Can China's Economy Bounce Back?

IN MID-2017, CHINA’S GROWTH RATE once again held steady, at just below 7% in the first quarter of the year. But that rate is far below what it once was, and concerns are mounting over whether China can sustain the momentum. This spring, Moody’s Investors Service downgraded the country’s long-term credit rating—the first such move in almost 30 years—citing China’s rising debt burden and eroding financial strength. At the same time, the Asian giant is making notable strides in transforming its economy and implementing needed reforms. In this interview, DeAnne Steele, investment executive for the western United States at U.S. Trust, discusses the outlook for China, its importance to the global economy, and what it all could mean for U.S. investors.

MERRILL LYNCH: Is China headed for an economic hard landing?

DEANNE STEELE: The annual growth rate of China's gross domestic product (GDP) is certainly slowing and is expected to fall toward 6.0% over the next few years¹ — but we don't expect a hard landing. One reason is that although the growth rate is slower today than a decade ago, the GDP base is larger. So, in a rough comparison of the two periods, a GDP base of $10 trillion and an annual growth of 5% could add $500 billion to GDP; by contrast, a $3 trillion GDP base and a 10% growth rate added far less—some $300 billion—to GDP.²

Five years ago, Beijing initiated its plan to transition from an economy driven by manufacturing to an economy driven by consumption, a move that appears to be working. The services sector, which includes consumption, is now over 50% of GDP in China and it recently overtook industry as the largest share of GDP.³ (For more, see "Services Sector Gains Traction in China," below.) That’s still low compared to the U.S., where services represent almost 80% of GDP, but it marks a notable change from the past.

Another change: China's retail sales were up 10.7% year over year in April 2017.⁴ As more and more rural Chinese people move to urban centers, "ghost cities" appear to be filling up. Wages are rising, according to some estimates, and high-end manufacturing is increasing. Yes, the Chinese face challenges, but we believe they have the tools to make the transition work. Those tools include foreign currency reserves—about $3 trillion as of April 2017—that China can use to trade for its currency, the yuan, to help stem its depreciation; and an annual current account surplus in 2016 of close to $200 billion.⁵

ML: Explain the volatility that the yuan has been experiencing.

DS: At times, the Chinese government does a lackluster job of communicating its plans for the currency, which can lead to misinterpretation. For instance, in August 2015, the yuan began a 20% depreciation against the dollar, and nervous investors wondered how much more it would need to weaken before depreciation was complete. This led to capital outflows at a time when China needed domestic investment to help support its economic transition.

More recent efforts by China have helped to stabilize the yuan, which was rising against the dollar in the first few months of 2017. These include steps to slow the pace of capital outflows, which have helped stem expectations for further depreciation. In the run-up to China’s leadership transition later this year, the government will continue to prioritize economic and financial market stability, and we would expect these efforts to increase, should outflows pick up again.

ML: Does a slowdown in China mean a slowdown in the U.S.?

DS: We think the U.S. economy is strong enough to withstand China's slowing growth rate. That said, there's little question that the slowdown could affect U.S. company earnings, as well as our stock market and economy, as we saw in 2015. This is why we look beyond Chinese government data to company surveys and other sources of insight to help refine our estimates of China's growth rate, and to support our view that their economy will not face a hard landing. This is important in an environment where global growth is only 3.5% or so. However, some policy and communication missteps are likely, which can lead to volatility in the markets.

ML: What does this mean for those wanting to invest in China?

DS: We recommend focusing on investing in companies that are based in developed countries and that supply goods and services to Chinese consumers. We would consider travel, healthcare, pharmaceuticals, consumer goods, technology and health and fitness. As China transitions toward a more consumer-based economy, and as rural Chinese move into cities and gradually become wealthier, these key areas should benefit.