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Slower growth necessary for China’s health

But Standard & Poor's has increasing concerns about the quality and sustainability of the country's economic growth.

Are you worried about China’s growth trajectory?
Not in the near term. Despite concerns about market volatility in recent months, Standard & Poor’s expects the Chinese economy to maintain a still-respectable 6.8% growth rate this year. And we are forecasting a decline of about one-half of a percentage point in 2016 and 2017. Notably, we continue to see the balance of risks as being on the downside.

But all is not well. While we are less concerned about a slowdown in near-term growth than other market observers, we do have rising concerns about the quality and sustainability of growth. In our view, the growth rate is being propped up a combination of aggressive government spending, stepped-up lending by policy banks, restructuring local government debts, and keeping loss-making SOEs operating and employing. This is creating imbalances now that need to be paid back later by slower growth as excesses need to be digested.

Is Chinese growth still stable?
The available data suggest it is, although there are understandable doubts. What we continue to see is a rotation to a more consumption- and services-based economy, even if GDP growth may not be quite as high as official estimates suggest. Also, indicators like purchasing managers indices for manufacturing and electricity consumption might be underestimating growth since those measures focus on the parts of the economy that are slowing. In addition, external demand again appears to be contributing modestly to growth.

To ensure stability going forward, we think there is a strong case to accept slower, but higher quality growth. The upcoming five-year plan in our view should both lower the growth target from the current 7% and move to a range. A medium-term average GDP growth target of 5% to 6% would be more sustainable and allow a greater role for market forces to help the economy rebalance toward consumption and services.

How will the rest of Asia Pacific fare?
The economies of Northeast Asia (excepting Japan’s large, domestically-focused economy) plus Australia are most at risk, owing to strong trade linkages to China’s investment sectors. Southeast Asia and India fare better, given weaker trade linkages as well as more domestically oriented economic models in most cases.

The new and less-understood risk emanating from China is financial contagion. The equity market rollercoaster in China and moves to liberalize the exchange rate regime, neither of which the authorities handled smoothly, have generated volatility worldwide. The short-term pressures have been driven by risk aversion, leading to falling equity prices and weaker exchange rates in emerging markets generally. The evolution of exchange rates has always been tricky to forecast, but is now more so, given the emergence of China in the picture. The near-term risks are on the side of continued weakness in emerging market assets.

Which sectors are most at risk?
Companies in the automotive, chemicals, gaming, technology, metals and mining sectors will bear the brunt of a Chinese deceleration. Global metals and mining firms have become especially dependent on Chinese demand. China is now responsible for 40% - 50% of raw material consumption, and concerns about weaker demand have resulted in multi-year price drops for copper, nickel, iron ore, coal, aluminum and steel. In response to these trends, Standard & Poor’s lowered its internal price assumptions for base metals in August.

Similarly, the slowdown will likely result in lower demand for smartphones, personal computers and other consumer electronics. We expect global semiconductor sales to be low, and hardware sales growth may be near zero for the year. Autos and component manufacturers are seeing anemic or even negative growth in mature regional markets like Japan, and lower oil prices are likely to be of limited benefit in highly-regulated markets like India and China (despite a robust auto market in India).

How will this affect overall business confidence across Asia?
The impact of China's economic slowdown on commodity prices and regional currencies has been stark. What is harder to see, though, is the effect on capital flows and business confidence. Business confidence will influence the level of future capital expenditure in the Asia-Pacific.
While we had previously anticipated some decline in capex, the risk of further falls is more critical over the medium-to-long term. If companies view the prospects for their economy as being less bright than previously assumed, the pace of investment may decelerate. This slowdown could bring about the reduced prospects the corporates fear, creating a self-reinforcing spiral that would negatively affect corporate credit profiles. Not surprisingly, we intend to keep a close eye on the forward investment plans of China and other Asia-Pacific issuers in the coming months.
Where does China go from here?

A less dogmatic attachment to a fixed growth rate would give China some flexibility in responding to coming challenges. China can afford to decelerate its relentless economic growth, and as a middle-income country, perhaps it should.

The authors of this article are Paul Gruenwald, Standard & Poor's chief economist for Asia-Pacific, and Terry Chan, Standard & Poor’s head of corporate research in Asia-Pacific.

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