China Growth Scare More Nuanced Than You Think

4 February 2016 | by Arif Karim, CFA

China has been in the headlines a lot lately, especially as it relates to their economy slowing, spurring global markets to panic about its impact on global growth. Over the past decade it quietly and then suddenly exploded onto the global scene as the second largest economy in the world and a major driver of global growth. So, what happens in China is significant across economic, political, financial and cultural spheres.

The often simplified narrative used by most to report on China and the Chinese economy tends to miss the glaring nuances that it has embedded in it. The market has taken hold of the current meme that Chinese growth is collapsing and will drag the rest of the world down with it. This could very well be true… or not. It’s just not that simple to figure out and forecasting macroeconomic events with any precision is generally impossible, especially for a country the size and complexity of China.

China is undergoing a massive shift from a manufacturing, export oriented economy, which has driven its growth for four decades, towards a more sustainable one that relies much more on internally-generated services driven growth. When you’ve grown to become the second largest economy in the world (from 12th in 1990), among a customer base of slow growing developed markets, it’s probably time to change the model.

This transition is not likely to be smooth but it’s also unlikely to be disastrous (disastrous events are some of the hardest to predict, since by definition they are low probability occurances). There are pitfalls along the way, the existence of which have been the product of the top-down Government-driven capital allocation approach. But the free-market approach also produces its own speculative pitfalls too (e.g. financial crisis). Worries of a banking crisis and large drop in the Renminbi are the result of this uncertainty. These pitfalls are generally the cost of long term productivity and investment, albeit writ large when it comes to the scale of a country. Bill Janeway of Warburg Pincus provides a great framework for thinking about this with his concept of productive bubbles.

It is, therefore, important to remember that the nuances that characterize a unique entity such as China are important when thinking about its long-term development and impact to the rest of the world. I found former Morgan Stanley Chief Economist and Asia chief Stephen Roach’s interview resonated particularly well when he spoke of the importance of context in an interview on Barry Ritholtz’s Masters in Business podcast. When addressing the issue of slowing growth in China, he makes the point that our context in the West shapes our view of how the world looks and will behave.

One example of context he mentioned was on the topic of the ghost cities in China.

The Chinese government has sanctioned the building of entire cities in remote parts of China for the last few years and then provided incentives for residents from other places to populate them. As a result, many have reported on walking through fully built up cities that are almost completely empty, truly an eerie post-apocalyptic sight from a Western context. This looks like a rampant misallocation of capital akin to funding “bridges to nowhere” and seen as the evidence for a government desperately trying to keep economic growth afloat by creating jobs and demand for state funded commodity driven industries.

However, Roach makes the point that when you think about the scale of urbanization with 15-20 million people migrating from the country side to the cities every year, you can’t use the organic, slow development model of cities we’ve seen in Europe and the United states. In the West, as people arrive, they bid up prices which then provides market incentives to build housing, retail, schools, infrastructure, etc. over a number of years. The scale of flows relative to the size of existing cities are manageable in order to build after the aspiring urbanites have arrived.

When you are talking about migration patterns on a scale that are orders of magnitude larger than we see anywhere else in the world, the result on existing cities can quickly become a recipe for all of the ills that 19th century cities were known for. Don’t forget it’s the rapid urbanization over this past generation (a doubling of its urban population since 1991 to 54% in 2014, i.e. within a single generation!) that has enabled China to achieve the massive growth it has seen over the past four decades. It is estimated there are about 300MM more people that will urbanize over the next 10-15 years. In our Western contextual view, these dynamics may not be the ones we’re used to seeing when it comes to driving decision-making or even the standard economic model. China will have on the order of 220 cities with populations over one million compared to 35 in Europe (there are about 10 in the US today).

The world is much more complex than simple narratives often give it credit for, and the topic of China’s economic growth is a great example of that. Though predicting what will happen is just as difficult with a more nuanced view of world events as it is reading only the headlines, it definitely serves to improve understanding. This deeper understanding can then be used to better align an investment portfolio with the range of outcomes that can be possible as unpredictable events unfold.

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