First in, first out: China’s fortunes are of more than passing interest


Dave Mohr | Chief Investment Strategist | Old Mutual Wealth | mail me |









Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me |

Although we all know the coronavirus that causes COVID-19 first emerged in China, there is some debate as to exactly when. As it spread through the city of Wuhan, authorities took what at the time seemed like an extraordinary decision to place the whole metropolitan area in quarantine from late January onwards.

Other cities and provinces soon followed. The rest of the world looked on in amazement and very few had any inkling that this would be their fate a month or two later.

As far as we can tell, the Chinese lockdowns worked. There are now very few new COVID-19 cases and, overall, the disease has been much less deadly there than in some other countries.

The cumulative deaths-per-million people in places like Sweden, Italy and the UK exceeds 500, while for the US it is almost 400. In China it is only 3.3 and in South Africa it is around 40.


With the virus now more or less under control, China was therefore first-in, first-out (FIFO), to use the accounting term.

It suffered the first decline in broad economic activity in 40 years in the first quarter, when gross domestic product declined by 6.8% in real terms from the same quarter in 2019. In the second quarter, it grew by 3.2% from a year ago.

The average growth rate in the five years prior to the pandemic outbreak was 7%, so the Chinese economy is not fully healed.

Chart 1: Chinese real GDP growth, year-on-year%

Source: Refinitiv Datastream

The official Chinese growth numbers are released on a year-on-year basis, not quarter-on-quarter as is the convention elsewhere, including South Africa.

On the quarter-on-quarter annualised basis that is more familiar to us, the Chinese economy collapsed 40% in the first quarter and rebounded 46% in the second. This challenges some of the traditional definitions of a recession.

One widely used definition has been ‘two consecutive negative quarters’, which this clearly hasn’t been. The other approach, followed in the US, is to identify widespread, deep, and persistent declines in economic activity. This episode was certainly deep and widespread, but it was short-lived.

In fact, it looks very much like a V-shaped recovery, though GDP is still below the pre-pandemic level. However, it was largely driven by the industrial side of the economy where government stimulus has been more effective.

Consumer spending has been much slower to respond. Retail sales were still 2% lower than a year ago in June, while industrial production was 5% higher.

Consumer spending relies both on the willingness and the ability to spend. The ability is clearly influenced by lockdowns. Even now, China allows very little foreign travel in and out, while pre-pandemic tourism was a fast-growing sector.

The willingness relates to how confident consumers feel about their own financial situation and future, but also, in this instance, how safe it is to be out and about.

One interesting snippet from Swiss-based JSE-listed luxury goods company Richemont was that sales of watches and jewellery in China increased sharply in the second quarter as a result of affluent Chinese consumers, who traditionally made these purchases while on holiday in Europe and America (and elsewhere), being forced to shop at home in the second quarter.

Chart 2: China retail sales and industrial production, year-on-year %

Source: Refinitiv Datastream

Re-balancing on hold

Prior to the pandemic, one of the big themes in Chinese economics was the ‘re-balancing’ away from export-and-investment-led growth towards consumption-led growth.

There was progress on this score, but at the end of 2019, consumption was still less than 40% of GDP while in the US it was almost 70%.

With global trade and manufacturing under pressure in 2018 and 2019, this was seen as a relative strength for the US and a weakness for China.

Now the tables are turned. Having a large service sector, particularly services that involve close human interaction (restaurants, hairdressers, cruise ships), seems to be a liability, particularly in the US where coronavirus cases are still surging higher (thankfully so far without a matching increase in the death rate).

However, there was a reason why China needed to re-balance. Dependence on external demand (i.e. exports) is all good and well until your trading partners start feeling aggrieved, as was the case with US President Trump’s trade war (which everyone has forgotten about now, but is still alive in the background).

China has, however, successfully reduced dependence on exports in recent year, while it had little success in reducing its dependence on investment to drive growth.

It may sound terrific to have an investment rate of 43% of GDP (we in South Africa are desperate to push it up to 25%), but in reality much of it is redundant and unproductive, concentrated in real estate and infrastructure and built by state-owned enterprises and other public sector entities.

In fact, it is precisely this old playbook of ramping up public infrastructure spending that Beijing seems to have dusted off to deal with this latest crisis.

Worst of all, this strategy relies on increasing debt. It is well known that debt levels have surged in China over the past decade. By some measures it has been the fastest build-up in debt anywhere, ever. Much of it has been supplied by state-owned banks to other state-owned companies with little by way of the discipline of market forces.

A sizeable portion of the debt is also denominated in US dollars, so the recent appreciation of the yuan against the dollar will be welcome.

Servicing all this debt – dollar and yuan-denominated –  is fine as long as economic growth is strong, but weaker growth obviously makes it difficult. Ultimately, the state is likely to be on the hook for much of it.

A debt crisis in China is likely to be a very different animal than in other countries since the state has such a firm grip on the banking system and the broader economy. The debt chickens will come home to roost eventually, but for now they are still clucking about happily.

In the meantime, Chinese equities have rallied as the economy recovers, supported by the government encouraging investors to climb into the market. But despite outperforming non-Chinese equities in dollar terms by around 15% this year, the MSCI China Index has lagged over the past decade.

Chart 3: Chinese and global equities, US$

Source: Refinitiv Datastream

Demographic headwinds

Other long-term internal challenges faced by China relate to demographics and the environment. The one child policy in effect from the late 1970s to 2016 means that the country’s working age population is starting to decline.

There are still many potential workers in rural areas who could move to more productive jobs in cities, but there are few examples of countries sustaining high levels of economic growth without a growing workforce.

Environmental degradation is also a consequence of a growth-at-all-costs approach. China is so well known for terrible air pollution that tracking the improvement of air quality during the lockdown was a useful way of getting a real-time gauge of economic activity.

The appearance of the coronavirus itself was also probably the result of human encroachment on nature.

The great power game

Perhaps China’s biggest challenge of all is navigating its place in the world as a rising Great Power to challenge the US. Unfortunately, history is replete with examples of conflict between emerging and dominant powers.

In the nuclear age, this doesn’t necessarily mean direct military confrontation, which could have consequences too ghastly to contemplate. There are many other ways in which this conflict can play out.

No doubt with significant prodding from the US, the UK this week banned Huawei from participating in its 5G roll out. Also, fierce competition in some areas such as technology does not preclude cooperation in others.

After all, there is substantial integration of supply chains and other economic relationships between China and America (and other Western economies), while the integration of financial markets is increasing rapidly.

And yet, one of history’s worst predictions was made in a 1910 book by British journalist Norman Angell, who argued that Britain and Germany would not go to war because the economic cost would be too great. Economic interdependence, he wrote, would be ‘the real guarantor of the good behaviour of one state to another’. Four years later, war broke out. Let’s all hope Angell’s reasoning applies a century later.

For now, China’s muscle-flexing has been largely contained to its immediate neighbourhood through its expansion of island military bases in the South China Sea and its imposition of a security law on Hong Kong that has begun to erode the city-state’s last vestiges of independence.

There were skirmishes with India over a long-standing border dispute that left several soldiers dead and made a mockery of the supposed BRICS unity.

Where does this leave South Africa?

Our economic ties with China have increased dramatically over the past two decades, mostly in the form of commodity exports and imports of manufactured goods.

While our financial system is deeply integrated with the West, our political elite tends to look East. If the world does split into two broad global systems over time – one Chinese-led and one US-led – it is not clear where we would fit in. These are longer-term questions though.

For the time being, China remains the world’s biggest importer of raw materials from South Africa and elsewhere. If it does return to re-balancing its economy towards consumption and services, this appetite for ‘hard’ commodities will fade. What will be more important for us is exporting food and encouraging Chinese tourists to visit (when it is safe to travel).

China already shapes the world economy, but is playing an increasing role in global financial markets. Its ability to add or detract to risk appetite will have a key bearing on South Africa.

As we’ve seen time and again, our financial markets rise and fall on tides of global risk appetite and capital flows.

Our equity market also has substantial direct and indirect exposure to China. Apart from Richemont and the mining companies, Naspers is still largely a Chinese internet company, though it continues to take steps to grow beyond its stake in Tencent.

Tencent itself is fortunately exposed to the New Economy in China, while the mining companies are very much exposed to the Old Economy. The size of Naspers/Prosus, Anglo American, BHP and Richemont on the JSE means South African investors in a typical balanced fund are significantly exposed to China.

The global equity holdings in most balanced funds will also have direct and indirect exposure to China.

The JSE, commodity prices, capital flows and the rand are heavily influenced by Chinese developments. The future of China, in other words, is of more than academic interest to South African investors.



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