Cracks in the China?

Chinese GDP grew 7.5% y/y in Q2—in line with the government’s full-year target, but slower than Q1 and Q4 2012. Some called it a slump, while others deemed it evidence of a structural shift, yet a close look at the data suggests it’s neither. China’s simply maturing, and while the days of double-digit growth may be over, global stocks likely do fine.

That said, “slower growth” is something of a misnomer. Yes, if China hits the full-year target, in percentage terms, growth will be slower than 2012’s 7.8%. But in dollar terms, it will accelerate—a $339 billion increase, compared with 2012’s $327 billion rise. Should China match the target for the next few years, the dollar-based gains get bigger and bigger (Exhibit 1)—and higher than the dollar gains seen when the growth rate exceeded 10%. The slower growth rate isn’t a sign of weakness. It just means China’s growing off a much bigger base. In fact, China could miss the target and still add significant value to the global economy and be a key source of revenue for developed-world companies—what ultimately matters for stocks.

Exhibit 1: China Growth Rate Vs. Value Added

Source: World Bank, National Bureau of Statistics of China, as of 7/15/2013. 2013 – 2016 calculations based on government’s official growth targets.

China’s state-run media—the Communist Party’s mouthpiece—spun the news a bit differently. They used the slower growth rate to underscore their ongoing call for economic reforms, calling them necessary now that the government is not boosting growth through state-led investment as it “breaks away from the old growth model.” Many US outlets seized the story, suggesting the state’s new hands-off approach fueled the slowdown. But data tell another story. Investment by state-owned/controlled businesses has accelerated year-to-date and is on track for a record year (Exhibit 2). And it’s going to the usual places—fixed investment in manufacturing and transportation infrastructure is on record pace.

Exhibit 2: Fixed Investment by State-Owned or Controlled Firms (Accumulated Since January)

Source: National Bureau of Statistics of China, as of 7/15/2013.

Engineering a shift from a manufacturing- and infrastructure-based economy to services and domestic consumption may be the government’s long-term goal, but evidence suggests the shift largely hasn’t started. The state is still supporting growth, just as it has since China started opening 30-plus years ago. Premier Li Keqiang has said this will change looking forward, but policymakers frequently say one thing and do another.

When the shift toward services and consumption does start, it likely takes years, if not decades. Even in a command economy, you can’t change the economic model overnight. Chinese officials don’t want to significantly shrink the manufacturing sector. They just want to improve productivity so workers can migrate to higher-paying service jobs without diminishing total manufacturing output—much as the US has done over time. If China makes manufacturing productivity gains too quickly, they risk displacing millions of industrial workers, which could drive civil unrest—something the government’s keen to avoid.

Plus, to achieve sustainable long-term growth, officials will have to liberalize the financial system so capital can flow more efficiently, particularly to private small- and mid-sized firms. Absent reform, money will keep going to the same bloated state-run firms and municipal governments, whose ROI is dwindling. The government understands this, hence the repeated calls for and recent attempts at economic reform. But officials also know a freer economy is harder to control—and China’s technocratic leadership likes pulling levers to manipulate growth. So they tweak the rules, moving incrementally toward a more market-oriented system while maintaining control as best they can.

And they’re still learning how to do this—their reforms haven’t been perfect and probably won’t be moving forward. For example, when they tested legalizing private financing in one region last year, they forgot to define it. No one knew the difference between legitimate and “illegal fundraising”—a crime punishable by death—other than that business owners who raised money through seemingly legitimate avenues, and whose businesses then went bust, received death sentences. Unsurprisingly, most business owners and entrepreneurs remain scared of raising money from private financiers, and China’s private sector remains credit starved.

So China has lots to do and a long road ahead. Anyone expecting a complete, successful economic reengineering within a couple years will be disappointed. But China doesn’t need an overnight metamorphosis for Chinese stocks to do alright. Continued reforms, however slow, should provide a tailwind.