The latest piece of Chinese data to hit those post-Q1 GDP nerves is today’s HSBC/Markit services PMI.
It gave a April reading of 51.1, down sharply from 54.3 in March, and was the lowest since August 2011:
What makes it more interesting is that that August 2011 reading was lower than any in 2008. Meanwhile on Friday the official non-manufacturing PMI was published, and it too showed a fall though a less drastic one, to 54.5 from 55.6 in March.
Zhiwei Zhang of Nomura points out that the services PMI has risen by an average of 1.1 points in April since the series was made available in 2008. New orders in the official survey also looked weak, dropping to 50.9 from 52, the lowest level since December 2011.
These signs of slowdown in services growth raises the question of where Chinese growth is now coming from, given that April manufacturing PMIs also disappointed. Importantly, what does it say about the composition of China’s economy, which the country’s leaders acknowledge needs to move from an unusually heavy reliance on investment towards more consumption-based growth?
As we explored last year, gauging whether or not rebalancing is occurring is not straightforward. However the Q1 GDP data did show some promise.
From Reuters, in April:
Domestic consumption was the biggest driver of growth in Q1, delivering 4.3 percentage points of the 7.7 percent total. Capital formation delivered 2.3 percentage points while exports generated the 1.1 percentage point balance.
Oh, but hang on a minute:
But as construction is a major component of domestic consumption, economic activity is still largely dependent on investment spending which is currently worth around 50 percent of GDP and a level which worries the International Monetary Fund, among others.
Hmm.
The Economist wrote last month that consumption’s rising share of GDP growth was a cause for optimism that rebalancing was occurring (it added that on a sectoral basis, services have been bigger contributors than industry for three consecutive quarters now, which maybe won’t be such a sure thing for Q2 if this new PMI trend continues).
Michael Pettis recently looked at the signs that rebalancing is occurring, and his view is basically that while it may be happening, the progress has been meagre so far.
Firstly, he says, assuming consumption’s share of total GDP is moving slowly away from its trough, the proportion of GDP growth that consumption must generate would need to be very much higher to began to rebalance the economy toward a more typical mix of investment and consumption. Fixed-asset investment, after all, is still growing at rates of above 20 per cent; it’s just becoming less successful at generating GDP growth. Pettis reckons “several years in which close to 100 per cent of the growth is explained by consumption” is required to really rebalance. He also notes that the relatively small degree of rebalancing we’ve seen so far in the growth figures has been accompanied by a very noticable fall in the overall growth rate.
Second, even though investment contributed only 2.3 percentage points of total GDP growth, it is hard to argue that the slower growth occurred because of a sharp reduction in investment. On the contrary, investment has still risen quite quickly – certainly debt has – and yet it was unable to contribute more growth than consumption. This suggests what we might already know – it will take more and more credit and more and more investment to generate a constant unit of GDP growth.
Pettis also looks at an IMF working paper by Il Houng Lee, Murtaza Syed, and Liu Xueyan that attempts to develop a framework for identifying wasteful investment, which may shed some light on why Chinese investment is becoming less effective. Analysis using this framework suggested that “some types of investment are becoming excessive in China, particularly in inland provinces”, the authors write. But perhaps more alarmingly, they found that investment is driving consumption:
In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity.
More encouragingly, the authors found this effect was less pronounced in coastal provinces, which ” on average appear to have reached a stage where consumption is self-sustaining and not dependent on contemporary investment”.
The contrast between inland and coastal regions, Pettis says, is an interesting one, and contradicts the old argument that China’s capital stock will inevitably grow simply because it is low.
We looked at that argument in depth last year but the whole question of how to differentiate useful investments from those that are wasteful has been on our minds for a while lately, so we’ll look at it here in the context of the regional divide.
What are those missing ingredients that help make investment productive?
One of the paper’s key findings is that investments in agriculture and services tend to be both less wasteful and better at boosting household income than investment in manufacturing and real estate. For this reason, they suggest that the inland provinces would benefit from reduced total investment, with more of the remainder going to agriculture and services.
They add (our emphasis):
This train of thought also relates to urbanization. The stages of urbanization would start with infrastructure investment, and construction of housing, putting in place the social services system, and then finally the creation of a market where further value-added will be generated and economic activity sustained. While the first two stages are relatively straightforward since this would be broadly continuing the current practice, the creation of a market will require a different set of skills that should be underpinned by transparent and simple rules for businesses. Otherwise, urbanization could lead to growth of the urban poor, which will be more difficult to tackle than rural poverty.
Here is how Pettis sees it (our emphasis again):
Richer, more productive economies with higher levels of social capital (which include property rights, a clear legal framework, education, minimal regulatory distortions, minimal government intervention, limited corruption, etc.), in other words, are better able to absorb investment than poorer less productive economies. The appropriate level of investment for a country that is much poorer than the US is much lower than the appropriate level in the US. China does not have infinite ability to expand investment productively, and in fact, I would argue, has long ago passed the point where investment in the aggregate is wealth creating.
In otherwords, again, it is the difficult decisions for policymakers that is key to China’s long-term economic strength; yet the need for these reforms is lost on most analysts following the country’s growth.
Related links:
China Myths: The rapid march towards urbanisation – FT Alphaville
China’s (not remotely insignificant) rebalancing challenges – FT Alphaville
China is not rebalancing a) yet, or b) enough – FT Alphaville