Thursday, April 16, 2015

Why China had to shift to slower lane?

Planned or no other go?


China is reporting lower GDP growth rates and is vacating the top spot it held for many years. Is there something wrong or is it a common phenomenon? Let us try to understand. China expanded its economy in the last two decades focusing on exports and investments. But the same focus is not bringing further growth so it is turning focus on consumer driven economy. Though China is driven towards it, it is partially intentional.

Digesting mountains of debt is a priority


China's debt (% of GDP) and real estate prices. (Source: MarketWatch)
China's total debt is close to 3x of its GDP. While debt fueled investments contributed to GDP growth, they also took up asset prices. Now property prices in Shanghai are comparable to that of New York. Since half of China’s debt is related to real estate, it needs to ensure its real estate market does not collapse. Further debt/investments in property market will increase the risks beyond manageable levels. Priority for China is to bail out their financial system. So China had to let the wages
rise to improve the affordability in its domestic market to increase consumption and to service debt. When wages rise and currency does not depreciate exports will fall. So China reported lower export numbers for last month. Newspapers and journals said it is a surprise. But the Chinese were not surprised as they knew their next leg of growth does not come from exports. Its imports are also reduced with intentional efforts. China’s defense spending has increased but imports are reduced. Increased wages, Govt. spending in local market, stable currency bringing capital gains from financing activities would help China digest its mountains of debt. Moreover slower growth is unavoidable as the economy base increases.

Strong contender with a grand plan


When economies expand, wages in that country rise. To retain competitiveness, the exporting country will weaken their currency artificially to keep the prices same. China too pegged the currency with Dollar and used the dollars earned from surplus trade as reserves and expanded their monetary base. This had worked well and helped China rise in the economic ranks. Now it seems China has higher ambitions. To be number one, you need to avoid dependency on the exports to the country you want to beat. So China seems to be making required changes. Look at the chart, its currency has not depreciated much in the last three years while wages are consistently going up.

China's increasing wages (Source:tradingeconomics.com) but currency weakening stopped (Source: investing.com)

China's holding in US debt are not growing (Source: MarketWatch)
It has also reduced its money flow into US treasury bills. Now Japan is the largest holder of US debt and not China. China instead chose gold and Euro in the recent past. This change in trend is likely to continue. But it is not just decoupling from dollar. China seems to have higher ambitions of elevating their currency to the status of the dollar. So China is asking its partners to trade in their own currencies. Last year China entered into a multi-billion dollar gas supply agreement with Russia which does not involve dollar. Looking beyond trade, it is promoting a bank for Asia. You do not want a weaker currency when you want to lend your capital. All this reveals China is a strong contender to be a big brother with a consumption led economy and a stable currency.

Next time, when we hear of slower growth in China, we need to remember it is not entierly bad for them. They are working towards changing their image of ‘low cost manufacturing country’ and they have a grand plan.