mitigating interest burdens shouldn’t be a pretext for keeping zombie companies alive. Most importantly, the fixation with a GDP target has to be done with; economic cycles are healthy as they prevent accumulation of excesses.

Growth challenge aside, macro-economic or RMB stability would be keenly watched in 2017/18. The risks to this come from locals than foreigners who still view RMB as pegged to USD rather a trade weighted basket of currencies. A monthly trade surplus of USD 30-50bn gives enough ammunition to ensure RMB stability, however it is important that authorities in their overzealous zeal to defend reserves don’t create a USD shortage and an unnecessary panic in the system.

The rhetoric on protectionism would get even more intense with election of Donald trump, China has behaved in a matured way by advocating commitment to globalization at World Economic Forum, Davos. However, the same has to go beyond lip service to actual opening up of sectors and ease of doing business for foreign companies.

Despite the headwinds of trade barriers & overinvestment, there is enough good in the China story. R&D spends are up nearly 10x in last decade and China’s share of global patent filing is up from 4% in 2004 to 35% in 2014.

Share of Global Patent Filing

This paranoia on being technology leader rather than copycat will ensure that the country will be at the forefront of next industrial revolution of robotics and internet-of-things post 2020s. It is in the interim years that the Chinese leadership has to dexterously navigate the rough seas, acting with maturity and staying calm to any provocations.

By Rahul Chadha , CIO, Mirae Asset Global Investments Hong Kong

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