Just before the summer, the liquidity crunch in China and the heated debate about whether shadow banking was getting out of control drove investors to the side lines. Liquidity conditions have since stabilized and the new government has announced various small-scale, growth-supportive policies. On the back of stronger-than-expected economic data and encouraging interim results, the downward revision of the 2013 gross domestic product fore-cast of a few months ago has been reversed.

After deteriorating somewhat before the summer, Chinese economic data improved again in July and August. It now seems that the Chinese economy is picking up steam again. The improvement in data is partly due to the ‘mini stimulus’ measures, which include reducing taxes on small businesses, simplifying export procedures and advancing investments in the railways sector.

Chinese companies reported a profit growth of 13 percent compared with a year ago in their half-year results. The interim results are encouraging, given the slower economy and the tough global business environment in the first half of this year. The most profitable industries are banking and insurance. Banks alone accounted for over 50 percent of total market earnings. Other bright spots are utilities and information technology, which recorded profit growth of 88 percent and 64 percent, respectively. As expected, the steel and coal industries reported heavy losses, as a result of slower demand, low commodity prices and overcapacity.

Given the stronger-than-expected economic data and the encouraging interim results, we now expect quarter-on-quarter GDP growth to improve thanks to ‘targeted easing’, micro-level support and stronger external demand. Year-on-year growth will continue to slow, however, due to the base effect.

Wealth gap

With the global economy picking up and inflation remaining moderate at less than 3 percent, we believe now is a suitable time for the new government to implement reforms. Urbanization, narrowing the wealth gap and fighting corruption are amongst the top priorities of its reform agenda. Given the encouraging economic data and the strong interim results, we believe the Chinese economy has bottomed. However, while on a quarterly basis GDP growth will pick up again in the next quarter, we expect it to remain modest on a yearly basis. We expect the economy to accelerate slightly next year, to 8 percent growth year-on-year, as by then the effect of reforms will become visible.

The rapid growth in the last 30 years resulted in significant imbalances within the country: between the coastal and inland regions; between the public and private sectors. These imbalances have contributed significantly to the slowdown we are seeing today.

The policy makers are determined to adjust these imbalances at the expense of GDP growth, if need be. Since the official handover of power in March, president Xi Jinping and his government presented firm policy plans and showed strong determination to reform. However, after the liquidity crunch in the interbank market and the sharp correction in the stock market in June, the tone has softened somewhat and there have been only small-scale, supportive measures. These comprehensive reforms are sometimes intricately linked and sometimes at odds with each other, as shown by for example the power tariff reform and resource pricing reform; the personal income tax reform and the increase in private consumption; the rural land reform and the environmental tax reform.

It is not surprising that there is a constant change in direction or a change in tone, in order to compromise with different interest groups.

Investors have to balance between over-reacting to the sudden and constant changes in policy and the long-term benefits of investing in China.

The widening wealth gap is a pressing issue in China and one that is most challenging. Whichever way the Gini coefficient is presented, as there are numerous ways for calculation, China’s Gini coefficient paints an alarming picture. Although rural income has increased tenfold in the last twenty years, it is way behind the increase of urban income.

The urban-rural income disparity is now over six times. Urbanization and the Hukou reform (the household registration system which distinguishes between urban and rural households, hence the distribution of resources and benefits) are at the top of the government’s reform agenda. Reform implementation will be a long and gradual process, as it will affect many powerful interest groups and raise social conflicts.

Owing to the one-child policy back in the 70’s, China’s population growth rate has dropped consistently since. The aging population is driving wages up and productivity down. After nearly 40 years, the changing circumstances have led to debate about the suitability of this policy.

It is now being reviewed and, in fact, it has already been relaxed to a large extent. This is a problem that will need 10-20 years to be solved. In the meantime, China has been losing its competitiveness to South East Asia, where cheap labor is abundant at the lower end of the value chain. It is therefore imperative that China moves up the value chain to stay competitive.

Lack of coordination

In the past, the performance of local government officials was mostly measured by local GDP growth. This incentive structure has led to fierce competition between local governments to attract investments. This competition and a lack of coordination has resulted in over- or wasteful investments such as the building of duplicate highways between neighboring counties. In order to get funding for these investments, some local governments have been aggressively issuing debts through Local Government Financing Vehicles, which they have difficulty in repaying as they have invested in non-profitable projects.

In a recent speech to president Xi Jinping specifically stressed that going forward GDP growth will no longer be the only performance measure. Instead, welfare improvement, social development and environmental protection will be the new performance indicators.

We expect there will be a lot of mixed signals about what will happen next. Investing in China will no longer be a story of fast growth. The Chinese government aims for a GDP growth of 7.5 percent this year, which may seem slow after a decade of surging, double-digit growth. We believe China will continue to grow in the next few years, but at a slower pace.

We also believe that the immediate effect of this slowdown will be manageable. In the longer term, the impact of the structural, badly needed reforms and a more balanced growth will be more profound and beneficial to the Chinese economy as a whole.

It was only two months ago when the market was in major panic about a liquidity crunch. In hindsight, this was more of a lesson for financial institutions disregarding the idea of risk management, rather than a real threat of a possible liquidity meltdown. Meanwhile, the higher-than-expected HSBC Manufacturing PMI and official China PMI and the half-year results have been encouraging.

Going forward, we do not expect substantial government stimulus measures, but rather targeted spending on energy-savings, IT and 4G, railways in the less developed western region and ad-hoc stimulus when needed.

The Third Plenary Session of the Chinese Communist Party will be held in November. More details about the reforms will likely be unveiled then. For the final quarter of this year, we are cautiously optimistic and maintain our overweight stance on China.