The cause of China’s struggles
One look at Figure 1 and it becomes apparent just how elevated China’s national savings rate is versus the rest of the world. Their gross national savings are close to double that of most other major economies. Simply put, China’s fundamental problem is that it is saving too much. One should ask why are excessive national savings a problem?
Figure 1 – China saves too much
If you think back to your economics courses at university, you may recall encountering the following identity:
National Savings (S) = Investment (I) + Current Account Balance (CA)
Firstly, in economics, savings is the difference between what a country produces and consumes, and not one’s savings in a bank account. With this in mind, the equation above simply says that any savings that a country generates, must either be used for investment or exported abroad.
Over the past 20 years, China’s share of global manufacturing value added has climbed from less than 10% to around 30%. As a share of global GDP, their trade surplus in goods stands near record-high levels – see Figure 2. The net result of China producing so much more than they consume has allowed them to maintain both a high level of investment, and a decent current account surplus.
Figure 2 – Over the past 20 years China’s share of global manufacturing has tripled
Now though, China’s trading partners are beginning to take note of the negative effect this is having on their own local manufacturing industries. One by one they are faltering due to the rise of Chinese low-cost competition. As a result, China is now facing increasing international resistance to their export led model which has served them well for so long.
The limit to export-led growth
Unhappy with the influx of Chinese made products imported into their countries, developed market (“DM”) governments are now fighting back. For example, Trump has pledged to raise tariffs against Chinese goods from an average of 10% to 60% should he be re-elected. While both the US and Canada have already placed a 100% tariff on Chinese EVs. Meanwhile, the EU is raising tariffs on Chinese EVs by as much as 45%.
In response, China has been forced to diversify their trading partners and they now increasingly export to emerging market (“EM”) economies. To a large extent, they have succeeded in doing so, now exporting more to EMs than they do to DMs. However, this solution is far from ideal for a few reasons.
Firstly, developed economies account for 58% of global GDP in US dollar terms, while emerging economies excluding China account for just 25%.
Second, even EM governments are beginning to push back against China. Indonesia has increased tariffs on Chinese textiles and other goods. Chile and Mexico have levied anti-dumping tariffs against Chinese steel. And just a few days ago, less than a month after President Xi visited the country, Brazil imposed tariffs on Chinese iron, steel, and fibre optic products. Even locally, we have seen the South African Revenue Service (“SARS”) move to protect the local textile industry by charging VAT on previously exempt imports of R500 or less from Chinese companies like Temu and Shein.
In the first three quarters of 2024, China’s real GDP grew at 4.8%, 1.1 percentage points of which was contributed by net exports. In other words, exports represent a significant component of China’s GDP growth. Given the deteriorating export environment, it is likely that the contribution from exports to Chinese GDP growth will steadily decline over the coming years.
The loss of a major growth driver
As the identity above suggests, one way to spend a high savings rate is through investments. China has typically opted for this through a variety of infrastructure projects, which up until now has been largely beneficial for their nation’s growth.
A large part of China’s investment spend has been in the housing market. In fact, the IMF has published that residential housing accounts for at least 20% of the total economic activity in China. Now though, most real estate developers are facing acute funding shortfalls, which has led to building-floor-space-started dropping by 60% since March 2021 – see Figure 3.
Figure 3 – Chinese housing starts are down by two thirds
In response, the government is beginning to use the proceeds from bond sales to buy unsold homes. The problem is, China does not need more housing. It is estimated that China already has 16 million excess homes. With the working-age population forecast to shrink by 70% over the next 100 years organic, demand for housing is unlikely to rise – see Figure 4.
Figure 4 – Projected decline in China’s working-age population
What else can China spend its savings on?
China can and has historically spent on non-residential assets such as infrastructure, increasing the countries production capacity. However, China does not need more industrial capacity as they face falling export demand due to foreign governments tariffs, and they already have sufficient existing infrastructure to meet their domestic demand.
As a result, any further investment in infrastructure will lead to a deteriorating return on capital. In practice, dogmatic investment in industrial capacity will lead to increases in supply that cannot be met by demand, leading to prices falling and an increasing number of industrial enterprises becoming loss making as seen in Figure 5.
Figure 5 – The number of loss-making firms is rising
The only way out
Ultimately, the continued focus of funnelling savings into investments or exports will not work. The only viable way for China to reignite growth is by bringing down their very high savings rate.
This could be achieved in one of two ways. They could opt to do nothing and allow their savings rate to decline on its own, a natural result of the declining global demand for their goods. Of course, this would have the undesirable outcome of lowering income and negating their stated goal of sustained economic growth.
The second and more attractive option would be to provide stimulus cheques directly to consumers, funded with government savings. This fiscal stimulus would boost local consumption and support GDP growth while also reducing national savings. To date, the government has yet to announce sizable spending measures. The impulse from total government spending has been close to zero this year, against a budgeted target of 2.2% of GDP – see Figure 6.
Figure 6 – Government spending is well below target
While it is imperative that the Chinese central government steps up and provides stimulus to households, we know the Chinese Communist Party philosophically objects to large-scale income transfers. They view such policies as something that only the spendthrift West engages in. Instead, the government has pledged to bolster support for lower-income households, students, and young parents, but the numbers discussed have been underwhelming.
Until the ruling party changes their philosophy on large scale stimulus, China will remain on a deflationary path, much like that of the other high savings nation we have seen in the past – Japan. Importantly for equity investors, unlike Japan of the 1990s, the Chinese equity market is not in a bubble as the CSI 300 currently trades on a PE of just 13.2x compared to the Nikkei at roughly 60x in 1990.
Investment takeaway
Since the initial People’s Bank of China (“PBOC”) press conference on the 20th of September, Chinese stocks have risen 18%, and yet they remain reasonably cheap.
The PBOC’s recently introduced swap facility should further boost demand for equities, allowing them to stage another rally over the next few months. However, simply boosting demand for equities is not enough, as the long-term earnings outlook for Chinese companies must rise for their share prices to continue their upwards move over the long term. Once it becomes clear that little has changed for earnings, share prices will likely fall.
If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.
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Source: Bloomberg, 31 October 2024