Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
This article first appeared in the Telegraph
‘Crossing the river by feeling the stones’ has been used many times over the years to describe China’s test and learn approach to economic reform. The introduction of limited agricultural freedoms, creation of special economic zones and cautious partial privatisations of state-owned enterprises have all been examples of China’s slow and steady approach to change.
A new wave of regulations across a range of sectors in the past year or so has caught investors on the hop, prompting some to question whether the risks of unexpected policy changes in China now undermine the structural growth story that has long been a key part of the case for investing in the world’s second biggest economy. In fact, it is arguably just another example of the experimental approach to creating a socialist market economy ‘with Chinese characteristics’.
Concern about the China investment story has been exacerbated recently by the unfolding Evergrande saga, the ripples from which look to be spreading further into the country’s massive and systemically important property sector. In fact, the Evergrande story is just a part of China’s push to address the acute issue of the country’s growing inequality. So, what is China trying to achieve? And what might the implications be of building this new Chinese economic model?
Thirty years ago, China was still relatively egalitarian. The Gini co-efficient calculated by the World Bank to measure the relative income inequality of different countries put it on a par with Sweden in 1987. Today China looks more like the US in this regard and is less equal than all the main European countries including the UK and even Russia. The disposable income of the richest fifth of Chinese is ten times that of the poorest.
The Chinese government has tolerated a widening gap between rich and poor as a price worth paying for economic growth. But more recently, and most clearly in a speech made by President Xi in August, it has changed its tune. Beijing has identified ‘three mountains’ - property, education and healthcare - that it sees as key to shifting the Chinese economy towards ‘common prosperity’.
There is nothing new in this ambition. If anything, it is just a return to the status quo ante before Deng’s reforms in the 1970s kick-started the miraculous rise of China over the past forty or so years. And just as China has been prepared to compromise the purity of its principles for more than four decades in the pursuit of wealth, it is likely to play a similar long game as it returns to its revolutionary roots. The target date for achieving common prosperity is 2050.
The reason the Chinese authorities have targeted property, education and healthcare is not hard to discern. The three account for the lion’s share of spending by ordinary Chinese families. Property alone can swallow 70% of household disposable incomes, more than three times the average in developed countries. Add in the other two drains on the family budget and the figure rises to as much as 90%. It doesn’t leave much over for consumption in other areas. That’s a problem for a government trying to shift the Chinese economy from exports and investment to consumption and services.
Of the three, property is by far the most challenging mountain to climb because it has been so fundamental to the growth of the Chinese economy and accounts, directly and indirectly, for as much as a quarter of economic activity. For many Chinese, property speculation has come to seem like a one-way bet. Real estate employs as much as 20% of the urban workforce. Land sales account for a third of local government revenue. Property is not a sustainable source of growth for China.
Beijing’s goal is to reform the property sector, in part by shifting from transactional taxes to an annual levy, in order to create more sustainable government funding and reduced credit risks. Taming the property tiger in this way, reducing its returns and incentivising investment in more productive and less speculative economic activity, might give manufacturing, consumption and services a look in.
You only need to look at the numbers to realise that reform of China’s property sector is long overdue. The country has one of the highest vacancy rates in the world, at 20%. Nine in ten urban households already own their own home. Most new home sales are to people that already own another property. Well-known stories of ghost cities and the demolition of homes that have never been occupied confirm that the sector is no longer performing a socially useful function.
The key question for investors in China is whether the country’s dependence on property can be unwound in a measured way. If the real estate sector is permanently reduced the bigger hit may not be felt by the financial system (China’s pockets are deep enough to ensure this is no Lehman moment) but in reduced economic output.
And that has implications for us all. Research from Bank of America suggests that as much as a quarter of the revenues of US companies are derived from sales to China. Nearly a third of global GDP growth has come from China over the past 20 years, half as much again as came from the US.
So, the onus is on the authorities in China to manage the rebalancing of their economy with care. If policies are well designed and implemented, China will transition into a new phase of more sustainable growth and investors will look back on the past year as just a tricky adolescent phase in the country’s development. A more equal, innovative economy could be an engine of global growth for years to come. But the stones are slippery, and the current fast, out here in the middle of the river.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.
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