China in 2013: A Year of Transition

China’s economy will continue to grow at a high rate, and the government will implement reforms incrementally.by Minggao ShenChina is entering a pivotal decade that could bring the country lasting prosperity. The 18th National Congress of the Chinese Communist Party (CCP) has concluded a full power transition for the first time in its 91-year history. This has cleared political uncertainty in the near term. But unlike their predecessors, China’s new leaders are unlikely to rule over an economy growing at double-digit rates, and they have been called on to ensure economic growth is more balanced and beneficial for all Chinese citizens. The new leadership wants to double the size of the economy and per capita household income by 2020. Analysts may have high expectations for reform or rebalancing, but the reality is that reforms will likely be incremental and focus on stability.

Growth in 2013 will likely be shaped by policies in three stages: on-going policies from 2012, initiatives introduced for 2013 at December’s Central Economic Work Conference, and the policies announced at the 3rd plenary session of the CCP Congress in 2013. Citi expects China’s GDP to grow at a rate of 7.8 percent and 7.3 percent in 2013 and 2014, respectively. A hard landing—GDP growth below 5 to 6 percent a year—can only be avoided over the next five years if the new leaders embark on substantial and timely structural reforms.

THE REBOUND IN 2012 SHOULD CONTINUE

The macro economy has shown an upward trend in the fourth quarter of 2012 and that growth will probably continue in the first half of 2013. Relatively accommodative monetary policy by the People’s Bank of China and accelerated infrastructure investment have contributed to the growth rebound. This has been confirmed by various measures of China’s manufacturing activity that are now showing expansion after months of contraction, including Citi’s China leading indicator reading, which is a combination of variables such as steel production and power consumption. The rebound in China’s GDP growth is largely driven by cyclical factors. In our view, the economic growth rebound will likely be mild and temporary unless there is more policy support from the Chinese government. Retail sales have accelerated, but given its relatively small share of consumption in GDP, retail sales alone cannot sustain this level of GDP growth.

The cyclical rebound was led by infrastructure investment and will likely be capped barring a stimulus in 2013. This trend will likely be extended to the first half of 2013 due to the low base this year. The recent rebound of infrastructure investment came with no aggressive stimulus and might have crowded out investment elsewhere. Given that policy tightening in the property sector may continue, the upside of its investment will likely be capped. Export growth will be influenced by the impacts of the “fiscal cliff” negotiations in the United States over taxes and spending. Assuming major spending cuts or tax hikes can be avoided in the United States, the export growth rate will likely be in the single digits again next year.

POLICY INITIATIVES IN 2013 WILL MATTER

The economic recovery in China will likely be determined by policy and investment initiatives under the new leadership. During the recent CCP Congress, members of the new Chinese leadership highlighted areas of future growth that include upgrading industrial technologies, information technology, urbanization, agricultural modernization, and environmental conservation. To double the size of the economy by 2020 in real terms, the new leadership will need new policy initiatives, such as a stimulus package or other measures that would help rebalance the economy towards more consumer spending. The former requires new sources of funding, while the latter involves inventing new growth engines. The latter is more probable, although the reforms will likely be incremental.

Investment will be the key instrument to sustain growth in the near term, and Citi expects investment growth to accelerate in 2013. Unless the new leadership is willing to tolerate slower growth, policy initiatives will aim to maintain investment momentum. Historically, investment growth is strongest in the third year of each Five-Year Plan (FYP). Since 1981, when China began instituting market economic reforms, China has implemented six FYPs. Fixed-asset investment growth rates have been in or near the highest level in the third year of five of the FYPs. This year is unlikely to be an exception.

New policy initiatives may offer additional support to investment growth next year. Citi expects that the reforms initiated in 2012 and earlier will likely be carried out by new leaders in 2013 and beyond to ensure policy continuity. Reforms include interest rate liberalization, more renminbi flexibility, converting the business tax into a value-added tax in the services sector, property tax reform, resource price reform, hukou reform, banking sector discipline, and financial sector reform. Out of the sectors or areas highlighted in the CCP Congress, Citi expects new policy initiatives to be introduced to promote investment in urbanization and environmental conservation.

Urban public infrastructure investment would benefit from a pro-urbanization policy, especially reform of the hukou system—China’s household registration system that assigns social benefits based on a citizen’s birthplace. (In most cases, citizens are assigned either “urban” or “rural” and “agricultural” or “non-agricultural” hukou status.) In addition to abolishing the hukou system in third- or fourth-tier cities, policymakers may consider extending social security and other entitlements to cover migrant workers. If policy reforms are implemented appropriately, urbanization could become one of China’s growth engines in the next 10 to 20 years.

Urban infrastructure investment will likely gain momentum in coming years as well. If implemented, its share of GDP would rise consistently from 3.6 percent in 2010 to around 5 percent or more. In the 11th FYP period (2006-10), total urban infrastructure investment amounted to ¥22.1 trillion ($3.6 trillion), up 21.8 percent per year, or 23.9 percent of total fixed asset investment during the same period. It is expected that ¥7 trillion ($1.1 trillion) is planned in the 12th FYP period, up 59.1 percent from the previous five years.

New leaders are also keen to promote environmental conservation to better the quality of growth, launching the concept of “beautiful China” during the CCP Congress. New policies to increase investment to alleviate pollution and reduce carbon emissions are expected to be launched, including retiring heavily polluting and energy-intensive industries or factories. The government may also provide more subsidies to research and development (R&D) projects and innovations in environmentally friendly technologies.

Policy initiatives for environmental conservation could open more investment opportunities in related areas. During the 11th FYP period, total investment related to environmental conservation was ¥3.5 trillion ($562 billion), and its share of GDP was mostly below 1.5 percent (see Figure 1). In 2009, total investment surged to ¥905 billion ($145 billion), up 89.5 percent from ¥477.6 billion ($76.7 billion) in 2005. It is expected that total investment in the 12th FYP would be more than ¥5 trillion ($803 billion), up 42.9 percent from the previous five years.

WAITING FOR A NEW DIRECTION

The direction of the Chinese economy in 2013 will depend on the reform agenda under the new leadership, which could be laid out in the 3rd plenary session of the CCP Congress in the fall of 2013. New leaders will spell out policies to sustain growth and the policy path to transfer the manufacturing-led economic model to a more consumption-led one.

New leaders have been vocal about the necessity for drastic economic reforms. Citi believes the most likely scenario is that the next generation of leaders will be focused on a pro-stability framework and incremental reforms that will be just enough to sustain growth. However, there is always a chance that reforms or rebalancing are more aggressive than expected, or vice versa.

• During the opening speech at the fall 2012 party congress, outgoing President Hu Jintao demanded political bravery and wisdom to deepen reforms in critical areas in a timely fashion.

• In his speech after the nomination as party general secretary, Xi Jinping declared that the party aims to offer people better education, stable jobs, good income, reliable social security, better quality healthcare services, comfortable living conditions, and a less polluted environment. Xi warned the party to fight against corruption, isolation, formalism, and excessive bureaucracy.

• Li Keqiang, who is expected to become China’s next premier, was quoted recently in a media report as saying that “reform is the biggest dividend,” although it’s not clear what kind of reforms he meant.

Future actions from the new leaders will likely be consistent with the rebalancing that is necessary for China’s future success. International experiences suggest that, for economies with a GDP per capita between $10,000 and $15,000, the average economic structure is 4 percent agriculture, 31 percent manufacturing, and 65 percent services (see Figure 2). Citi developed two possible scenarios for the evolution of China’s economic structure, assuming China will surpass the United States to become the world’s largest economy by 2025, and global manufacturing value-added as a percentage of GDP remains stable before 2025.

The first scenario uses the average economic structure of 14 selected economies, such as the United States, Germany, and Brazil, when their GDP per capita was between $10,000 and $15,000 to project China’s structure in 2025. China’s GDP per capita would grow to $15,000 if the government target to double 2010 GDP in a decade materializes. China’s manufacturing sector would make up 26 percent of the world’s output by 2025. This share is slightly lower than the historical peak of 28 to 30 percent achieved by the United States, and implies average growth in manufacturing output of only 6.3 percent per year in nominal terms between 2012 and 2025.

The second scenario uses Germany’s economic structure when its GDP per capita was between $10,000 and $15,000, and manufacturing made up 39 percent of the country’s GDP. Following the same assumption for China, China’s manufacturing sector could make up 33 percent of the world’s output by 2025, implying a growth of 8.1 percent per year in nominal terms between 2012 and 2025 (see Figure 3).

WHAT CHINA HAS TO DO TO ACHIEVE ITS GOALS

The exercise above shows that the government will have to rebalance the economy between manufacturing and consumption and services before 2020. Such an achievement would be subject to the following conditions:

• China would have to improve the efficiency of resource allocation. Significant reforms should include restraining expansion of state-owned enterprises and local governments.

• China would need to invent new growth through urbanization or other channels, but this would require critical reforms, such as land reform.

• Facilitating job creation would be necessary to absorb layoffs from the manufacturing sector going forward, and would require deregulation of the services sector.

Reforms would help restore market confidence in the Chinese economy but may result in a further economic downturn. During an economic slowdown in which GDP growth is lower than 8 percent, sectors benefiting from cheap input prices, such as labor and natural resources, could face more pressure. The risks of bankruptcy could also rise if reforms are implemented. Cost normalization—an increase in prices of capital that have been suppressed by government policy—will likely be a painful process. Meanwhile, households, the private sector, and consumers should be winners from a structural rebalancing. Reform should lay a solid foundation for a slower but better quality growth in years to come. Manufacturing consolidation, efficiency, and a more balanced economy are likely three key themes of China’s economy in 2013 if the economic reform transition officially takes place.

[author] Minggao Shen ([email protected]) is managing director and head of China research at Citigroup Inc. [/author]