Chinas New Growth Model

Arthur Kroeber

February 2013

China is still growin but differently ng

1. 2. GDP growth will average 7% in 201 12-20, down from 11% in 2002-11 Structural reforms are necessary fo that level of growth; new leaders will or deliver enough despite political opposition and debt constraints The Th growth driver is already shifting f hd i i l d hif i from investment to consumption i i Demand f i D d for investment in i f t ucture, h i and new plant i still t t i infrastru t housing d l t is till strong and will be a key swing facto or Financial liberalization is moving fa aster than many realize, but capital account opening is constrained by financial repression elsewhere

3. 3 4. 4

5.

1. Trend growth is slo owing, but still solid

At 20% of US per capita GDP (at PPP), China still can still P
enjoy another decade of fast c catch-up growth on the model of Japan, Korea and Taiwan d l fJ K dT i P t ti l growth is now arou d 7-8%, d Potential th i und 7 8% down from 11% in f i the past decade, and volatility will rise p y Yet thanks to the high base e g effect, Chinas global impact g p will continue to grow rapidly

Catch-up growth still has a long way to run a

but the potential GDP growth rate is now lower

yet slower growth does not mean China gets less important

The low volatility of 2001-07 will not return 0

2. Policy shifts from cyclical ma anagement to structural reform Governments ability to smoot cycles by pumping up credit th
and investment is constrained b hi h investment and d b di i i d by high i d debt ratios Achieving potential growth requires reforms to improve capital allocation:
o Financial liberalization o Competition o Fiscal o Factor prices ( g er (highe return on investment) ) (curtai SOEs and local protectionism) il (impro local govt incentives) ove (energ water, land) gy,

New leaders will pursue reform but cautiously and m, m incrementally

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The downturn in China was nearly as severe as in 2008

yet the policy response was much weaker o

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Politics does not explain why China was slow to stimulate y

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The real constraint: Debt levels are now higher b

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Another constraint: Tight job market means more inflationary pressure e

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New leaders: cau utious reformers

Chinas ne guard ew
The Politburo Standing Committe of the 18th Central Committee ee Protocol rank 1 2 3 4 5 6 7 Name Xi Jinping p g Li Keqiang Zhang D ji Zh Dejiang Yu Zhengsheng Liu Yunshan Wang Qishan Zhang Gaoli Birth year 1953 1955 1946 1945 1947 1948 1946 New jo ob* President Premie er NPC C i Chairman Ch CPPCC Chairman C Vice President Discip pline chief Execut Vice Premier tive Old job Vice President Executive Vice Premier Chongqing Ch i Shanghai chief Propaganda chief Vice Premier Tianjin chief

* Not yet official as government positions will be ann nounced in March 2013. 2013
Xinhua, GK Dragonomics research

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3. Rebalancing to more cons sumption has already begun

After rising steadily from 199 onward, investment/GDP 98

ratio fell slightly in 2011 and 2 2012 By the end of the decade rea investment spending al growth could b as l as 3 5 with consumption th ld be low 3-5 5%, 5% ith ti g growing nearly double that g y Growth in high-value consump g mption could be extremely y strong due to the acceleration phenomenon n

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Diminishing returns from a high investment rate m

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Investment growth has slowed permanently a

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External imbalances are much less severe

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How low could inve estment growth go?

Average real Average real e n growth in growth in final ption investment consump Average real GDP growth Investment ratio at end of period

Period

1996-2000 2001-2005 2006-2010 2011-2015e 2016-2020e

8.8% 14.6% 16.4% 6.5% 3.2%

8.9% % 8.6% % 11.1% % 10.4% % 9.8% %

8.6% 9.8% 11.2% 7.8% 6.7%

34% 40% 46% 44% 39%

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Acceleration means fast growth in high-value consumption w

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Income inequality means a fat tail of affluent consumers

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4. Investment deman is not going away nd

Chinas capital stock per cap is still a bit low; further pita
large-scale investments in inf frastructure , housing and industrial l t i d t i l plant are justifiable j tifi bl C t Contrary t popular belief Chi capital allocation is to l b li f hinas it l ll ti i already reasonably efficient y y Housing construction is about to plateau at a high level g p g

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No capital misallocation: Returns in industry rise as state role shrinks

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No capital misallocation: Low-return industries get less investment u

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A chronic housing shortage s

We estimate Chinas urban housing stock to comprise around 170-180m units of independent housing (those with their own kitchen and bathroom) by 2012. This is significantly less than the total number of urban households. The remaining under-housed population is mostly migrant workers whose living quarters do not meet the definition of independent housing. The Th government-led boost t l db t in the construction of lowcost housing since 2009 will help gradually address this shortage.

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Housing construct nears its peak tion

Policy will determine which pat China's housing supply takes th Supply of completed housing versus sou urces of demand, in units and households
14 Scenario 12 10 8 6 4 2 0 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 Baseline

million

New urban households

Replacement of existing housing t

Housing completions CEIC, GaveKal Data

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Outside the coast, housing is reasonably priced

The most u unaffordable cities
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Hous sehold dispo osable income RMB thous e, sand

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Shanghai g Suzhou Guangzhou Xiamen Hangzhou Beijing j g zhou Wenz Shenzhen

30
Nanjing j g

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Tianjin

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Sanya Taiyuan East North Northwest South Central Southwest Northeast

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10 0 250 500 750 1,000 1 000 1,250 1 250 1,500 1 500 Average 100sq house price, RMB thousand qm 1,750 1 750 2,000 2 000
CEIC, NBS

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5. Financial liberalizat is well under way tion

Interest rates started to liber ralize in 2010 through wealth

management products and sh hadow banking Private sector access to capit is rapidly improving tal O Openness t portfolio i fl ws h dramatically increased to tf li inflow has d ti ll i d RMB is being adopted as a tr rading currency But financial reforms are mainly domestic: the capital account cant be fully opened while the US/EU/Japan are d manipulating exchange and interest rates
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De facto interest rate liberalization is advancing b

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Lending: More bottom up r

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Investment: Less top down

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A switch to promoting rather than restricting portfolio capital h

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A more international currency

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Summ mary

1. China has begun a transition from the capital i l mobilization to the i l bili i n h capital efficiency efficiency phase of g growth. growth 2. A relatively smooth t a s t o requires . e at e y s oot transition equ es structural reforms to which the new o leaders are cautiously committed. 3. The 3 Th most likely outc lik l come i slower b is l but more sustainable gro owth. owth
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Contact & disclaimer Thank you! k

Please contact us or your GaveKal represe entative with any questions or comments. Email: sales@ @gavekal.com All research is available online at: research.gavekal.com

Copyright GaveKal Ltd. Redistributi prohibited without prior consent. ion This report has been prepared by GK Dragonomics mainly for distribution to market professionals and institutional investors. It should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. e, References to specific securities and issuers are not intended to be and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been ob btained from sources believed to be reliable, but not guaranteed.

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The changing environment for Chinese companies

Last decade Next decade F growth as most ma k Fast h arkets G Growth i sales volume slows h in l l l in early stages of as markets mature development More competition as Li it d competition due t Limited titi du to capacity catches up t it t h to structural undersupply demand All firms have pricing po ower Pricing power falls Plentiful supply of labor at r low prices Low and undifferentiate ed real interest rates Fast-growing markets reward those who can e enter first and expand capacit ty most quickly Restricted labor supply; high and rising wages Higher and more differentiated cost of capital Slower-growing, more crowded markets reward those who can control costs and develop durable competitive advantages
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Revenue

Costs

Winners