The New ‘Normal’ of the Chinese Economy [First published on November 2015]

The Chinese economy, now headed for its slowest growth in 25 years, continues to top headlines in more ways than one. Commodities are continuing to endure the slump; according to the Bloomberg Commodities Price Index, the performance of commodities “has plunged two-thirds its peak in 2008, to the lowest level since 1999”, strictly confirming that the commodity super-cycle that is heavily-rooted from Chinese demand has finally ran its course. China is the second largest economy, with a gross domestic product of $10 trillion, just behind the United States; it is undoubtedly categorized as an economic superpower, such that China’s slowdown negatively impacts the world economy. Ironically, although the Chinese slowdown does not bode well for markets or the world economy, it is positive news for China.

Despite being the second largest economy in the world, China is classified as a developing economy according the World Bank. Using this definition as a benchmark, the Chinese economy has achieved extraordinary growth in the last several decades, with an average annualized GDP growth rate of 9.83% since 2001, and growing as much as 14.2% in 2007. This rapid pace of growth was considered normal for a developing economy, with astrong emphasis placed on development of infrastructure and the manufacturing industry. Foreign investors hungry for high yields, and businesses aiming to maximize profit margins had their eyes glued on China for its growth potential and low production costs respectively. The world economy’s dependence on China, supplemented with its classification as a developing economy created expectations within investors that the Chinese economy will keep churning out double figure growth rates. However, China has not achieved growth of over 10% since 2010 (10.6%), and it is pertinent to think it is the last time that China will produce growth of this level for the foreseeable future.

Wall Street’s biggest names have weighed-in their opinions on the implications of the Chinese slowdown. Goldman Sachs Chief Executive Officer Lloyd C. Blankfein, says “the economic model that drove China’s growth… won’t necessarily support it in the next couple of decades.” Newly elected Chief Executive Officer of Credit Suisse Tidjane Thiam offered his insights into the Chinese economic slowdown on markets when he spoke on Bloomberg <GO>. “I actually welcome the slowdown” he says. “China was not going to grow at 10% forever, the market told itself a narrative that is simply not true.” The markets, influenced by investors’ over-expectations of the Chinese economy, have pushed fundamental market prices such as commodities too high, and is therefore experiencing the current slump. Furthermore, Mr. Thiam states, “China has experienced quantitative growth, and now they are going to have qualitative growth. Growing between 4-6% is healthy because it resets expectations at a reasonable level.” The percentage growth expression can be misleading because China’s economy today is much greater than in the last decade, so in absolute terms, growth is actually larger today compared to before.

Rapid economic growth has brought prosperity to the Chinese (not to mention foreign investors), but has also brought about new challenges. Firstly, environmental sustainability is a long-term problem that needs to be addressed; according to China’s National Bureau of statistics, “about 90 percent of the 161 cities whose air quality was monitored failed to meet official standards.” Secondly, economic inequality is large and increasingin China even after decades of growth, with the Gini Coefficient estimated at 46.9 according to the CIA. Finally, external debt is at more than 200% of gross domestic product, and leverage is still growing despite efforts to deleverage, which could potentially wipe out the economy if private sector companies default. If the rate of growth, strategy for growth, and type of growth remain unchanged, the Chinese economy would be aggravated with these symptoms in the long-run.

Finance Minister Lo Ji Wei said in an official statement on the People’s Bank of China website, that 7% is the new ‘normal’. The World Banks’ overview of China states “its annual growth target of 7 percent signals the intention to focus on quality of life, rather than pace of growth.” The modern Chinese economy is experiencing structural changes to its development model and industries. According to Bloomberg, consumption exceeds investment in terms of contribution to economic growth at around 60%. Government funds are being allocated to projects that improve standard of living such as energy conservation, high-speed transportation in rural areas, and environmental protection. Moreover, China is showing signs of switching from a secondary(manufacturing) economy to a tertiary (service) economy that is driven by the growth in e-commerce and technology firms. The quality of human capital is increasing with better education. Better-educated individuals refrain from jobs in manufacturing, and instead create their own start-ups or join large corporations in the service industry.

In thereafter, to illustrate this phenomenon with an example, imagine that economies are similar to cars poweredby engines. Maxing out the engine would make the car go faster, but the engine would most likely last for a short period of time. Keeping a moderate pace would sustain the engine’s functionality and quality. Overall, China is easing-off the accelerator pedal as embraces the structural changes to sustain its engine for the future.