Group Economics Emerging Markets
China Watch
Arjen van Dijkhuizen +31 20 628 8052,
Ten urgent questions
21 September 2015 •
The way the authorities handled the stock market rout and communicated the change in the exchange rate regime seem to have raised doubts about their capability to manage macroeconomic and financial stability risks.
•
We have cut our economic growth forecast for 2016 from 7% to 6.5%.
•
This assumes that China’s economy will continue a gradual slowdown, as the authorities remain willing and able to add stimulus while services and consumption hold up better than industry and investment.
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However, China faces several major macro-financial risks, which if not managed well could trigger a hard(er) landing.
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In this report, we give some background on China’s growth story and risks by posing and answering ten key questions.
1. Why are markets so concerned about China? Over the past months, global financial markets have become more concerned about China’s outlook. China’s sharp stock market correction in June-August, the unexpected change in the exchange rate regime mid-August, the sharp drop in commodity prices and weak macro economic data all have contributed to rising fears that the economy is doing worse than official (GDP) figures suggest. Weak liquidity in global financial markets in August and the looming Fed rate hike also look to have added to market volatility as well. In our view, the concerns regarding China are understandable, although we think that over the past few months market perceptions regarding China seem to have changed more than China itself. Given China’s sheer size and its intransparency, negative developments surrounding China always have the potential to cause market jitters, certainly if these come unexpectedly. At the same time, downside risks to the Chinese economy are certainly not new (see below). Moreover, China’s economy has lost momentum in the course of this year, but macro economic data are still pointing to a gradual slowdown. All in all, the way the authorities handled the stock market rout and communicated the change in the exchange rate regime seem to have raised doubts about their capability to manage macroeconomic and financial stability risks.
published on 5 August). For instance, banks were instructed to provide lending, alongside the PBoC, to the national marging trading provider (CSF). The severe policy reaction shows that the government is prepared to launch short-term stabilisation measures, even if that might hurt longer-term goals. Still, the measures have raised questions on the government’s commitment to financial liberalisation. The developments also illustrate the need to improve the governance of the equity markets. Meanwhile, the stock market correction adds downside risks to the economy (confidence effects, lower contribution financial services to growth), but overall (wealth) effects look relatively contained.
Stock market rout SSE index, A shares
7000 6000 5000 4000 3000 2000 1000 0
2. What does the stock market correction tell us? After having more than doubled since October 2013, Chinese stock markets lost some 40-45% since mid-June, although with some stabilisation in recent weeks. The sharp correction partly comes from concerns on China’s slowdown, but has been magnified by the tightening of margin requirements and the closing of leveraged positions. The correction should be placed into some perspective. The extreme rally over the past year, partly driven by supportive policies and the increased use of margin lending, was not in line with fundamentals and looked unsustainable. In that sense, the correction is even welcome to a certain extent. The authorities have rolled out a wide range of measures in reaction to the stock market rout (see our China Watch
00
02
04
06
08
10
12
14
Source: Thomson Reuters Datastream
3. Did the change in the CNY regime make sense? Yes, but communication could have been better. The authorities wanted to show commitment to incorporate more market elements into the CNY regime, in the run-up to the IMF’s decision on SDR inclusion (which has been delayed to 2016). What is more, pegging the currency to a strong USD was hurting China’s external competitiveness. Some currency depreciation will not only help to restore competitiveness somewhat, but can also help pushing Chinese inflation a bit higher. Although we expect some more moderate CNY weakening in 2015 and 2016, we do not think that the yuan
2
China Watch: Ten urgent questions – 21 September 2015
devaluation will trigger a full-blown currency war. First, the steps taken so far are not very aggressive. Second, we expect the CNY to remain a heavily managed currency, as the authorities aim to avoid too sharp a depreciation. 4. So, what are China’s key macro-financial risks? For long we have pointed to several key macrofinancial risks – next to (geo)political – risks that may trigger a stronger slowdown or even a hard landing of the Chinese economy, if they are not managed well. In our view, the most important macro-financial risks that could derail our base scenario of a gradual slowdown are: 1. China is faced with elevated debt levels, partly resulting from the major stimulus package that was unrolled in 2008. China’s overall debt levels are estimated to have risen to around 280% of GDP, making them comparable to those of developed economies such as the US and Germany and being high for EM understandings. In our view, these debt levels should be reduced over time to safeguard China’s longer term growth path.
China’s debt build-up
5.
Finally, while the core of the financial system is clearly state-supported, linkages between real estate, local governments and shadow banking activities pose risks. Moreover, the industrial slowdown and falling corporate profitability is driving a rise of non-performing loans.
5. Will the authorities be able to engineer a soft landing? That’s indeed our base scenario. Although downside risks are rising, deleveraging is easier to steer in a high growthenvironment than in a low-growth environment. Moreover, the government is prepared to focus on short-term economic stabilisation even if that would (at least temporarily) compromise longer-term reform goals Moreover, there is still room for monetary and fiscal stimulus (see below). What is more, China has a strong external position. The current account surplus has risen to around 2.5% of GDP. Moreover, despite the recent drop explained by FX interventions to keep the CNY from depreciating too much , FX reserves remain abundant also in comparison with imports and foreign debt. This gives China more leeway to cope with external threats. Finally, China has a stable political environment, although that does not mean there are no policy and (geo)political risks.
Indices, 2010 = 100
Room to manoeuvre?
300
Indices, 2010 = 100
250 200
20
22
15
21
150
10
100
5
50
0
0
-5
2000 Government
Households
2007
2014
Fin. institutions
Non-financial corporates
Source: McKinsey Global Institute
2.
3.
4.
The old growth model driven by public investment and exports is unsustainable. China cannot continue boosting investment, while the global market is not large enough (also reflecting China’s rise) to sustain the high export growth rates of the past. However, tweaking the country’s growth model is not easy and comes with risks to growth. As a legacy of the past investment-led growth strategy, China’s industrial and real estate sectors are faced with significant overcapacity. This is depressing investment demand and has driven producer prices into deflation territory for several years now. This overcapacity will remain a drag on growth for the coming years, which could trigger broader effects pulling down overall growth. While reforms such as financial liberalisation are needed to safeguard China’s longer term growth, the opening up of China’s financial system to the global financial markets poses several financial stability risks, such as the potential of spikes in capital outflows.
20 19 18 17 16
-10
15 08
09
10
11
Headline inflation (lhs) Policy rate (lhs)
12
13
14
15
Producer price inflation (lhs) Bank RRRs (rhs)
Source: Thomson Reuters Datastream.
6. What kind of stimulus can we expect? On the monetary front, the PBoC lowered the key policy rates by 100 bps over the past year and general banks’ reserve requirements (RRRs) by 200 bps. Still, the difference between the key policy rate (4.6%) and headline inflation (2% yoy in August) remains large. Also, RRRs (at 18%) are still high from an international perspective. We expect the PBoC to remain quite cautious with regard to policy rate cuts, given its longerterm goal of reducing overall debt levels. We expect one more policy rate cut this year. The authorities are likely to use RRRs more actively, also in reponse to the liquidity drain stemming from FX interventions. We expect 50 bp in additional RRR cuts this year, followed by another 150 bp next year. We expect the PBoC to use other parts of its monetary toolkit as well, including its standing facilities, targeted lending to policy banks
3
China Watch: Ten urgent questions – 21 September 2015
or targeted RRR cuts for financial institutions with a specific mandate (like SME lending). But there is more in the authorities’ toolbox. The authorities also use targeted fiscal stimulus and we expect them to continue, particularly in the form of more infrastructure spending and specific targets such as shanty town and rural development. The expansion of the local government debt-tobond swap programme could also provide some leeway for local governments to keep spending up. Moreover, the authorities will continue to use prudential regulation. They have for instance abolished the loan to deposit ratio and have eased downpayment requirements for second homes. 7. Are rebalancing and reforms underway? To a certain extent. In our view, economic rebalancing is partly a natural phenomenon as wealth levels rise, but will take years anyway even if the government actively manages such a process. Investment still is the dominant spending category, although its share has fallen from 44.6% in 2010 to an estimated 42.4% this year. So far, the share of private consumption to GDP has risen from 36% in 2010 to 38% in 2015. However, private consumption is being underestimated in China’s GDP. What is clear is that the dominance of China’s industry is fading. Since 2012, services have become the largest sector, with its GDP share at almost 50% this year.
8. Do GDP figures tell the truth? The debate to what extent China’s GDP figures are reliable. has intensified after the official GDP numbers for Q1 and Q2 came in at 7.0%, in line with the 2015 growth target. Several alternative indicators have been developed and some of them point to growth of 4-5% instead. However, one of the characteristics of many of these alternative indicators is that they typically focus on activity data that are related to industry , where China’s economic weakness is indeed concentrated. While we cannot neglect China’s official GDP data, we also monitor alternative indicators and use Bloomberg’s monthly GDP estimate as one of the alternatives to GDP growth. This indicator averaged 6.6% for the first half of 2015, which is somewhat (but not that far) below the official GDP figures.
Official GDP figures and Bloomberg’s GDP estimate % yoy
14 12 10 8 6 4
Broadening and deepening reforms, such as SOE reform, is needed to support high-potential sectors and bolster private initiative in order to safeguard long-term economic growth. However, recent policy actions show that despite a whole spectre of reform plans, in practice ‘nationalist’ political goals are dominating economic reform goals in China too. Still, some reforms are underway, for instance in the areas of public finances (amendment of Budget Law, local government debt swap programme), deregulation or financial liberalisation, but more is needed. Moreover, the handling of the stock market and the exchange rate shows that the reform process is often characterized by ‘ taking two step forwards, one step back’.
07
08
09
10
11
Real GDP growth (official)
12
13
14
15
Bloomberg GDP estimate
Sources: Bloomberg, Thomson Reuters Datastream
In any case, improvement of Chinese statistics remains necessary. Recently, he National Bureau of Statistics announced that China will start calculating its quarterly GDP based on single-quarter data (in stead of cumulative data),to capture short-term economic fluctuations more accurately. This move would bring China closer to adopting the IMF’s Special Data Dissemination Standard, a global benchmark for macroeconomic statistics.
Services holding up better than industry % yoy
18 16 14 12 10 8 6 4 2 0 00
02
04
06
Industry Source: Economist Intelligence Unit.
08
Services
10
12
Agriculture
14
9. How is the Chinese economy doing currently? The economy is undergoing an ongoing slowdown, driven by the weakening of investment and construction activity which showed a clear drop in early 2015. Overcapacity in the industrial and real estate sectors will remain a drag to growth for a while. Consumption and services are holding up better, although the stock market correction leaves its mark and will reduce the growth contribution of financial services. All in all, after a weak start to the year, momentum stabilised in May and June. However, over the past months the economy has showed renewed signs of weakening. Meanwhile, government stimulus is helping to keep China’s slowdown gradual, with fiscal expenditure growing sharply in July and August.
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China Watch: Ten urgent questions – 21 September 2015
The August data published last weekend were quite a mixed bag. Fixed investment slowed to a 15-year low of 10.9% yoy (July: 11.2%). Industrial production rose marginally to 6.1% yoy (July: 6.0%). Meanwhile, retail sales growth rose to a seven-month high of 10.8% yoy (July: 10.5%). Overall, growth seems to have shown some stabilisation in August, with Bloomberg’s monthly GDP estimate coming in at 6.6% yoy (similar to July’s level).
Gradual slowdown continues
10. Why do we lower our 2016 growth forecast? Taking economic, policy and structural developments into account, we have cut our 2016 growth forecast from 7.0% to 6.5%. We are of the view that aiming for 7% growth next year would become too challenging and costly, while the relative strength of the labour market suggests that China can also live with 6.5% growth. All in all, in our base scenario we maintain our view that China is undergoing a gradual slowdown.
Key forecasts for the economy of China
% yoy
25
2012
2013
2014
2015e
2016e
40
GDP (% yoy)
7.7
7.7
7.3
7.0
6.5
35
CPI inflation (% yoy)
2.6
2.6
2.0
1.5
2.0
-3.0
20 30 Budget balance (% GDP)
15
25 20
-1.6
-1.9
-2.0
-2.5
Government debt (% GDP)
15
15
15
17
19
Current account (% GDP)
2.5
1.9
2.0
2.5
2.5
Gross fixed investment (% GDP)
44.5
44.6
44.2
42.4
41.8
Gross national savings (% GDP)
49.0
48.4
47.9
46.9
45.7
USD/CNY (eop)
6.3
6.1
6.2
6.6
6.8
EUR/CNY (eop)
8.2
8.4
7.5
6.6
7.4
10 15 5
10 08
09
10
11
Industrial production (lhs) Fixed investment (rhs)
12
13
14
15
Retail sales (lhs)
Source: Economist Intelligence Unit.
Growth, CPI, b udget balance, current acc. for 2015 and 2016 are rounded
Source: EIU, ABN AMRO Group Economics
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