Author: Joep Huntjens, Lead Portfolio Manager, Asian Debt Hard Currency & EM corporate Debt at NN Investment Partners
China’s economy has been eerily steady this year. GDP grew by 6.7% in the third quarter, the exact same figure for the previous three months and for the quarter before that. The manufacturing PMI, a key influence on investor sentiment, expanded for most of this year, compared to a contraction in the second half of 2015. This consistency has lulled investors and helped propel Asian US dollar bond markets to an 8.2% gain in the year to October 2016.
The trouble is that China has continued to rely on government stimulus – and creating more debt – to meet its economic growth targets. Since the global financial crisis, total debt has quadrupled to 250% of GDP. Credit to the corporate sector is the main driver of China’s rising debt and this level is well above the level of its emerging market peers (and exceeding even developed economies).
China’s focus on economic stability means that crucial market reforms have inevitably stalled. This is most notable in the state-owned enterprise (SOE) sector, which has been the linchpin of government industrial policy used to reach development goals. Faced with less market competition and overcapacity problems, the return on assets for SOEs in 2015 was estimated to be a paltry 2.8%, versus 10.5% for private sector firms.
So far, Beijing’s main strategy for tackling its inefficient firms is to combine big companies into even larger ones, with some US$1 trillion of mergers announced since late 2014. But this is unlikely to solve the root cause of overcapacity and inefficient allocation. A mass layoff is unlikely to happen, given China’s fear that it could lead to social unrest, but surely the best long-term solution seems to move workers from lossmaking state firms to the country’s rapidly expanding consumer and services sectors. Accepting a lower GDP number (such as 5%) is infinitely better than pursuing low-quality and unsustainable growth propped up by credit creation.
While China tinkers with reforms, its Asian neighbours India and Indonesia have pushed through far-reaching improvements this year. India’s Prime Minister Narendra Modi worked with opposition politicians to introduce a new bankruptcy law, while the long-awaited Goods and Services tax, aimed at replacing a plethora of indirect taxes into a single tax, was passed. Like Modi, Indonesian President Jokowi had to overcome political roadblocks in his first two years at the helm, which he achieved by reshuffling the cabinet and appointing technocrats to key positions. These moves have paid off: since July this year, the government has added more than US$7 billion to state coffers with the implementation of the world’s most successful tax amnesty programme.
Granted, India and Indonesia face different problems than China. Some critics might say that plugging infrastructure gaps and improving bureaucratic processes are relatively straightforward tasks. But unlike China, India and Indonesia have less control over investment activity due to the much less prominent role of state-owned-enterprises. They will have to increase fiscal revenues and allocate a larger share of those revenues fund infrastructure spending. Additionally, they will have to persuade private money to invest in their countries.
Consequently, both India and Indonesia have managed to achieve high levels of growth on the back of robust private consumption instead of government spending and rising debt levels. India grew by 7.9% in the first quarter and 7.1% in the second, while Indonesia has averaged about 5% growth this year. And with the implementation of these reforms, their GDP numbers are likely to improve and, most importantly, result in high-quality and sustainable growth.