Recent data in China shows two sets of important changes in what is now one of the most important drivers of growth in the world economy. First, there are indications of a cyclical slowdown, with economic growth showing signs of weakening more than anticipated in the short term. Second, there are structural changes in China that affect its competitive positioning in global markets, thereby affecting the region. The net effect of these changes may well be positive in the long term.

Cyclical prospects: Slower economic growth, but downside risks likely contained
Trends in Chinese data point to a deceleration in economic activity, raising concern of growing downside risks:
•     Purchasing manager indices suggest sharply slower growth: The HSBC-Markit PMI fell to 49.4 in July from 50.4 in June — a reading below 50 indicates a contraction. China’s official PMI, however, fell to 51.2 in July from 52.1 in June, suggesting a deceleration rather than an outright contraction.
•     Lead indicators spell a slowdown: The lead indicator for China created by the OECD is pointing to a modest deceleration in economic activity over the next two quarters. Surveys within China suggest that the value of new orders received by businesses is now growing very slowly, pointing to slow demand growth in coming months.
•     Investment in projects under construction decelerated sharply: Since this is a lead indicator of future investment, it suggests that investment — a key driver of China’s growth — will slow.
•     Monetary growth has slowed sharply: M2 growth eased dramatically to around 19% in June. If the official target for new loans that all Chinese banks have to meet continues to be enforced, the value of new loans extended to businesses will have to fall by about a third in 2H2010. That would represent a drastic tightening of credit.
•     Property prices have fallen a tad: Since the authorities switched to a tightening policy earlier this year, credit conditions for the real-estate sector have tightened materially. This is the main reason property prices in China’s 70 largest and mid-sized cities fell 0.1% m-o-m in June after rising every month since the nadir of the global crisis in February 2009.

In short, the downside risks to economic growth have risen in recent weeks, although nothing in the data indicates that it will be drastic. The slowdown is primarily driven by policy actions — the authorities were concerned that the economy had been expanding at an unhealthily rapid pace and used carefully chosen administrative measures to reduce growth to a more sustainable level. It is possible that in the short term, the authorities could even continue with other measures to reduce some of the overhang of excessive lending. Barring an unforeseen financial or external shock, the policymakers retain the ability to loosen up again if they believe such measures overshoot and cause a slowdown of unintended proportions. We suspect some administrative restrictions on investment will be eased in coming months. The most likely scenario therefore is that growth slows from the overheated rates of close to 11% in 1H2010 to a still respectable 9% in 2H.  

Important structural changes underway
Longer term, it is the structural changes in China that will matter most to Southeast Asians. They include:
First, two big demographic changes in China are accelerating. Within a few years, the new additions to its workforce will start to diminish: The rate of growth of the workforce will slow substantially, reducing China’s potential rate of growth unless labour productivity growth accelerates sharply. In addition, the pace of urbanisation is intensifying. The urban population may exceed 700 million in five years, according to the National Population and Family Planning Commission. This means for the first time, its urban population will surpass those in rural regions.  
Second, the demographic changes will produce a huge shift in the dynamics of the labour force. The recent labour unrest does not reflect just short-term worker anger over low pay and poor work conditions. It reflects a shift in the bargaining position of workers as the population ages and fewer younger workers join the labour force. Wage rises are likely to continue and will raise the wage share in GDP while also raising labour costs for businesses and spurring considerable restructuring of the economy up the value chain.

Third, the renminbi has been floated and is likely to appreciate substantially over time. This will also support the shift in China’s competitive positioning described above.

Fourth, China is likely to enjoy a long period of positive benefits that will flow from the investments in human capital and infrastructure it is currently making. For instance, the super highways and high-speed rail networks that are being rolled out will reduce transportation and other transaction costs, creating new business opportunities and integrating the domestic market into a more efficient one.

Fifth, policy is shifting away from simply promoting high economic growth to a more nuanced development policy of promoting growth that is less polluting, more driven by productivity rather than increased inputs and which produces a fairer distribution of income.

In essence, what this probably means is that China’s growth will probably slow down towards the end of this decade. But this will also be accompanied by better-quality growth that will transform China’s economic structure to one that is more sustainable.

What does all this mean for Southeast Asia?
In the short term, slower growth in China may not affect the region too badly. A look at recent trade trends suggests that the main beneficiaries of China’s growth have been commodity-exporting economies such as Indonesia, Malaysia and Vietnam, or exporters of capital goods such as Germany or the US. For China to have a more substantial impact on the region, it needs to become a bigger importer of manufactured articles from Southeast Asia. That may take a while more.

The longer-term impact will probably be mixed but overall positive:
•     As China shifts out of making low-value footwear, garments and toys, some of this production will move to Southeast Asian economies such as Indonesia, Vietnam and Cambodia. Already, foreign direct investment in footwear in Indonesia is soaring again.
•     But China will move into niches such as electronics components and other intermediate goods that Singapore, Malaysia and Thailand produce. That may be negative in the near term but companies in these countries will re-engineer themselves and move up the value chain, or move into different types of goods. The eventual impact is still likely to be positive so long as policy and corporate-sector responses in these countries remain sensible.
•     In the meantime, China’s expanding and urbanising economy will also create all kinds of new demands — tourism will move up-market; demand for more sophisticated financial products will rise; portfolio capital will move from China into the region, boosting our financial markets; and there will still be lots of manufacturing niches that China cannot fill, leaving space for the more innovative and adaptable companies in the region to exploit its growth.

In short, big changes are coming from the giant next to us. These changes will provide huge opportunities as well as some challenges. Those countries that pull off the right policy responses and in which corporate-sector restructuring is effective will see a net positive effect.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

This article appeared in Forum page of The Edge Malaysia, Issue 818, Aug 9-15, 2010