No Hard Landing In China And What That Means For Investors

by: Tony Daltorio

Bearish predictions have been circulating about China's economy lately, pushing down China-related stocks and ETFs. This is nothing new...such forecasts have been around for over 30 years, even since China moved away from the Communist economic model.

Slowing demand for Chinese exports, rising production costs, and high debt levels at some Chinese companies. These are all factors leading bears on China to forecast that a “hard landing” - a sharp slowdown in economic activity – is just around the corner for China.

But the bears are wrong again on China. Bears are focusing far too much on exports, on the China of the past. China's economic success over the past 30 years (with economic growth averaging 10% a year) was built on cheap capital, cheap labor, cheap energy and cheap land. But no longer...

China is shifting its growth paradigm. What the bears and investors in general should be focused on is the country's new emphasis on stronger domestic consumption, greater investment in services and a liberalized financial sector.

A look back

Now don't get me wrong. The old growth model used by the Chinese government worked very well for over three decades.

It was in 1978 when China, under the leadership of Deng Xiaoping, launched market-oriented reforms in the agricultural sector. This led to soaring rural incomes. This was followed by reforms encouraging industrialization and investment in manufacturing, which led China to become the “workshop of the world.”

By 1990, China had made great progress but per capita incomes was still 30% lower than the average for sub-Saharan Africa. Today, it is vastly different. Per capita income is now three times greater than sub-Saharan Africa at more than $4,000.

But this economic model is today leading to far too much environmental damage and rising social inequality, leading to unrest. And cheap credit, energy and labor (minimum wage is up more than 20% in the past year)are become scarce.

A look ahead

The latest five-year plan from Beijing, which runs from 2011 to 2015, states the government wants the economy to move toward domestic consumption and away from exports and infrastructure investment.

The authorities though have been saying similar things for over a decade and nothing much has happened in that direction. Part of the reason for the lack of movement was the 2008 financial crisis and China's attempt to keep economic growth booming.

But now the leaders are realizing the old model is nearing the end of its usefulness and are pushing hard this time for true structural reform.

One key reform that is occurring is the loosening of the authorities' grip on their currency – the renminbi or yuan. This has been occurring gradually over the past two years.

Two examples of currency reform include the creation of an offshore renminbi market in Hong Kong and the setting up of numerous currency-swap agreements with many other of the emerging nations around the globe. The currency swaps allow bilateral trade to be conducted in renminbi instead of U.S. dollars.

These reforms are important because a stronger currency would encourage businesses to focus less on exports and more on service industries, such as healthcare.

Another critical change is the authorities allowing interest rates to be determined by market forces rather than by government dictate. This will likely raise the cost of capital and deter wasteful spending in sectors like property and encourage investment into more profitable service sectors. It would also give households a decent return on their savings.

Finally, China is making a strong push to fortify its social safety net. The country is ramping up investment in areas including healthcare and education and other consumer-related areas. These are the sectors that investors need to be looking at for profit opportunities.

With a stronger safety net, it will give Chinese consumers the confidence to spend their money more freely since they will not have to worry about saving for a medical emergency, for instance.

The main risk to the belief that China will avoid a hard landing is whether the Chinese leadership can get its new economic growth model rolling before the old one expires of old age.

Investors wishing to bet that the leadership can roll out their new economic model in time should stick to the seven industries the government itself outlined last year as “strategic.” These industries are targeted to have a 15 percent share of the economy by 2020, up from about 2 percent presently.

These seven industries are: advanced materials, alternative energy, alternative fuel cars, biotechnology, environmental and energy saving technology, high-end equipment manufacturing and new-generation information technology.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.