walled-in china's great dilemma

8/17/2019 Walled-in China's Great Dilemma

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Insight

We believe China’s debt burden, the inevitable rebalancing of the economy, unfavorable demographics,structural fault lines and the weight of history will bear down on its growth rates.

Investment Management Division

Investment Strategy Group | January 2016

Walled In:

China’s Great Dilemma


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This material represents the views of the Investment Strategy Group in

the Investment Management Division of Goldman Sachs. It is not a product

of Goldman Sachs Global Investment Research. The views and opinions

expressed herein may differ from those expressed by other groups of

Goldman Sachs.

Sharmin Mossavar-Rahmani

Chief Investment Officer

Investment Strategy GroupGoldman Sachs

Jiming Ha

Managing Director

Investment Strategy GroupGoldman Sachs

Maziar Minovi

Managing Director

Investment Strategy Group

Goldman Sachs

Matheus Dibo

Vice President

Investment Strategy Group

Goldman Sachs

Additional Contributors

from the Investment

Strategy Group:

Gregory Mariasch

Vice President

Robin Xing

Vice President

Harm Zebregs

Vice President

Amneh AlQasimi

Associate


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Insight Investment Strategy Group

Overview

Concerns about the slowdown in China’s economy and theChinese government’s tenuous and, many would say, opaquepolicy responses have been the primary driver of the last twosignificant downdrafts in global equity markets. Between August10 and August 27 of 2015, a 21.5% drop in local Chinese equities

as measured by the CSI 300 Index triggered a 5.5%

decline in US equities as measured by the S&P500 Index, an 8.1% drop in non-US developedequities as measured by the MSCI EAFE Index andan 8.4% decline in the MSCI Emerging MarketsIndex. Similarly, in the first two weeks of 2016,China jolted the financial markets with a 16.4%drop in Chinese equities, triggering an 8.0%decline in the S&P 500 Index and an 8.8% and10.7% drop in the MSCI EAFE and MSCI EMindexes, respectively. In both instances, changes tothe mechanism for setting the renminbi exchange

rate have created even further uncertainty aboutthe Chinese government’s policy objectives, sincewhat was initially billed as a “one-off” currencychange on August 11, 2015, has morphed into aseries of “one-off” depreciation measures againstthe US dollar. We believe that investors shouldbrace themselves for more of the same.

We expect China to remain a significant sourceof volatility in financial markets and commodity-driven economies over the next several years.China faces a great dilemma and has limitedattractive options. It faces the herculean challengeof rebalancing the economy toward consumptionand a more sustainable growth path whileavoiding disorderly and destabilizing adjustments.At a minimum, meeting this challenge requiressuccessful implementation of the reform agenda setout following the Third Plenum of 2013.

China is walled in. If the reforms areimplemented too quickly, the country risks a sharpslowdown. If the reforms are implemented too

slowly or not at all, China risks an unsustainableincrease in its debt-to-GDP ratio, which couldpush the country past the tipping point into

economic and, in all likelihood, political instability.

China is also walled in by its deep structuralfault lines, ranging from weak demographics andlow rankings on human capital factors such astertiary education, to low rankings on businessenvironment indicators such as the HeritageFoundation’s Index of Economic Freedom and theWorld Bank’s Ease of Doing Business Index andWorldwide Governance Indicators.

China faces these challenges against a backdrop ofslow global growth and an increasing list of countrieswhose own currencies are depreciating against the US

dollar. Its leadership must also contend with a UnitedStates that is more vigilant about protecting againstalleged Chinese cyberattacks, promoting a levelplaying field for American companies doing businessin China and pushing back against China’s militaryintentions in the South China Sea.

This Insight reviews the current state of China’seconomy and examines the extent of China’simpact on the rest of the world’s economies andfinancial markets. We show that the swings inthe financial markets—particularly in the UnitedStates—are excessive relative to the direct andindirect impact of a slowdown in China. We reviewthe progress—or lack of progress—made to date onthe reform agenda of 2013. We present our short-,intermediate- and long-term economic outlook forChina and conclude with the portfolio implicationsof our views. Our 2013 Insight report, EmergingMarkets: As the Tide Goes Out , contained arecommendation to our clients to reduce theirstrategic asset allocation to emerging market assets.

This 2016 Insight report, Walled In: China’s GreatDilemma, recommends a further reduction toemerging market assets.

2016 INSIGHT


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Walled In:


2016 INSIGHT

Contents

4 Walled In: China’s Great Dilemma

7 China’s Economy: Slowing and Slowly

Rebalancing

7 Quality of GDP Data

10 How China Matters to the Rest of the World

16 Is China Growing at 3%, 7% or SomewhereIn Between?

18 Rebalancing the Chinese Economy

21 Identifying the Tipping Point in Chinese Debt

24 Walled In: Balancing Reforms with Economic

Stability

24 A Brief Review of the Reform Agenda

26 Taking Stock of the Progress on Reforms

SOE Reform


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Financial Market Liberalization

Rural Land Reform and Hukou Reform

One-Child Policy

Environmental Regulation

Fiscal Reform

In Summary

40 The Economic Outlook: Short, Intermediateand Long Term

41 2016 Outlook

44 2016–20 Outlook

Base Case Scenario

Alternative Scenario

47 Longer-Term Prospects

Implications of a Large and Growing DebtBurden

Diminishing Export Competitiveness

The Weight of History

Persistent Structural Fault Lines

A Japan-Style Slowdown

58 Minimal Impact from New Initiatives

59 Investment Implications

62 2016 Return Expectations

62 2016–20 Return Expectations

63 Longer-Term Implications

65 Conclusion


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2016 INSIGHT

Walled In:


N without at least one attention-grabbing

article, if not several, on China. Some are quite alarming. In“The Thucydides Trap: Are the US and China Headed for War?”Graham Allison of Harvard University details how, when a “risingpower” has challenged a “ruling power,” war has resulted in 12 of16 cases over the past 500 years, and warns of a similar outcomebetween the US and China.1 In “The Coming Chinese Crackup,”David Shambaugh of the Brookings Institution argues that China

is approaching a “breaking point.”2 In “The Great Fall of China,”the Economist suggests that investors are right to be nervous giventhat a slowing China drags down emerging markets, commoditiesand countries such as Germany that have significant exportsto China.3 In “Chinese Domino Effect Still Threatens WorldMarkets,” the Wall Street Journal reports how problems in China

are reverberating across the world and affecting the outlook forglobal growth.4 In “China’s Biggest Export Could Be Deflation,”the Financial Times forewarns market participants that China isexporting deflationary pressures across the world.5

Admittedly, there has also been a smattering of positivecommentary. Not surprisingly, much of it comes from the Chinese

state-sponsored People’s Daily, China Daily and Xinhua newsagency, but the positive reporting also extends to the West.


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In “False Alarm on a Crisis in China,” longtimeChina observer Nicholas Lardy of the PetersonInstitute for International Economics contendsthat the negative narrative on China is not wellsupported by the facts, and that China is growingat an annual pace of about 7%.6 In “China’s

Woes Are Overplayed—It’s an Opportunity,” theFinancial Times advocates that a major inflectionpoint upward is coming.7 And to top off thepositive sentiments, London arranged several daysof pomp and ceremony for President Xi Jinpingin October 2015 to launch what Prime MinisterDavid Cameron has called the “golden era” ofSino-British relations.8

The latest economic news out of China—a grossdomestic product (GDP) growth report of 6.9% in2015—has helped fuel the positive sentiments. Yet

such a report raises more questions than it providesanswers for economists and investors alike.

How reliable is the underlying economic data?What is the exact size of China’s foreign exchangereserves? Will the People’s Bank of China (PBOC)devalue the renminbi gradually or will we suddenlywake up to a 15–20% devaluation that willinvariably destabilize developed and emergingfinancial markets? Are the reforms set forth by theThird Plenum of the 18th Central Committee ofthe Communist Party of China (CPC) meeting in

November 2013 proceeding apace, or are China’sdeep structural fault lines so entrenched thatprogress will be slower than anyone expected?What trade-offs is the CPC leadership preparedto make in the transition from an export-orientedand investment-driven economy to a balanced,consumer-focused economy? At what point willever-increasing debt as a percentage of GDP lead toa credit crisis?

The list of questions is a long one, and allpoint to the same dilemma: China is walled in. Ifit rebalances the economy too quickly, China mayface a hard landing. If it opens its capital accounttoo quickly, China may face significant outflowsthat would weaken the currency and destabilize the

economy. If it embraces reforms too quickly, theCPC leadership may lose control of the economy.If the central government stands behind too muchof the debt issued by local governments and state-owned enterprises (SOEs), it risks engendering abelief that all such debt is “implicitly guaranteed”by the central government.9 If it steps backtoo quickly from such guarantees, the centralgovernment risks introducing more uncertainty intothe financial system and the economy. If China fullyopens its markets to foreign competition, SOEs may

suffer. If it consolidates too many SOEs, absenceof local competition—let alone meaningful foreigncompetition—may compromise quality and reducealready limited efficiency. If China fights corruptiontoo aggressively, there is a risk that governmentofficials and SOE executives will delay decisionsand approvals for fear of making a mistake orbeing caught in a future corruption probe. Hereagain, the list is long. Moreover, as evidenced bythe measures taken to manage the equity andcurrency markets over the last several months,

the risk of policy mistakes looms large. Chinafaces these challenges against a backdrop of slowglobal growth and an increasing list of countrieswhose own currencies are depreciating against theUS dollar. Its leadership must also contend with aUnited States that is more vigilant about protectingagainst alleged Chinese cyberattacks, promoting alevel playing field for American companies doingbusiness in China and pushing back against China’smilitary intentions in the South China Sea.

This Insight will address these issuesin order to assess their impact on ourclients’ portfolios. We acknowledgethat some of the answers are largelyunknowable: Data is limited and of poorquality, and the policy objectives anddecision-making processes of the centraland local governments are somewhatopaque. Nevertheless, we believe that wecan draw some important conclusionswith respect to China’s short-,

intermediate- and long-term prospectsand any implications thereof.

“One plus one equals two. But it’s not

always the case, especially when you

are talking about … local and national

gross domestic product (GDP) data

in China.”

—Xinhua


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We begin with a review of China’s economy,highlighting how China matters to the rest of theworld’s economies and financial markets. We thenrevisit China’s structural fault lines, which werediscussed in our 2013 Insight report, EmergingMarkets: As the Tide Goes Out , to examine any

progress resulting from the reform agenda of theThird Plenum of 2013. We then present our viewof China’s short-, intermediate- and long-termeconomic outlook. Finally, we conclude with theinvestment implications for our clients’ portfolios.

China’s Economy: Slowingand Slowly Rebalancing

Investors are concerned about China’seconomy because of its direct impact on theirChinese holdings and non-Chinese holdingsthat have sales and profit exposure to China,as well as its indirect impact on the growth

of developed and emerging markets. Worries abouta slowdown in China reverberated throughout thefinancial markets in the summer of 2015 when localChinese stocks nosedived and the PBOC alteredthe renminbi exchange rate fixing mechanism.US equities, for example, dropped nearly 13%

in one week. Similarly, in the first two weeks of2016, China jolted global financial markets again,triggering an 8% drop in US equities. We addressthree critical issues affecting our clients’ portfolios:

• First, we examine the direct and indirectchannels through which China affects the globaleconomy and financial markets.

• Second, we estimate the degree to which Chinais slowing.

• Third, we gauge the extent to which China hasrebalanced away from an investment-led andexport-driven economy toward a consumption-focused economy so it can grow on a moresustainable path.

Before we proceed, we provide some context onthe quality of Chinese data.

Quality of GDP Data

Questioning the quality of China’s economic data

is not new. Since the mid-1990s, Professor HarryXiaoying Wu, currently of Tokyo’s Hitotsubashi

University, has contended that China’s officialGDP data is unreliable.10 In 2007, Premier LiKeqiang, then Communist Party Secretary ofLiaoning province, reportedly said that China’sGDP data is “man-made.”11 This led to the creationof the Li Keqiang Index, composed of electricity

consumption, rail freight volume and bank lending,indicators that Premier Li Keqiang thought were abetter gauge of economic activity. More recently,in 2014, Xinhua News Agency, the official pressagency of the Chinese government, published a“Xinhua Insight” titled “The Enigma of China’sGDP Statistics,” in which it wrote, “one plus oneequals two. But it’s not always the case, especiallywhen you are talking about … local and nationalgross domestic product (GDP) data in China.”12

The US-China Economic and Security Review

Commission (USCC), created in 2000 by the USCongress, published an extensive report in 2013on the unreliability of China’s official statistics.13 It attributed this unreliability to decentralizeddata gathering, inconsistent quality and methodsacross the country, tax evasion by the private sector(including households and private corporations),and manipulation of data by the central and localgovernments and SOEs.

The poor quality of China’s data manifests itselfin several ways; examples include how quickly

GDP data is released and the type of revisions thatfollow, the deviation between aggregated dataand the sum of the underlying components, andthe very low volatility of China’s GDP. We brieflyreview these three examples.

China is one of the first countries to report itsGDP, usually about two weeks after the end of eachquarter. This compares with developed economiesthat collect smaller volumes of data more efficientlyand take between four and six weeks. There is alsoa lack of clarity regarding the revisions. Accordingto the USCC, the “revisions are frequent, large,and not always clearly explained.”14 The NationalBureau of Statistics (NBS) of China has revisedupward the real level of 2004 GDP by a whopping16.8% due to greater output from the servicesector.15 Real GDP growth in 2007 has also beenrevised upward to 14.2% from an initial estimateof 11.9%. The revisions in China are systematicallyupward and some are very significant.

This is in sharp contrast to the GDP data

releases in the US. The Bureau of EconomicAnalysis (BEA) publishes its advance estimate


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near the end of the month following the end ofeach quarter. As more data is received, secondand third estimates are released near the end ofthe second and third months, respectively. Finally,quarterly GDP estimates that incorporate annualand comprehensive revisions are released in Julyof each year. A final version published five years

later incorporates changes in methodology tobetter reflect the evolving US economy. As shownin Exhibit 1, the third quarterly revisions in USGDP data have deviated an average of 0.9% onan absolute basis relative to the first advanceestimate, and the final estimate has deviated anaverage of 1.3% on an absolute basis. The largestabsolute deviation is 4.5%. Most importantly, thesedeviations are both positive and negative and haveaveraged less than 0.1 percentage point in terms oftheir impact on US GDP growth rates.

There is also considerable discrepancybetween aggregated data and the data underlyingthe aggregated data in China. One of the mostfrequently used examples is the difference betweenlocal GDP data from China’s 31 provinces andthe national GDP. Since 2003, the sum of theGDP levels reported by the provinces has been

on average 6.1% higher than the national data;in 2012, the sum was nearly 8% higher. ManyChina observers believe that local provinceofficials systematically exaggerate growth tosecure promotions. In fact, a National Bureau ofEconomic Research (NBER) report found thathigher city-level GDP growth has been highlycorrelated with CPC secretarial and mayoralpromotions.16 Tom Orlik, chief Asia economistfor Bloomberg and author of UnderstandingChina’s Economic Indicators, believes that this

overstatement is a remnant of the1958–61 Great Leap Forward, whenlocal officials exaggerated the harvestto meet Chairman Mao Zedong’s goalof creating an agricultural surplus tofund the industrialization of China.17 The USCC points to a popular Chineseidiom, guanchu shuzi, shuzi chuguan,which means “officials falsify economicstatistics because economic statistics

determine their achievement, implyingthat manipulating statistics is a custom

Exhibit 1: Mean Absolute Revisions to US Real GDP

Growth

Revisions to GDP growth are much smaller in the US than in China.

0.50.6

0.9

1.1

1.21.3

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

Advance toSecond

Advance toThird

Advance toFirst Annual

Advance toSecond Annual

Advance toThird Annual

Advance toLatest

BenchmarkRevision

Percentage Points

Note: Based on data between 1992 and 2013.

Source: Investment Strategy Group, BEA.

Exhibit 2: Difference Between Provincial and

National GDP Levels

The sum of local GDP levels does not match the national

reported data.

-15

-10

-5

0

5

10

1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012

Sum of Local GDP Data >National Reported GDP Data

Difference (%)

Data through 2014.

Source: Investment Strategy Group, CEIC, NBS.

Many China observers believe

that local province officials

systematically exaggerate growth

to secure promotions.


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dating back to pre-modern China’s mandarinbureaucracy.”18 Exhibit 2 shows the differencebetween the sum of the provincial GDP levels andthe reported national level. Over the entire historyof the data series, the sum of provincial data hasactually been lower than national GDP more often

than it has been higher; the Great Leap Forwardera and the post-2003 period are the exceptions.

It is likely that statistics are manipulated whenofficials are incentivized. If this is the case, thenincentives to manipulate statistics exist in today’senvironment given the stated goal of doublingChina’s GDP and GDP per capita over 10 years.This goal was first stated by then-President Hu Jintao in 2012,19 and was most recently reiteratedby both President Xi Jinping20 and Premier LiKeqiang.21 We should note that since 2011, all

enterprises have been required to report datadirectly to the NBS via an online system inorder to reduce the impact of local governmentoverstatement of growth. However, this policymeasure has not narrowed the gap between localand national data, as shown in Exhibit 2.

A third reason for questioning the quality ofChina’s data is the lower volatility of its GDPrelative to the volatility of other developed andemerging market countries’ GDP, as well asrelative to other measures of economic activity in

China. The volatility of China’s real GDP (de-trended to capture economic cycles) is 25% lessthan that of the US, 56% less than that of Japan,and half to one-third that of Asian economiessuch as South Korea and Indonesia. We can alsocompare the volatility of China’s GDP to thevolatility of China’s economic activity indicators.We examined two such measures: the EmergingAdvisors Group (EAG) China Activity Index andthe Goldman Sachs Global Investment Research(GIR) China Current Activity Indicator. The EAGChina Activity Index is a compilation of nearly 50different data series that includes expenditure andincome estimates from households, corporationsand the government sector, as well as directphysical production figures.22 Although the seriesstarts in 1992, EAG believes the data from 2000onward is more reliable. Over the last 16 years, theactivity indicator has both exceeded and laggedChina’s reported GDP, as shown in Exhibit 3. Inaggregate, underlying economic activity based on

this index is 50% more volatile than the reportedreal GDP growth rates. Such lower volatility

compared with that of other countries and relativeto various activity indicators has led most Chinaobservers to conclude that the NBS smooths thereported GDP data.

The unreliability of data also applies to otherdata series beyond GDP. For example, DerekScissors of the Heritage Foundation has concluded

that retail sales growth has consistently beenoverestimated, since retail sales have outpacedpersonal income at the same time that personalsavings have increased.23 Higher consumption hasto be funded by either higher income or lowersavings. The USCC similarly points out that retailsales may be overestimating true sales becausethey are based on output by suppliers rather thangoods actually purchased by consumers; retailsales are not adjusted for goods that are “dumpedin warehouses.”24

Finally, much of Chinese data is based onproduction—the net output of agriculture, industryand services—while most developed economiesrely more on expenditure-based data. In China, thediscrepancy between the two measures is too widefor either data series to be very reliable. The recentupward revision of coal consumption by a massive17% a year since 2000 illustrates how even a singlecommodity’s production data can be significantlyrevised with no explanation.25 To put this number

in context, the increase in 2012 equates to 70% oftotal US coal consumption annually.

Exhibit 3: Measures of Economic Activity in China

Alternative measures of economic activity exhibit more

volatility than China’s reported GDP.

6.86.15.2

0

2

4

6

8

10

12

14

16

18

2000 2002 2004 2006 2008 2010 2012 2014

Real GDP GrowthEmerging Advisors Group China Activity IndexGoldman Sachs China Current Activity Indicator

% YoY, 3-Month Moving Average

Data through Q4 2015.

Source: Investment Strategy Group, Emerging Advisors Group, Goldman Sachs Global Investment

Research, NBS.


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There is reason to believe that the quality ofdata coming out of China will improve over time.At the International Monetary Fund’s (IMF’s)annual meetings in Lima, Peru, in October 2015,China announced that it had subscribed to the

IMF’s Special Data Dissemination Standard.26 Inthe meantime, however, we remain circumspectabout the quality of its reporting.

Given the unreliability of data and limitedtransparency with respect to policy objectivesand decision-making processes, one may wellask how the Investment Strategy Group canprovide investment recommendations withsome degree of confidence. On this topic, we arereminded of our discussion with Pieter Bottelier,senior adjunct professor at Johns HopkinsUniversity’s School of Advanced InternationalStudies and a China scholar: He warned that“anyone who speaks with great certainty[about China] needs their head examined.”27 Weagree. There is a range of confidence intervalsaround all our views. For example, we havegreater confidence that China will maintainreasonable growth over the next year or so.We also have greater confidence that Chinawill not successfully rebalance its economy

toward consumption without lowering long-term growth targets. Similarly, we believe China

will not challenge US preeminence in this centuryand is unlikely to escape the “middle-incometrap” (where middle income is defined as GDP percapita between 10% and 40% of US levels basedon Geary-Khamis dollars) over the next decade.However, we have limited confidence regarding

whether actual 2015 real GDP growth was 6.5%,5.5% or even less. We have even less confidenceregarding whether the renminbi will be devaluedby 5%, 10% or 15% by the end of 2016. Suchuncertainty has been factored into our investmentrecommendations. We proceed with caution.

How China Matters to the Rest of the World

In mid-2013, our colleagues in Goldman SachsEquity Research wrote, “China has providedseveral shocks to the world: cheap labor and hence

cheap goods, cheap capital via export of excesssavings, and lastly, a massive demand shock forcommodities, particularly basic commodities.”28 How the tide has turned. Today, policymakers,economists and investors worry that China is onthe verge of providing a major deflationary shockto the rest of the world. At her September 2015press conference, Federal Reserve Chair JanetYellen referenced “heightened concerns aboutgrowth in China” as one of the reasons for notraising interest rates.29 She expressed concern about

Exhibit 4: Chinese Share of Global Demand

for Commodities

China accounts for a significant share of demand for

many commodities.

-10

0

10

20

30

40

50

60

70

N a t u r a l G a s ( D r y )

S u g a r

C r u d e O i l

W h e a t

C o r n

S o y b e a n s

C o t t o n

L e a d

Z i n c

T i n

S t e e l ( C r u d e )

C o p p e r

N i c k e l

T h e r m a l C o a l

A l u m i n u m

I r o n O r e

Total Chinese Demand

Chinese Net Imports

% of Global Production

Note: 2015 estimates except for natural gas (2014) and steel (2013).

Source: Investment Strategy Group, Bloomberg, British Petroleum, US Energy Information

Administration, Goldman Sachs Global Investment Research, US Department of Agriculture, World

Bureau of Metals Statistics.


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the spillover effects of slower growth in China toemerging markets, to Canada as an important UStrading partner, and to the US itself.

Let us examine the salient facts about China’seconomy to see how its slowdown can affect othereconomies and financial markets. We note that thisimpact cannot be measured precisely because datais not available across all countries and sectors.

Most importantly, we cannot, ex ante, know theimpact of a slowdown in China on risk aversionand market sentiment.

There is no question that China matters tothe rest of the world. The question is how muchit matters and whether the volatility in globalfinancial markets has been commensurate with thedirect and indirect economic impact of a slowdownin China. China is the second-largest economy inthe world, as measured by its GDP of $11.4 trillion.It is the most populous country in the world, with1.375 billion people. Most importantly,China accounts for 13% of globalexports and 10% of global imports. Itsdemand accounts for 50–60% of theglobal production of iron ore, nickel,thermal coal and aluminum, and asignificant share of copper, tin, zinc, steel,cotton and soybeans (see Exhibit 4).While its imports of commoditiesmake up a smaller percentage of global

production, we believe total demand ismore relevant since excess production

relative to local Chinese demand will have adampening effect on relevant commodity pricesglobally, especially when the excess productionis exported. Witness the preliminary decision bythe US Commerce Department to impose 236%duties on imports of corrosion-resistant steel fromChina, due to what the US steel industry has called“illegal and unfair practices.”30 ArcelorMittal’s

third-quarter 2015 earnings report also cited lowinternational steel prices “driven by unsustainablycheap Chinese exports.”31

China has also been an export market for manydeveloped and emerging market countries. Asshown in Exhibit 5, exports to China account for2.3% of developed markets’ GDP; in Australia,exports to China are much higher, at 5.1% of GDP.Of Australia’s total merchandise exports, over one-third are exported to China. In the US, exports toChina account for just 0.7% of GDP. Merchandise

Exhibit 5: Exports to China as a Share of GDP

The impact of a China slowdown on developed and emerging markets has been overstated.

0.51.0 1.2

1.7 1.82.1 2.3 2.3 2.4

3.4

6.1

7.3

8.3

10.3

0.6 0.7 0.81.0

2.1 2.32.7

5.1

0

2

4

6

8

10

12

I n d i a

C o l o m b i a

H u n g a r y

B r a z i l

I n d o n e s i a

R u s s i a

S o u t h A f r i c a

E M e x - C h i n a

P h i l i p p i n e s

P e r u

T h a i l a n d

C h i l e

M a l a y s i a

S o u t h K o r e a

I t a l y

U S

F r a n c e

C a n a d a

G e r m a n y

D M

J a p a n

A u s t r a l i a

Emerging Markets (EM) Developed Markets (DM)

% of GDP

Data from Q3 2014 through Q2 2015.

Note: Based on merchandise exports.

Source: Investment Strategy Group , IMF.

“Anyone who speaks with great

certainty [about China] needs their

head examined.”

—Pieter Bottelier, Senior Adjunct Professor

at Johns Hopkins University


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exports to China also account for 2.3% ofemerging markets’ GDP, reaching as high as 10.3%in South Korea. Of South Korea’s total exports,one-quarter are exported to China. We note thatexports to China as a share of GDP are even higherin countries such as Oman and Angola, but their

combined GDP is less than 0.3% of world GDP.

Hence, the share of GDP affected by a Chinaslowdown is not large in either developed oremerging market economies, at 2.3% in each case.Furthermore, these trade linkages overstate thetrue economic exposure because many exports toChina are reprocessed and exported outside China.In their report “China’s Changing Growth: TradeSpillovers to the Rest of Asia,” our colleagues in

GIR use value-added exports to China as a moreeffective measure of true economic exposure.32 For example, while exports to China account for5.1% of Australia’s GDP, about one-third of thisexposure is to final demand outside China, i.e.,China is reprocessing those Australian goods andre-exporting them to other countries. As shown inExhibit 6, value-added exposure to China is oftenless than the gross trade exposure.

In addition to direct exposure through exportsand commodity prices, global economies areexposed to a slowdown in China through theirbanking sectors’ loans to China. This exposure islimited, as shown in Exhibit 7. Exposure in thedeveloped economies ranges from a low of 0.1%of bank assets in Italy to a high of 3.0% in theUK (primarily driven by HSBC Holdings PLC andStandard Chartered PLC), with a modest 0.8%in the US. To put these numbers in context, USand German banks’ exposure to mortgages andto European sovereign debt, respectively, was

substantially higher (see Exhibit 8).

Exhibit 8: Banking Sector Exposures

US and German banks are not meaningfully exposed to China.

0

5

10

15

20

25

3035

40

45

Exposure toChina

(Q2 2015)

Exposure toMortgages

(2007)

Exposure toChina

(Q2 2015)

Exposure toPeripheral Europe*

(2011)

US Germany

Foreign Claims (% of GDP)

Source: Investment Strategy Group, Bank for International Settlements, Federal Reserve.

* Claims on Greece, Ireland, Italy, Portugal and Spain.

Exhibit 6: Exports to China

Exposure based on value-added exports is lower than gross

exports imply.

0

2

4

6

8

10

12

14

16

P o l a n d

S p a i n

T u r k e y

U n i t e d S t a t e s

M e x i c o

U n i t e d K i n g d o m

I t a l y

F r a n c e

B r a z i l

I n d i a

R u s s i a

H u n g a r y

G e r m a n y

I n d o n e s i a

J a p a n

S o u t h A f r i c a

A u s t r a l i a

C h i l e

T h a i l a n d

S o u t h K o r e a

Gross Exports to China

Value-Added Exports to China

% of GDP

Data as of 2011 (latest available).

Source: Investment Strategy Group, OECD.

Exhibit 7: Banking Sector Exposure to China

Loans to China are only a relatively small share of developed

market banks’ assets.

0.10.2

0.4 0.5

0.8 0.8

3.0

0

1

2

3

4

5

Italy Spain Germany Japan France US UK

% of Bank Assets

Data as of Q2 2015.

Note: Based on consolidated claims on China on an ultimate risk basis as a share of total assets.

Source: Investment Strategy Group, Bank for International Settlements.


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Countries are also exposed to a slowdownin China through their corporate sectors. Largemultinational companies derive sales and profitsfrom goods manufactured and sold in China andfrom services provided in China; this corporateprofit is not captured by exports. Lower profitsstemming from a slowdown in China have a second-

order effect on global economies as equity marketsmay weaken, resulting in tighter financial conditions.

Our colleagues in GIR have estimated thesales exposure of companies represented by majorequity market indexes. As shown in Exhibit 9,this exposure ranges from 2% in the US to asmuch as 10% in Germany and Australia. Wemust note, however, that it is very difficult toquantify the exposure of major markets’ corporatesectors to China with much precision. Manymajor multinational companies aggregate theirAsia-Pacific sales and do not break out Chinaseparately. Therefore, estimates of sales to China,in all likelihood, understate actual sales. Moreover,earnings, which are most relevant, are notattributed to specific regions, so we have to turn tothe national income accounts for a gauge of profitexposure to China. Such exposure is much smaller,measuring 0.7% in the US and about 3% in Japan.

We conclude that the direct and indirecteconomic and banking sector exposures to China

are not of a scale to have significant impact onmajor economies and financial markets. The

substantially greater risk from a slowdown in Chinaemanates from its impact on financial markets andinvestor risk aversion. In their report “The Dragfrom China: Many Channels, Limited Impact,”our colleagues in GIR break down the impact of aslowdown in China on the US economy by trade,exchange rate and financial conditions.33 Some of

the impact is direct, as in the case of exports toChina, and some of the impact is indirect, such asexports to other developed and emerging marketcountries that do business with China. As shown inExhibit 10, the direct impact is nearly eight times asgreat as the indirect impact. But most importantly,the impact of financial conditions may be as bigas—if not bigger than—the direct impact. Theconfidence interval around the impact of financialconditions is wide: if the impact is negligible, a1% reduction in Chinese GDP lowers US GDPby 0.11% by the end of this year; if the impact issignificant, US GDP declines by 0.47%. In such ascenario, the impact of financial conditions willdwarf the direct and indirect impact of economicand banking sector factors.

The Organisation for Economic Co-operationand Development’s (OECD’s) latest semiannual“Outlook” also concludes that the drag fromchanges in financial conditions could be greaterthan the economic impact.34 It estimates that a

two percentage point decline in domestic demandgrowth in China would slow global growth

Exhibit 9: Sales Exposure to China

US companies are less reliant on China than their developed

market peers.

2

34

5 5

6

10 10

0

2

4

6

8

10

12

US(S&P 500)

Spain(IBEX)

Italy(MIB)

Japan(TOPIX)

France(CAC)

UK(FTSE 100)

Australia(ASX 200)

Germany(DAX)

% of Index Sales

Data as of 2014.

Source: Investment Strategy Group, Goldman Sachs Global Investment Research.

Exhibit 10: Impact of a 1% Reduction in Chinese

GDP on US Real GDP at End-2016

Financial conditions will ultimately determine the drag on

the US economy.

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

Direct Impact Indirect Impact Impact on US GDP

Trade

Exchange Rate

Financial Conditions (Ex-FX)

Baseline(-0.19)

Lower End(-0.11)

Upper End(-0.47)

Effect on US GDP (%)

Data as of 2015.

Source: Investment Strategy Group, Goldman Sachs Global Investment Research.


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Goldman Sachs

by 0.33% per year for two years. However, ifsuch a decline negatively impacts the financialmarkets, global growth would slow by 0.75–1%per year for two years. The IMF also highlightedChina’s financial market impact in its October2015 “Global Financial Stability Report”: “The

main spillover channels from China to the restof the world remain economic growth and trade,but confidence channels and the direct financiallinkages have also become stronger since 2010.”35

We believe that developed financial marketswill, in all likelihood, overreact to deterioratingconditions in China. Part of the overreaction willbe driven by expectations of further deteriorationin emerging markets, especially if a continuedslowdown in China corresponds to further depre-ciation of the renminbi. However, some of theoverreaction will be driven by the inevitably greaterfocus of market participants on the latest headlines.As Nobel Laureate in Economics Daniel Kahnemanhas pointed out, the availability of informationthat readily comes to mind affects how individualsformulate their investment views.36

In the second quarter of 2015, the key themehighlighted by the Goldman Sachs “S&P 500Beige Book” report was “earnings at risk fromChinese slowdown.”37 The report highlighted

companies such as General Motors Co., FordMotor Co., Caterpillar, Inc., United Technologies

Corp., Johnson & Johnson Inc. and others inthe industrial and commodity-linked sectors.The third-quarter “S&P 500 Beige Book” reporthighlighted examples of companies with exposureto China in the information technology andconsumer discretionary sectors, such as Apple Inc.,

McDonald’s Corp. and Starbucks Corp., with veryfavorable commentary on their sales to China.Since these names readily come to mind whenwe think of China, it is likely that the US equitymarket would overreact to news of an economicslowdown in China relative to the country’s 2%(or slightly higher) share of S&P 500 sales and themeager 0.7% share of profits in the US economy.

The increase in the correlation between USand Chinese equities in recent years reinforces thisnotion. As shown in Exhibit 11, the correlationhas now reached levels last seen during the globalfinancial crisis, and its increase is greater thanwhat would be suggested by the direct and indirecteconomic impacts.

We also believe that the attribution of thebroad-based decline in commodity prices to theslowdown in China has been overstated. Somecommodities, such as the ones our colleagues inGIR call the “capex commodities”38 (commoditiesused in heavy industry to create infrastructure, such

as iron ore, steel, cement and copper), are affectedby the slowdown in China. Others, such as what

Exhibit 11: Correlation Between US and Chinese

Equities

The correlation has risen to levels last seen during the

financial crisis.

4441

-20

-10

0

10

20

30

40

50

60

Jun-01 Jun-03 Jun-05 Jun-07 Jun-09 Jun-11 Jun-13 Jun-15

6-Month Rolling Correlation

Average

Correlation (%)

Data through January 2016.

Source: Investment Strategy Group, Datastream.

Exhibit 12: Chinese Imports of Crude Oil

Imports have increased steadily over the last several years.

52.3

53.5

54.2

54.7

56.256.7

57.7

7

8

9

10

11

12

13

49

50

51

52

53

54

55

56

57

58

59

2009 2010 2011 2012 2013 2014 2015E

Chinese Imports

Chinese Share of World Imports (Right)

Million Barrels/Day % World Imports

Data through 2015.

Note: ISG estimate for 2015.

Source: Investment Strategy Group, US Department of Energy.


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they call the “opex commodities” (commoditiesused to operate the economy, such as oil andnatural gas), have not declined because of theslowdown in China.

A closer examination of the supply anddemand for crude oil best illustrates this

misattribution of the price declines. Crude oil isthe largest commodity produced and consumedin the world; it accounts for about half of globalcommodity production. And like that of most othercommodities, its price has declined significantlyover the last several years: 63% from its post-crisis peak in April 2011 and 59% since its mostrecent peak in July 2014, as measured by Brent.Yet, as shown in Exhibit 12, Chinese demand hasincreased steadily since 2011. Exhibit 13 providesadditional evidence that China is not the driver

of prices in the most important commodity in theworld. Since the second quarter of 2014, when oilprices peaked, Chinese demand has increased by8.2%, or 0.9 million barrels per day, according tothe International Energy Agency (IEA). Over thisperiod, crude oil prices have dropped by about65%. Clearly, China has not been the price setteras the marginal consumer of oil; in fact, the two-year rolling correlation between Chinese demandand crude oil prices is at -0.82 and at its lowestsince 1999.

As Michael Pettis, professor at Peking Universityin Beijing and author of The Great Rebalancing ,has so aptly stated, “China, like Japan in the 1980s,is the biggest arithmetical component of growth,but with its huge current account surplus, it createsnegative demand. The US is the engine of globalgrowth because it provides net demand.”39 MichaelPettis concurs that market participants haveoverestimated the impact of a slowdownin China on the rest of the world. Inits latest country report, the IMF alsopoints out that the near-term slowdownin China will have a “relatively minor”impact on other major economies.40

We conclude that while China’seconomic slowdown matters to the restof the world, the extent of the impacthas been overestimated by the financialmarkets. Hence, the developed financialmarkets have overreacted and willprobably continue to overreact in the

near term to any unanticipated changes inthe economy or policy measures in China.

Eventually, the market reaction may converge tothe real economic impact, but in the meantime, anyunanticipated slowdown will negatively impact thefinancial markets. Moreover, limited transparencyin the decision-making process and the rationalefor certain policy measures heightens investoruncertainty, which inevitably reveals itself in theform of higher market volatility. Of course, inthe extreme case of a hard landing (less-than-3%

growth rates), along with a sudden currencydepreciation of more than 15% (still substantiallyless than the 60% depreciation of the Brazilianreal and the Russian ruble), global economies andfinancial markets would be severely impacted.

Exhibit 13: Chinese Demand Growth vs. Oil Prices

Oil prices have fallen despite healthy demand from China.

3.4

2.1

5.0

6.1

6.5

7.8

3.9

20

40

60

80

100

120

140

0

1

2

3

4

5

6

7

8

9

2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15

Chinese Demand GrowthWTI Quarterly Average Price (Right)Brent Quarterly Average Price (Right)

% YoY US$/Barrel


Source: Investment Strategy Group, Bloomberg, IEA.

“China, like Japan in the 1980s, is

the biggest arithmetical component

of growth, but with its huge current

account surplus, it creates negative

demand. The US is the engine of

global growth because it provides

net demand.”

—Michael Pettis, Professor at Peking University


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Goldman Sachs

Is China Growing at 3%, 7% or Somewhere

In Between?

The interest in China’s GDP data has beenextensive. As our colleagues in GIR wrote in aSeptember 2015 report: “To state the obvious,China is top of mind.”41 A Google Trend searchshows that the increase in interest in a Chinaslowdown was greater than that in a Federal

Reserve interest rate hike in 2015.There is a wide divergence of estimates of

China’s current growth rate. At the higher endof the spectrum, the IMF, the World Bank andthe Institute for International Finance estimatedreal GDP growth in 2015 at 6.8%, 7.1% and6.8%, respectively. Nicholas Lardy of the PetersonInstitute also believes that the growth rate is closerto the official figure of just below 7%.42 At the lowend of the spectrum, Marc Faber, the Hong Kong-based editor and publisher of the “Gloom, Boom& Doom Report,” estimates growth of 3–4%.43 Bloomberg measures the Li Keqiang Index at2.8%. The EAG China Activity Index and the GIRCurrent Activity Indicator grew on average 5.5%and 5.6%, respectively. We believe the latter twoactivity indicators are more representative of theunderlying real growth rate in China.

China’s growth is a tale of two economies:the older investment-oriented and export-driveneconomy, which has slowed down considerably,

and the consumer-oriented economy, which isgrowing at a steadier pace, albeit more slowly

than its average pace since 2000. This divergencecan be seen across several measures. For example,as shown in Exhibit 14, the old economy asmeasured by industrial sales has dropped froma growth rate of 20–30% per year in the 2000sto a modest growth rate of about 7%, whilethe consumer-oriented economy as measuredby retail sales has slowed more modestly from

a growth rate in the high teens to about 9%.Similarly, as shown in Exhibit 15, the old economyas measured by freight turnover has droppedsharply from peak growth rates of 15–20% toan actual contraction, while passenger turnoverhas decelerated from a peak growth rate of about15% to around 7%. The divergence in the twoeconomies can also be observed in electricityconsumption—one of the indicators in the LiKeqiang Index. As shown in Exhibit 16, electricityconsumption in the secondary sector (comprisingmining, manufacturing, construction and utilities)is actually declining on an absolute basis fromdouble-digit growth rates just three years ago,whereas electricity consumption in the tertiarysector (comprising services such as hotels, realestate, financial services, transportation, storageand post, and other such services) increased by7.5% in 2015.

Data on crude oil and refined productsconsumption is most illustrative of this divergence.

As shown in Exhibit 17, consumption of gasolineand kerosene increased by 19% and 17% in 2015,

Exhibit 14: Industrial and Retail Sales in China

Growth in industrial sales has slowed sharply in recent years.

0

5

10

15

20

25

30

35

2001 2003 2005 2007 2009 2011 2013 2015

Real Industrial Sales

Real Retail Sales


Data through November 2015.

Source: Investment Strategy Group, CEIC.

Exhibit 15: Passenger and Freight Turnover in China

Freight traffic is declining while passenger traffic is still

growing at healthy rates.

-10

-5

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Freight Turnover

Passenger Turnover





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respectively, while naphtha and diesel consumptionincreased by 4%, again reflecting the highergrowth rates of Chinese consumption relative toChinese industry.

The tale of two economies can also be seenin the growing share of the tertiary sector as apercentage of GDP. The secondary sector’s sharehas been declining steadily from a recent peak of

47.4% of GDP in 2006 to a much lower 40.5%in 2015. The tertiary sector, on the other hand,has been growing steadily and has now reached ahigh of 50.4% of GDP. It is therefore reasonableto assume that as the role of services increasesand the role of industry decreases, data on theindustry-oriented components of the economywill not adequately reflect the growth in the wholeeconomy. As discussed earlier, one has to considermultiple sets of data to develop an approximatepicture of China’s economic growth rates,especially if consumption and service sector datais even less robust than more traditional industrialdata.

Clearly—and inevitably—growthrates in China are slowing down. Asearly as 2003, our colleagues in GIRforecast that China’s growth ratewould slow to mid-single digits in the2010–20 period.44 In “Asiaphoria MeetsRegression to the Mean,” Lant Pritchett

and Larry Summers, both of HarvardUniversity, warn that “abnormally

rapid growth is rarely persistent.”45 Moreover, ascountries become richer, their per capita incomegrowth rates slow, according to the conditionalconvergence growth theory.46 This can be observed

in Exhibit 18 on page 18, which shows thatmost countries in Asia that relied on an export-ledgrowth model driven by cheap currency and cheaplabor experienced rapid growth rates in the earlyyears of development, but inevitably slowed downafter a period of rapid growth. In our view, Chinawill not be an exception.

The key question is whether China cansufficiently rebalance its economy towardconsumption without risking a significant, andhence destabilizing, slowdown. To answer thisquestion, we first examine the extent to whichChina has rebalanced its economy.

Exhibit 16: Electricity Consumption by Industry

Electricity consumption is contracting in the industrial sector,

but rising in the service sector.

-10

-5

0

5

10

15

20

25

30

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15

Secondary ("Industry")Tertiary ("Services")




Exhibit 17: 2015 Growth in Chinese Demand for

Commodities

Demand for industrial commodities is weak.

-6

-3

0

3

6

9

12

15

18

21

C e m e n t

T h e r m a l C o a l

S t e e l

I r o n O r e

M e t C o a l

W h e a t *

C o t t o n *

C o p p e r

C o r n *

S u g a r *

D i e s e l

N a p h t h a

O i l ( t o t a l )

N i c k e l * *

C o f f e e *

S o y b e a n *

A l u m i n u m

Z i n c * * *

K e r o s e n e

G a s o l i n e

% YoY

Data as of 2015.

Note: Goldman Sachs Global Investment Research estimates.

Source: Investment Strategy Group, CRU, Goldman Sachs Global Investment Research, International

Energy Agency, US Department of Agriculture, Wood Mackenzie.

* Estimated 2015 annual consumption growth rate (monthly data not available).

** Calculated from apparent stainless steel demand.

*** Zinc galvanizing production.

“To state the obvious, China is top

of mind.”

—Goldman Sachs Global Investment Research


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Goldman Sachs

Rebalancing the Chinese Economy

As early as March 2007, then-Premier Wen Jiabaohighlighted the need to rebalance the Chineseeconomy away from an investment-led, export-driven economy toward a consumption-orientedeconomy when he told reporters at the National

People’s Congress that “the biggest problem inChina’s economy is that the growth is unstable,imbalanced, uncoordinated and unsustainable… these are all pressing issues that need to beaddressed as soon as possible or they will threatenChina’s economic growth … The governmentmust boost domestic demand, open markets andpromote technological innovation.”47 In 2006,the latest year for which data was probablyavailable at the time of Premier Wen Jiabao’scomments, investment was 40% of GDP and totalconsumption was 52.3%, of which14% was government consumptionand 38.3% was private consumption.We estimate that at the end of 2015,investment stood at 45.3% of GDPand private consumption at 38.2% (seeExhibit 19). In spite of Premier Wen Jiabao’s directive, the economy hasnot been rebalanced: investment hasincreased as a share of GDP, and private

consumption has decreased slightly.At 45.3% of GDP, investment is high

relative to China’s own history. It also exceedspeaks reached by other countries, including the“Asian Tigers” that pursued an investment-led andexport-driven growth strategy (see Exhibit 20).Similarly, at 38.2%, household consumption as ashare of GDP is extremely low both on an absolute

basis and relative to other major emerging marketand developed market countries (see Exhibit 21).

Looking at the most recent data, the long-termtrend may finally be reversing. Investment as ashare of GDP has declined from a peak of 47.3%in 2011, and consumption has increased from atrough of 35.9% in 2010. Furthermore, net exportshave decreased from 8.7% of GDP in 2007 toan estimated 3.3% in 2015. Of course, given thegeneral quality of the data, it may well be falseprecision to suggest a reversal in investment and

Exhibit 18: Selected Countries—Average Growth vs.

GDP per Capita

Growth in other Asian countries decelerated after a period of

rapid growth.

0

2

4

6

8

10

12

14

16

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000

GDP per Capita (in 2010 PPP US$)

Japan Taiwan

Korea SingaporeHong Kong China

10-Year Average Annual Growth Rate (%)

Data through 2015.

Source: Investment Strategy Group, Conference Board, IMF.

Exhibit 19: Breakdown of Chinese GDP

by Expenditures

China’s economy remains “imbalanced.”

45.3

13.2

38.2

0

10

20

30

40

50

60

2000 2002 2004 2006 2008 2010 2012 2014

Investment

Government ConsumptionPrivate Consumption

% of GDP

Data through 2015.

Note: ISG estimates for 2015.

Source: Investment Strategy Group, Datastream, NBS.

“The biggest problem in China’s

economy is that the growth is

unstable, imbalanced, uncoordinated

and unsustainable.”

—Premier Wen Jiabao, March 2007


21/74


consumption trends based on changes of aroundtwo percentage points.

However, we believe other data confirms anincrease in consumption. For example, consumer-oriented multinational companies have reportedstrong sales in China. In the US, Apple Inc., Nike

Inc., Starbucks Corp. and Under Armour Inc.have all highlighted their strong sales in Chinain third-quarter 2015 earnings reports. As TimCook, CEO of Apple, said during his third-quarter2015 earnings call with analysts, “frankly, if Iwere to shut off my web and shut off the TV …I wouldn’t know there was any economic issueat all in China.”48 Similarly, in Germany, DaimlerAG reported a 53% increase in its sales to Chinaafter launching the redesigned A-Class compactcar and the GLC and GLE sport-utility vehiclesin September 2015, and Adidas AG reported a48% increase in sales. In Japan, Honda Motor Co.reported a 33% increase in sales in 2015 throughOctober, and Fast Retailing Co. (owner of Uniqlo)reported an increase of 46% in revenues fromGreater China.

China’s Golden Week sales were substantiallystronger in 2015 as well. According to the Ministryof Commerce, sales at restaurants and retailerswere 11% higher than in 2014, box office revenues

were 70% higher and major home appliance saleswere 53% higher.49

The tale of the two economies may well bepointing toward steady—albeit very slow—rebalancing.

The most important question is whether theChinese economy can be rebalanced to a moresustainable mix of consumption and investment

while maintaining growth at the levels targetedby the Communist Party leadership. At the FifthPlenum of the 18th Central Committee of theCommunist Party of China meeting in October2015, President Xi Jinping set a goal of 6.5%growth for China’s 13th Five-Year Plan for 2016–20.50 He also confirmed that China needs to “solvethe problem of unbalanced, uncoordinated andunsustainable development.”51

We have simulated a number of scenariosto address the question of whether China canrebalance its economy without slower growth.There are several variables to consider. For example,what is a reasonable target for investment as ashare of GDP? Given that investment was 40%of GDP when Premier Wen Jiabao commentedon the imbalanced economy, we believe that40% is certainly a reasonable target for China—although still high by global standards, as shown inExhibit 20. Targeting a lower share of investmentis too onerous and therefore unrealistic. Similarly,

when should this target be achieved? By 2022,at the end of President Xi Jinping’s term? What

Exhibit 20: Investment as a Share of GDP

China’s investment ratio is higher than the peak reached in

other export-driven countries.

47.3

41.439.6 39.5 38.9 38.3

25.0

45.3

28.6

21.4 21.8

30.7

18.7 18.0

0

10

20

30

40

50

60

2011 2015 1991 2015 197 4 2015 1970 2015 2011 2015 1991 2015 1989 2015

China South Korea Taiwan Japan India Russia Brazil

Peak 2015% of GDP

Note: Based on data since 1960. ISG estimate for China in 2015, IMF estimates for all other countries.

Source: Investment Strategy Group, Datastream, IMF, OECD, national statistical agencies.

Exhibit 21: Private Consumption as a Share of GDP

Chinese household spending is low by international standards.

38

4952 53 54

55 5758 59 59

60 61 61 6263

68 69 69

0

10

20

30

40

50

60

70

80

% of GDP

Data as of 2015.

Note: ISG estimate for China, IMF estimates for all other countries.

Source: Investment Strategy Group, Datastream.


22/74

Goldman Sachs

total factor productivity (TFP)—a measure of howefficiently labor and capital are used as inputs togenerate output—should we assume: the averagehistorical rate achieved over the last five years,or a higher number based on anassumption of steady progress onstructural reforms? Alternatively,

we can assume that progress onreforms will be harder to achieve,thereby lowering TFP growth. Wenote that a decrease in TFP growthalso implies continued deteriorationin the incremental capital-outputratio (ICOR)—in effect, theoutput yield on every incrementalunit of capital—given its steadydeterioration since 2008, as shownin Exhibit 22.

We present two of thescenarios below since we thinkthey adequately illustrate thedifficulties China’s leadershipfaces in rebalancing the economyto more consumption-drivengrowth while maintaining highenough growth rates to meet theCommunist Party leadership’sgoal of “improving people’s lives

so that they can truly benefit from

living in a moderately prosperous society.”52 Thetwo scenarios are as follows:

Exhibit 22: China’s Incremental Capital-Output Ratio

China needs an increasing amount of investment to generate

the same rate of GDP growth.

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Deterioration

ICOR

Data through 2015.

Source: Investment Strategy Group , IMF.

Exhibit 23: Scenario 1—GDP Growth and

Investment Share of GDP

Faster TFP growth would support a more gradual decline in

GDP growth rates.

30

32

34

36

38

40

42

44

46

48

2

3

4

5

6

7

8

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Real GDP Growth

Investment (Right)

% YoY % of GDP

Forecast through 2027.

Source: Investment Strategy Group, NBS.

Services are a growing share of the Chinese economy, while the industrial sector’s share issteadily declining.


23/74


It is virtually impossible to identify

a specific debt-to-GDP level or time

period that will “tip” the Chinese

economy into a financial crisis.

• Scenario 1: Investment as a share of GDPdeclines to 40% by 2022 and real GDP growson average 6.5% between 2016 and 2020 (seeExhibit 23), given the stated goal of the 13thFive-Year Plan. Consumption grows at 8.5%and TFP growth rises from an estimated 1.6%in 2015 to 2.5% by 2022. Most importantly,

debt (as measured by total nonfinancial debt)increases from 218% of GDP to 257% by 2022.

• Scenario 2: Investment as a share of GDPdeclines to 40% by 2022, but TFP growth alsodeclines because of slow progress on reforms.Real GDP growth slows to an average of 4.8%(see Exhibit 24). Consumption is still growingat the robust level of 6.7%. Most importantly,debt reaches 285% of GDP by 2022 andexceeds 300% by 2024.

In most of the scenarios we examined, totalgross debt increases as a share of GDP, asshown in Exhibit 25. Such increases are asource of considerable risk in the future.In fact, the IMF has described the currentlevel of debt in China as excessive and asource of vulnerability that could resultin a “disorderly correction and/or aprotracted period of slower growth.”53

Identifying the Tipping Point in Chinese Debt

It is virtually impossible to identify a specificdebt-to-GDP level or time period that will “tip”the Chinese economy into a financial crisis. Theeconomy is evolving and factors that affect thetipping point are constantly changing. For example,as China rebalances its economy and implements

some reforms, it faces great uncertainties: thegrowth rate may well be slower than the stated goalof 6.5%, SOE reform might be harder to implement,and TFP growth may be much lower, all of whichwould lead to a faster rise in debt-to-GDP. We alsohave to treat the exact level of debt with a degreeof caution, given questions raised earlier about thequality of data. Finally, we note that we agree withthe prevailing view that much of the debt of SOEsand of local government financing vehicles (LGFVs)has the implicit guarantee of the central government;it is highly unlikely that the central government willlet several major SOEs default on their debt.

Exhibit 24: Scenario 2—GDP Growth and

Investment Share of GDP

Slow progress on reforms would lead to a sharper

deceleration in GDP growth.

30

32

34

36

38

40

42

44

46

48

2

3

4

5

6

7

8

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Real GDP Growth

Investment (Right)

% YoY % of GDP



Exhibit 25: Two Scenarios for China’s Debt-to-GDP

Ratio

Debt will continue to increase from already high levels in

both scenarios.

200

220

240

260

280

300

320

340

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Scenario 1

Scenario 2

% of GDP




24/74

Goldman Sachs

All that said, the rapid growth of China’sdebt load is cause for concern. Debt in Chinahas grown by double digits over the last eightyears, primarily driven by debt in the nonfinancialprivate sector, which is composed mostly of SOEs.As shown in Exhibit 26, the biggest year-on-year

increase occurred in 2009, after the governmentresponded to the global financial crisis by launching

a quasi-fiscal stimulus of RMB 4 trillion ($570billion) in November 2008. Such expendituresare generally dispersed over time, but in order toconvey the magnitude of the stimulus, we compareit to the GDP at the time of the announcement; it

was equivalent to 12.6% of China’s 2008 GDP.To provide some context relative to other suchprograms, in the US, the authorized amountof $700 billion for the Troubled Asset ReliefProgram (TARP) was 4.8% of 2008 GDP andthe $789 billion for the American Recovery andReinvestment Act (ARRA) was 5.5% of 2009 GDP.

Let us begin by comparing China’s debt-to-GDP ratio to its GDP per capita. As shown inExhibit 27, China’s debt burden is very highrelative to its low GDP per capita and is an outlierrelative to countries with similar GDP per capitalevels. Its debt-to-GDP ratio is on par with thoseof the US and Singapore, where GDP per capitais about seven times as high. Comparing themagnitude and pace of the increase in China’sdebt-to-GDP ratio to those of other countries, wesee that China’s increase is among the highest inrecent history. Every major country with a rapidincrease in debt has experienced either a financialcrisis or a prolonged slowdown in GDP growth

(see Exhibit 28). History suggests that China willface the same fate.

Exhibit 26: China’s Debt-to-GDP Ratio

China’s debt burden has risen rapidly, especially since the

2009 stimulus.

80

100

120

140

160

180

200

220

240

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

% of GDP

Data through 2015.

Source: Investment Strategy Group, Bank for International Settlements, IMF.

Exhibit 27: GDP per Capita vs. Debt-to-GDP Ratio

China’s debt is high compared with its low GDP per capita.

IND

IDN

THA

ZAF

CHN

TURMEX

MYS

BRA

RUS

HUN

POLCZE

KOR

JPN

HKG

USA

SGP

0

50

100

150

200

250

300

350

400

450

0 10,000 20,000 30,000 40,000 50,000 60,000

Debt-to-GDP Ratio (%, 2014)

GDP per Capita (US$, 2014)

Data as of 2014.


Exhibit 28: Change in Credit/GDP vs. Change in GDP

Growth Rates

Credit booms are typically followed by a financial crisis or a

prolonged slowdown in GDP growth.

GBR

BELDNK

ITA

NORSWE

SWE

FIN

GRC

IRL

PRT

ESP

ARG

BRA

URY

URY

MYS

PHL

THA

20

25

30

35

40

45

50

55

60

65

70

-10 -8 -6 -4 -2 0 2 4

GDP Growth Change (pp)

Followed by banking crisis

Credit-to-GDP Ratio Changein 5 Years (pp)

Data as of 2015.

Note: Based on data since 1960 for Argentina, Australia, Belgium, Brazil, Denmark, Finland, Greece,

Hong Kong, Indonesia, Ireland, Italy, Japan, Malaysia, Netherlands, New Zealand, Norway, Philippines,

Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan, Thailand, UK, Uruguay and Vietnam.

Source: Investment Strategy Group, IMF.


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We compare China to three of the Asiancountries that experienced financial crises, aswell as to the US and to the UK. As shown inExhibit 29, these countries, with the exception of

Thailand, had much lower increases in their debt-to-GDP ratios. Most also had lower levels of debtrelative to GDP and, again with the exception ofThailand, were far richer than China at the timeof their crises. China, however, has a very highsavings rate relative to these countries, estimated tobe 47.4% of GDP in 2015 (see Exhibit 30). In fact,China has the highest savings rate of any majorcountry in the world. The average savings ratestands at 21.5% of GDP for developed economiesand 25.4% for other emerging markets. A highsavings rate was not a sufficient condition forSouth Korea to avoid a financial crisis in 1998,however. It was also far richer at the time of itscrisis, with a GDP per capita that was about 45%higher than that of China today. In our view,the key difference is China’s limited reliance onexternal financing and hence limited vulnerabilityto foreign capital flight. China is more likely tofollow Japan’s path than South Korea’s: debt willcontinue to grow to higher levels for a few years,

drawing on high domestic savings. But, just like Japan, we believe China will eventually face a

period of much slower growth, especially if itdelays moving ahead on the structural reformsoutlined in the Third Plenum of 2013, as discussedbelow. The problem for China is that Japan entered

its period of slow growth as a much richer countryin 1990, with a GDP per capita that was 2.5 timesas high as that of China today.

China is indeed approaching a tipping pointin its debt levels, but no one knows where it willbe over the next several years. While we believethat the tipping point is not around the corner, wealso recognize that China’s model of maintaininggrowth by increasing investments that are, in turn,largely financed by debt is not sustainable. Chinafaces an extremely challenging balancing act: It hasto slow the pace of debt growth and investmentsbut not by so much that its economy slows downtoo sharply. This balancing act depends on makingfurther progress on structural reforms to accelerateTFP growth, which would enable China to boostGDP growth without increasing investments andgrowing debt-to-GDP.

Let us therefore turn to China’s progress onits reform agenda to see whether optimism iswarranted with respect to TFP and future growth.

Exhibit 29: Total Gross Debt and Cumulative 8-Year

Increase

China’s increase in debt relative to GDP is among the highest

in recent history.

0

50

100

150

200

250

300

350

Japan Thailand South Korea US UK China

+54pp +102pp +41pp +45pp +46pp +79pp

% of GDP

(2000–07) (2008–15)(1991–98) (2000–07)(1983–90) (1990–97)

Data through 2015.

Note: Includes gross government, household and nonfinancial corporate debt.


Exhibit 30: Comparison of Gross National Savings

at Crisis

China’s high savings rate stands out.

33.832.2

38.5

17.3 16.3

27.6

47.4

0

10

20

30

40

50

60

Japan(1990)

Thailand(1997)

SouthKorea(1998)

US(2007)

UK(2007)

Average China(2015)

% of GDP

Data through 2015.

Source: Investment Strategy Group, IMF.


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Goldman Sachs

Walled In: Balancing Reformswith Economic Stability

China faces the herculean challengeof rebalancing the economy towardconsumption and a more sustainable

growth path while avoidinga disorderly and destabilizing

adjustment. Meeting this challenge requiressuccessful implementation of the reform agendaput forth after the Third Plenum of 2013. If thereforms are implemented too quickly, China risksa sharp slowdown. If the reforms are implementedtoo slowly or not at all, China risks anunsustainable increase in debt relative to GDP thatwould push it past the tipping point into economicand, in all likelihood, political instability.

The stakes involved in a successfulimplementation of reforms in China have beencovered widely. In “China Will Stumble if Xi Stallson Reform,” Robert Zoellick, former president ofthe World Bank and Chairman of Goldman Sachs’International Advisors, warned in the FinancialTimes of the risk of retreating to the pre-reformgrowth model.54 Nicholas Lardy of the PetersonInstitute believes that “without reforms that raisethe ROA [return on assets] of state assets, and thusallow 6–7% growth with much less credit growth,

the wheels eventually will fall off.”55 The IMFhas “urged steadfast and timely implementationof the envisaged reforms” to avoid an increase in“vulnerabilities in the fiscal, real estate, financialand corporate sectors” and reduce the risk of a“sharp and disorderly correction.”56 The IMFestimates that reforms would boost China’s TFPgrowth by 1–1.5 percentage points by 2020.

Put succinctly, China cannot grow at asufficiently strong pace without a significant boostto its TFP, and faster TFP growth is dependent onthe successful implementation of the reforms of theThird Plenum of 2013. What are these reforms andhow much progress has been made?

A Brief Review of the Reform Agenda

In November 2013, the Third Plenary Sessionof the 18th CPC Central Committee publisheda report called “The Decision on Major IssuesConcerning Comprehensively Deepening Reforms,”or “the Decision” for short.57 The report laid

out a 60-point blueprint for reforms that wouldresult in better allocation of resources, increase

efficiencies in the public sector, enhance the role ofthe private sector, move to market-driven pricing,reduce pollution, shift the demographic profile bychanging the one-child policy and improve the ruleof law, which encompasses the anti-corruptioncampaign. There were additional blueprints

focusing on social, cultural, military and politicalreforms that are beyond the scope of this Insight .

The US-China Economic and Security ReviewCommission grouped the proposed economicreforms into six categories58:

• State-Owned Enterprises and the Private Sector:While public ownership is the pillar of China’seconomic system, the private sector has tobe developed and SOEs have to be reformed.Proposals include modifying ownership

structures; increasing dividend payouts;relying on market-driven pricing except inpublic utilities and services; and easing entryof the private sector into certain public sectorsdominated by SOEs.

• Financial System: Increase the role of the marketby liberalizing interest rates, the renminbiexchange rate and the capital account; permitprivate capital to establish small and medium-sized financial institutions; and establish adeposit insurance system and a market-based

exit mechanism for financial institutions.• Fiscal Policy: Improve the taxation system

by generating more revenues from personalincome, real estate and resource taxes; andimprove the budget process with moretransparency and better allocation of revenuesand responsibilities between the central andlocal governments.

• Rural Land Reform and Hukou Reform:While maintaining the current system of ruralland ownership by village collectives, farmerswho lease the land for 30-year periods shouldhave more property rights through betterlitigation and documentation to avoid coerciveexpropriation; farmers should be allowed tolease and mortgage their land to third parties.Hukou reform proposes changing the hukou residency permit system to allow migrants toobtain urban residence permits in order toaccess the social benefits of residency, includinghealth care, education and housing. The initial

focus is on small and medium-sized cities withstricter control in large cities and “megacities.”


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• Market Access and Foreign Investment: Chinashould allow more inbound and outbound

foreign investment and relax market entryrequirements. Examples include opening upservices such as finance, education, culture,medical care, building design, accounting,auditing and even “ordinary manufacturingindustries.”59 The number of free trade zonessimilar to the Shanghai Free Trade Zone (SFTZ)should be expanded.

• Environmental Regulation: “A comprehensivesystem is to be established, featuring thestrictest possible rules to protect the ecologicalsystem.”60 The proposal includes tougherpunishment for polluters; stronger naturalresource property right systems; and a shiftfrom a GDP-based assessment of localofficials to one that includes an audit onnatural resources and the responsibility forenvironmental damage.

While the Decision did not provide a specifictimetable for implementing the proposed reforms

(except for the increase in dividend payouts fromSOEs to 30%, to be achieved by 2020), it explicitly

stated that “decisive results are to be obtained inkey areas in 2020.”61 Now, more than two years

later, China observers and market participants areconcerned that slower growth, volatility in the localequity and currency markets, and significant capitaloutflows will slow the pace of reforms and furtherdelay the rebalancing of the economy away frominvestment-led growth and toward consumption-led growth.

According to the Wall Street Journal ’s review ofminutes of a September 2015 meeting between theNational Development and Reform Commission(NDRC) and the Ministry of Finance, there isconsiderable debate within the government onwhether to prioritize reform at the expense ofslower growth, or to prioritize growth throughtraditional monetary and fiscal stimulus measuresat the expense of reforms.62

If history is a useful guide—which is one ofthe pillars of our investment philosophy, as shownin Exhibit 31—reforms are likely to take a backseat to growth. As shown in Exhibit 32 on page26, every time growth slows below a stated

target level, policymakers resort to monetary andfiscal stimulus. Common measures used over the

Exhibit 31: Pillars of the ISG’s Investment Philosophy


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Goldman Sachs

last several years include boosting infrastructureinvestment, lowering lending rates and reducingbank reserve requirement ratios (RRRs). The samepolicy measures unfolded in 2015: The PBOC cutbenchmark interest rates six times and lowered

the RRR four times. As shown in Exhibit 33,these measures were broadly in line with thoseimplemented after the global financial crisis.Lending has also been encouraged, with the ratioof new loans to GDP increasing by 3.1percentage points.

Taking Stock of the Progress on Reforms

As we take stock of China’s progress on itsextensive reform agenda outlined in the ThirdPlenum report, we are reminded of the words ofGerman poet and playwright Bertolt Brecht in“The Measures Taken”:

And yet your report shows us what is

Needed to change the world:Anger and tenacity, knowledge and indignation

Swift action, utmost deliberationCold endurance, unending perseveranceComprehension of the individual and

comprehension of the whole:

Taught only by reality canReality be changed.63

Implementing these reforms would be aherculean challenge under any circumstance.It is even harder when reforms are opposedby entrenched powers such as SOEs, localgovernments and others with a vested interest

in the established system. We will examine sixproposed reforms to gauge the level of progress:SOE reform, financial market liberalization, ruralland reform and hukou reform, the one-childpolicy, environmental regulation and fiscal reform.We conclude that progress to date has been mixedat best.

SOE ReformIt is widely accepted that while China’s SOEscontrol a significant number of assets, the returnon those assets is unacceptably low given themagnitude of subsidies involved, includinglow interest rates, cheap land, lower tax ratesand preferential access to resources. About150,000 SOEs control over RMB 100 trillion($15 trillion) of assets in China, which, inaggregate and excluding financial institutions,returned 2.4% as of 2014. This compares withROAs of 3.1% for Chinese listed companies(excluding financial institutions) and 6.4% for

US companies (excluding financial institutions).

Exhibit 32: China Real GDP Growth vs. Stimulus

Measures

We expect Chinese authorities to continue to provide stimulus

to prevent rapid deceleration.

4

5

6

7

8

9

10

11

Q4 2010 Q4 2011 Q4 2012 Q4 2013 Q4 2014 Q4 2015

%YoY

%QoQ, SAAR

RRR and interest rate cuts,

stimulus to housing sector

and other measures

Reserve requirement ratio

(RRR) cut, NDRC accelerates

project approvals

PBOC conducts open marketoperations, NDRC accelerates

project approvals

"Mini Stimulus"

focused on railways

and social housing

Real GDP Growth


Source: Investment Strategy Group, Datastream, Bloo

walled-in china's great dilemma

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