Is China's Economy Finally Turning Around?

Signs Point to a Turnaround for the World's Largest Emerging Market

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China’s economic slowdown following the Great Recession has been a significant drag on global growth rates. Since 2010, the country’s gross domestic product growth rate has slowed from over 12% to less than 7% per year. Slower demand from developed economies — including the U.S. and Europe — have taken a toll on exports, while the country has been slow to transition from an export-driven economy to one focused on consumer spending.

China's Turnaround in the Works

In this article, we will take a look at whether or not China’s economy has turned a corner and what it means for investors.

Stabilizing Industrial Sector

China’s industrial sector represents approximately 40% of its economic output and remains a key source of growth for the economy.

China’s industrial production has been on a steady decline from nearly 20% in 2010 to around 6% this year. Fortunately, the manufacturing purchasing managers index (“PMI”) has been showing signs of improvement. The leading indicator has been at or above the breakeven level of 50.0 for two months, which is more stabilization than investors have seen in two years and reflects growing confidence among industrial manufacturers.

In addition to industrial production and manufacturing PMI, a plethora of other economic indicators have shown signs of improvement. Electricity usage rose 8% to its highest levels in more than two years, which suggests greater economic activity is taking place.

Business confidence also rose above the 50.0 level in August, which is the highest reading since October 2014 as output and new orders rose at a faster pace.

Consumer Spending on the Rise

China aims to transition itself to a consumer economy over the coming decades, which means consumer spending has become increasingly important.

China’s transition from an export-driven economy to a consumer spending economy has been accelerating over the past several months. During the 18th congress of the Chinese Communist Party, leaders established policies designed to favor household income growth, social safety nets, and the expansion of small and midsized service sector and private enterprises. Analysts expect this transformation to take several decades, but progress so far has been marked.

New vehicle sales surged 24% compared to year-ago results, with General Motors and Ford reporting record sales. These trends suggest that domestic consumers have increased consumption and could contribute more meaningfully to overall gross domestic product growth. Currently, approximately half of GDP comes from the domestic services economy compared to 71% in Japan and 78% in the United States.

Challenges Remain

China’s economy seems to be showing signs of improvement, but several key risk factors remain that could undo a lot of the progress.

Bad loans issued by the country’s state banks have quadrupled over the past two years, adjusted for write-offs and disposals, to 461 billion yuan, according to Bloomberg data. At the same time, the average formation rate for nonperforming loans reached 1.24% from just 0.36% in 2013.

The increase in lending activity has helped keep the overall rate of nonperforming loans steady, but deleveraging at the wrong time could jeopardize the recovery.

China’s stock markets also continue to be a risky place for investors. In fact, 2016 has been the worst year for Chinese stocks since 2011 amid lower odds of monetary easing and the risk of higher U.S. borrowing costs. Turnover in stocks has also fallen as the 2015 market rout encouraged investors to move into other asset classes like real estate. Some investors are now concerned that real estate has itself entered bubble territory.

The Bottom Line

China has experienced a significant contraction in its GDP growth since 2010 thanks to slower demand for manufactured goods. With the global economy starting to improve, the country could be in the midst of a turnaround, although several challenges remain.

The country’s leaders hope to transition the economy to a consumer-driven force over the coming decades in order to drive growth without as much reliance on global growth.

International investors may want to continue following these developments in the context of global growth and commodities demand, but investing directly in the emerging market may be premature given its ongoing debt issues and instability in equity and real estate markets.