Eng 2015 14 china by ABN AMRO

Global Ou utlook – 25 November 2015 2

China’s grow wth to slo ow furthe er in 201 6 and 20 017     

Arje en van Dijkhuizen Sen nior Economist Tel:: +31 20 628 8052 2 arje en.van.dijkhuizen@ @nl.abnamro.com m

2015: China co oncerns have e caused global turbuleence Whiile hard land n ding fears have h eased, risks remain We expect Chin na’s import picture to im mprove in 22016 Slow wdown to re emain gradu ual: growth falls to 6.5% % in 2016 an nd 6% in 201 17 Stilll, China’s on ngoing transition will come with occcasional hiccups

2015: China C spark ks turbulenc ce, but economic slowd down remain ns gradual Although h China has ca aused global turbulence this year, y our base sscenario of an gradual econo omic slowdow wn has held up.. Economic gro owth slowed fro om 7.7% in 20113 to 7.3% in 2014 2 and aroun nd 7% in 20 015, close to th he official targe et and our forec cast. After a weeak Q1 (1.3% qoq), q economicc growth came c in at 1.8% % qoq in Q2 an nd Q3. Annual GDP growth sllowed margina ally to 6.9% yoyy in Q3, while it was reporte ed at exact 7% % in the first two o quarters. Thiss caused a rev vival of the debate concerin ng the extent to o which China’s s GDP figures are reliable. Seeveral alternative indicators publishe ed by various in nstitutions point to figures of 4-5%, 4 but mostt of these have e a strong focuss on activity data d related to industry, where China’s weak kness is conceentrated. While we cannot neglect official o GDP da ata, we monitorr many indicato ors and use Blooomberg’s mon nthly GDP estimate es as an alterna ative growth tra acker. This indicator averagedd 6.6% for the first ten month hs of 2015, so omewhat (but n not far) below the official figurres.

China’s slow wdown remains gradual in n 2015

… although in nvestment co ooled sharply in early 2015 5

% yoy

3 30 2 25

2 20 9

1 15 1 10

5 5 08

Real GDP G growth (officcial) Source: S Bloomberg g

Bloom mberg GDP estimate

1 13

Industrial prroduction

Fixed investmennt

15 Retail sales s

Sou urce: Thomson Re euters Datastream m

Divergence betwe een industry y and service es is wideniing The shiftt of China’s gro owth model, aw way from industry and investm ment towards services s and consump ption, is a partl y natural phen nomenon (rising g wealth levelss will spur consumption) that will w take yea ars to play out ffully. Services have been the largest sector since 2012, with a share of almost 50% 5 of total vallue added in 20 015. Services are a holding up better than ind dustry, although h we expe ect the growth ccontribution of financial servic ces to fall in thee first half of 20 016. Industry and a construc ction cooled in Q3, to 6.0% yo oy (Q2: 6.1%), while servicess accelerated to o 8.4% yoy (Q2 2: 8.3%). Monthly M activityy indicators also o confirm this picture. p Industrrial production has gradually cooled, reaching r a posst-financial crisiis low of 5.6% yoy in Octoberr. Growth of fixed investment dropped sharply in earrly 2015, reflectting overcapac city in the indusstrial and real estate e sectors, and uently slowed g gradually to 10..2% yoy in Octo ober. By contraast, growth of retail r sales initially subsequ slowed in early 2015, b but recovered in the second half h of the yearr. This shows th hat the sharp on of the stock market in June e/July had a lim mited effect on consumer confidence and correctio spending g, as only a sm mall portion of households h invest in equities while stock ma arkets have stabilised. This diverge ence is also illu ustrated by the forward-lookinng PMIs.

Global Ou utlook – 25 November 2015 2

Hard la anding conc cerns have eased e …, The com mbination of we eak macro data a, the sharp sto ock market corrrection in June/July – after an n amazing g and unsustain nable rally –, and the unexpected adjustmennt in the excha ange rate regim me in August added a to China a’s hard landing g concerns. Th his caused turm moil on financia al markets, including g commodity m markets. Severa al months later, markets havee calmed some ewhat with rega ard to China a. The authoritie es have taken a range of mea asures to stabiilise the stock market, m including the build ding-up of intervventions funds s. While these measures m havee raised questions on the governm ment’s commitm ment to financia al reform, they have resulted in a stabilisatio on and even a recovery y of the stock m market. In addittion, fears have e eased that thhe devaluation of the yuan versus th he US dollar in n August would mark the startt of a currency war, as the au uthorities have prevente ed a sharp dep preciation by inttervening. The easing of hardd landing fears is also visible in the decliine of China’s C CDS premium,, from 140 bp in n late Septembber to just below 100 currentlyy.

PMIs also sh how that serv vices do bette er than indus stry

Hard H landing fears f have eaased in recen nt months

Indices

ndex, 1 Jan. 2013 = 100 In

6 60

CNY per USD U

6.5

2 250

5 58

6.4

2 200

5 56

6.3

5 54 1 150

5 52

6.2

5 50

1 100

6.1

4 48 4 46 11

12 13 3 Caixin Maanufacturing PMI NBS Manufacturing PMI

14 15 Caixin Services PMI NBS Non-manufacturin ng PMI

6 13

Stock market (lhs)

15 CDS premium p (lhs)

16 Exchange rate (rhs)

Sou urce: Thomson Re euters Datastream m

Source: S Thomson R Reuters Datastrea am

… but that does n ot mean the e risks have disappeareed Still, thatt does not mea an that there arre no longer an ny risks. As we pointed out be efore, China facces several macro-financia m al risks that, if poorly p managed d, have the pottential to deraill the economy: -

The e shift in China’’s growth mode el goes hand in n hand with maacro-financial riisks. The legaccy of th he old growth sstrategy is clea ar: overcapacity y in industrial aand real estate sectors is feed ding defllationary forcess and hurting profitability, p while remaining a drag on growtth. A failure to reduce overcapaccity (‘creative destruction’) cou uld backfire onn the economy in the longer te erm.

e rapid build-up p of debt. Debt levels have ris sen sharply sinnce the global crisis, c particularly The deb bt owed by com mpanies and fin nancial institutio ons. The growtth of aggregate e financing hass slow wed, partly than nks to the curta ailment of shad dow banking, bbut is still highe er than nominal GDP growth. Ove rall debt levels s are now estim mated at aroundd 250% of GDP P, comparable to ny western eco onomies, but ve ery high by em merging market standards. The authorities have man take en steps to low wer the debt burden (policy rate cuts, local ggovernment deb bt swap prog gramme, curta ailment of shadow banking), but b the deleveraaging process has yet to begin.

Fina ancial liberalisa ation comes wiith risks. The government hass taken steps to liberalise the e cap pital account, in n addition to tw weaking the exc change rate reggime, in the run n-up to the IMF F dec cision on inclussion of the yuan n in the SDR ba asket (we expeect a positive IM MF decision en ndNov vember). Still, lliberalisation allso poses finan ncial stability rissks, such as a shift in capital flow ws. Given its strrong external balances, b China is less vulne rable to the kin nd of balance-o ofpay yment stress th hat several EMs s occasionally face, but this m may change ov ver time.

Fina ancial sector ri sks stem from linkages with local governmeents and shado ow banks and risin ng NPLs affectting profitability y. The governm ment will becom me more selectiive with supporrt.

China’s rise as an n economic and d political heavyweight comess with geopolitical risks, as ations with neig ghbours and strrategic compettitors such as th the US will continue to be testted. rela

Global Ou utlook – 25 November 2015 2

Ongoin ng stimulus s will help slowdown rem main graduaal Now that we are aware e of the risks, th he crucial ques stion is: can thee authorities manage m them an nd hina towards a soft landing? We W think it will be a complex bbalancing act, but that the steer Ch answer is yes, they can n. The governm ment still has many m tools/buffe fers at its dispo osal to prevent a hard landing. These incclude monetary easing (e.g. policy p rate andd RRR cuts), fis scal stimulus (e e.g. g, tax cuts) and d easing of mac cro-prudential rrequirements (loan-to-deposi ( it infrastructure spending wnpayment req quirements forr housing). There is still a widee gap between n the key policyy ratio, dow rate (4.3 35%) and head line inflation (a around 1.5% yo oy). Although w we expect inflattion to rise to 2% 2 in 2016, we see room ffor further easing. We have pencilled p in anoother 50 bps cu ut in 2016. We ( bps), as RRRs R remain hhigh from an intternational anticipatte more scope for RRR cuts (150 perspecttive. We also b believe the PBo oC will use othe er parts of its m monetary toolkiit, including its lending facilities, f targetted lending to policy p banks orr targeted RRR R cuts with a sp pecific mandate e (like SME lending). We e also expect ongoing o fiscal stimulus and eaasing of pruden ntial requirements.

Im mport contraction partly, n not fully, driv ven by price

More room ffor stimulus % / % yoy

% yoy

2 20

100

-5

-25

-10

15 08

Headline in nflation (lhs) Policy ratee (lhs) Source: S Thomson R Reuters Datastrea am

Produ ucer price inflatio on (lhs) Bankk RRRs (rhs)

-50 06

Imporrt values

13 3

Estimated import i volumes

Sou urce: Thomson Re euters Datastream m

We exp pect China’s s import pic cture to imprrove in 20166 Although h China’s econ nomy appears to t be landing softly, the globaal economy and d commodity markets have felt the n negative effects s of a contraction in China’s im mports in 2015 5. In the first ten months of o 2015, merch handise imports contracted by y around 15% in value terms. There was a sharp drrop in early 201 15, on the back k of a slowdown in investmennt, which is still affecting the year-on--year numbers.. Lower import (including com mmodity) pricess explain the bu ulk of this drop. Our (rough) estimates suggest that China’s C merchandise imports hhave contracte ed by around 5% in volum me terms so far this year. Why y Chinese impo orts have been so much weak ker than the overall economy e is nott entirely clear, keeping in min nd that the yuaan has apprecia ated in real effective e terms. Part off the explanatio on stems from the t shift from inndustry to cons sumption, affecting g the demand fo for commodities s and certain other o goods. Suubstitution of im mports by domestic cally produced goods may als so have played d a role, along w with de-stockin ng. Still, as we expect China’s C econom mic slowdown to t remain gradu ual and negativve base effects s to fade out bit by bit, we fo oresee China’ss import data im mproving in 201 16 compared too 2015.

Economic growth to slow to 6.5% 6 in 2016 6 and 6% in 2017 Putting all a the pieces o of the puzzle together, we exp pect economic growth to slow w from 7% in 20 015 to 6.5% in 2016, as we e think that aim ming for 7% grow wth in 2016 ass well would be ecome too challeng ging and costly.. At the same time, t the relativ ve strength of th the labour mark ket suggests th hat China ca an live with 6.5 5% growth nextt year. We expe ect the graduall slowdown to continue in 201 17, with economic growth ffalling to 6%. All A in all, our ba aseline scenarioo assumes the e authorities willl be able to manage m the ma acro-financial risks and contin nue to steer Chhina towards a soft landing. Still, S China’s transition will u undoubtedly co ome with occas sional hiccups, as was clearly y the case in 20 015.