The dilemma of competing priorities between stable growth and structural reform has been quite well known for the Chinese economy over the past decade. However, the first half of this year has somehow painted a different picture. China economic data has surprised most investors to the upside; meanwhile structural reforms, especially deleverage and overcapacity cuts, have gained momentum. This is based on new evidence we observed:

China is gaining momentum towards developing a new growth driver from industrial upgrading Old growth drivers such as Fixed Asset Investment (FAI) in real estate and infrastructure remain solid Structural reforms have surprised to the upside, rather than bind growth

Structural Industrial Upgrades – new growth driver

Chinese producers have been moving up in the value-added chain. This was driven by three pillars: increasing competitiveness in the external market; domestic demand upgrade; and explicit policy support. High value added exports have climbed up to more than 50% of the total exports in China. This includes power and electrical machinery, telecomm equipment, and medium to high technology sectors. For example, electronic and circuit components such as transistors and LCD screens have gained market share from Japanese and Taiwanese competitors.

Meanwhile, increasing domestic consumer sophistication also forces manufacturers to move up to higher value added products. Last but not least, policy support in this area is strong – tax benefits for R&D, stronger intellectual property rights, government guidance funds, and a broad set of policy tools to facilitate the “Made In China 2025” national initiative*. This new growth drive could possibly add an estimated 0.4-1.2% of nominal GDP growth by 2030**.

Less worries from FAI Slow Down

Estimated impact on GDP growth from FAI in real estate is reducing. While sales in Tier 1 and 2 cities slowed down over the past year, Tier 3 and 4 cities, which take up to 60% of the total FAI in real estate and 70% of total land sales, have been more resilient than expected, as shown in Figure 3. Estimated impact on GDP growth from real estate and related sectors is reduced to -0.26% from -0.4% for the rest of the year. On the other hand, FAI in infrastructure remains robust, with more private-public-partnership (PPP) projects entering the construction phase after up to a year’s pre-construction work, as shown in Figure 4.

Structural reform gains momentum and does not bind growth

Two notable developments in 1H 2017 are the stepped up efforts in tackling financial risks and the over-capacity issues in industrial sectors. Banks have cut interbank assets and credit to non-bank financial institutions, while increasing the credit to corporates, as shown in Figure 5. This improves the efficiency of credit allocation by shortening the financing chains for end borrowers who contribute more to the real economy, while reducing the credit to low quality borrowers that have been weak contributors to GDP growth. In industrial sectors, supply side reforms have also gained momentum as shown in Figure 6. This has led to industrial profit improvement in both overcapacity and non-overcapacity sectors as shown in Figure 7.

Summary

Our fundamental outlook on China macro remains constructive. China is gaining momentum towards developing a new growth driver of industrial upgrading, which will help to offset its reliance on old growth drivers of real estate and infrastructure build. Financial deleveraging has not affected China’s GDP much due to:

A decrease in self-circulating funds among financial institutions and a guided re-allocation of funds from weak borrowers to good quality borrowers that contribute more to the real economy; and Improvements in corporate profitability backed by supply-side reforms, inventory restocking cycle and industrial upgrading.

* ”Made in China 2025” is a national initiative announced by China’s State Council. The goal is to comprehensively upgrade the Chinese industry, making it more efficient and integrated so that it can occupy the highest parts of the global production chains.

** Accenture