Investors are focused on the future prospects of the Chinese economy. Will China suffer the fate of the "middle-income" trap? Have institutional constraints become too prohibitive to allow for further growth? And importantly, what is the risk of an entrenched slowdown in the economy, in which case a much weaker currency may be appropriate?
Some of these worries have recently been intensified by a sharp deceleration in private investment. A more careful look, however, suggests that this is relatively concentrated in the "old economy," where returns have been weak. The deceleration in fixed asset investment is manifested most acutely in energy and construction-related building materials, which in turn reflect a significant decline of global energy prices and a prolonged downturn in domestic construction.
In contrast, capital expenditure growth has been robust in sectors where returns have been relatively high, such as services, automotive components and technology. The downturn in construction has depressed demand for trucks and iron ore, but not middle-income demand for cars, iPhones and diversified services. Sectorally, private companies are adapting to meet shifting demand.
Despite the strength in non-construction related sectors, they are not yet large enough to offset the weakness in the old economy. Real estate, energy and material sectors account for about 42% of fixed asset investment and 15% of gross domestic product, which is quite sizeable from a macroeconomic standpoint. The latter sectors are also heavily leveraged and may see rising defaults on corporate loans this year.
However, the slowdown reflects a necessary adjustment to reduce capacity overhang after a construction boom in the wake of the global financial crisis. A more definitive pointer that "creative destruction" is under way would be sharper capacity cuts and closures of unviable companies and sectors. While this is not yet the case, a significant drop in investment in low growth sectors is at least a step in the right direction.
Meanwhile the economy is upgrading despite the slowdown. Strong demand and brisk investment in the "new economy" should help to alleviate concerns that the slowdown in the old economy has spread due to income losses among affected workers or enterprises. It is also not the case that the "old economy" is tying up too many resources for other sectors to grow, or that institutional constraints have become too great and too rigid for long-term economic upgrade. In the words of Professor Michael Porter, "Successful economic development is a process of successive upgrading." Macroeconomic headwinds notwithstanding, microeconomic gains have continued.
Shift from construction
While the property and construction sectors are often the impetus behind the business cycles of a country, they are heavy on structures, yielding limited long-term productivity gains. The shift away from construction suggests that more investment is being allocated to equipment, machines, and research and development, which are better at improving productivity over time.
In the past, business investment has enabled Chinese products to upgrade and stay competitive. The global smartphone market is a case in point. By early 2016, China's four top technology brands -- Huawei Technologies, Xiaomi, Lenovo and ZTE -- together accounted for 24.3% of the global smartphone market.
Another example is the textile industry. Chinese manufacturers have reacted to rising labor costs with more automation and have moved up the value chain. China's global market share of sophisticated textile products such as knitted clothing has increased faster than that of more basic products, and the industry's overall global market share has remained relatively strong.
Economic conditions are still supportive for continued private investment, helping to overcome institutional constraints elsewhere. Savings are adequate, and while bank credit tends to favor state-owned companies the broadening of financing channels, including venture capital and private equity, has enabled more funding to be channeled into the private sector.
In addition, Chinese enterprises benefit from growing scale because of the rapid growth of the domestic market. Incremental growth in Chinese consumption will amount to $2.3 trillion over the next five years, according to Economist Intelligence Unit estimates, putting China on a par with the U.S. in this respect.
A widely cited front-page article in the People's Daily recently compared the Chinese economy's likely recovery path to the letter L. Fundamentally, the economy has settled on a lower trend of growth since the 2008 global financial crisis, as China makes a transition towards a service-based economy with lower overall productivity growth. The shift of investment away from construction-related sectors is a promising sign of sustained productivity gains in the private sector, despite slow reforms in many areas.
The L shape can also be used to describe other major economies since the global crisis. Even the U.S., the best performer among the advanced economies, has experienced a sluggish growth recovery. In addition, U.S. business investment has been soft, well below the rate of growth for previous recoveries. Weak business investment implies not only a softer recovery at present but also lower productivity gains in the future -- a point highlighted by comments made by Janet Yellen, chair of the U.S. Federal Reserve, in recent meetings.
An interesting contrast can be drawn between China and the U.S.: While the Chinese economy is weighed down by the construction downturn, other business investment has remained relatively robust. The situation in the U.S. appears diametrically opposite: Weak business investment has been offset by robust housing investment.
The contrast in the investment mix between the two countries implies more near-term headwinds in China. But in a world of lower growth for longer, or an "L-shaped" world, China still retains a relatively strong appetite for business investment for future economic gains, supported by its developing country status, its considerable internal savings and its sizeable market. This offers hope for sustained productivity gains and provides support for the long-term value of the yuan.
Li Cui is managing director and head of macro research at China Construction Bank International in Hong Kong.