China: policy support offsetting structural headwinds

Shanghai

Despite concerns that China’s economy was undergoing a ‘hard landing’ in January 2016, fiscal, monetary and other government policy stimulus ensured that it was growing slightly faster at the end of the year than it had been at the start. Nevertheless, with the country in the middle of a structural transition from investment towards consumption, we expect its growth rate to come under renewed pressure as the effects of this stimulus wear off. That said, we also expect China’s authorities to manage its economic slowdown by providing further stimulus as and when required.

What is driving China’s growth?

The stabilisation of China’s economy has been of the most positive developments for investors over the past year, as the country has become the primary driver of global growth. However, in judging how China’s growth will progress in the coming years, it is important to understand what has driven the economy’s better-than-expected performance since the start of 2016 and how these trends may progress:

1. Rapid credit expansion

The rate of credit growth in China remains above the rate of GDP growth; over the longer term we see this situation as unsustainable (Figure 1). High debt levels reduce productivity through the inefficient allocation of capital, while they also increase the risk of defaults, particularly if growth slows. Recently, China has shown that it is beginning to rein in the rate of credit growth to bring debt-to-GDP levels to more manageable levels, with a particular focus on the country’s large shadow financial system. Some of the methods it is using include withdrawing financing for unviable firms and slight raises to borrowing costs. The clampdown on bond market leverage appears to be working, with corporate bond issuance having fallen significantly in recent months.

Chinese credit growth

Figure 1: The rate of debt creation continues to outpace the rate of nominal GDP growth within China. We are concerned that this is unsustainable over the longer term and when the cyclical tailwind of credit creation declines, we expect China’s economic growth to come under renewed pressure.
Source: Thomson Reuters Datastream

Although defaults can be highly problematic for investors, it can also be argued that by allowing weaker firms to fail China’s authorities will boost the economy’s longer-term growth prospects and resilience. We note that contagion from such events has been limited in the past as a result of government intervention. Nevertheless, a fall in the rate of credit creation will weigh on economic growth, particularly in sectors such as real estate where the benefit of rapid credit creation has been greatest in recent years.

2. More accommodative monetary policy

The People’s Bank of China (PBoC) cut its benchmark lending and bank reserve requirement rates significantly between late-2014 and 2016 to support the economy and to reduce risk within the financial sector. Although it has kept both rates steady in recent years, it has recently begun to raise the rates at which it lends to commercial borrowers through other facilities, specifically its short and medium-term corporate financing operations.

The decision to raise the rates of these supplementary lending facilities has had various effects. Although it has only marginally raised the actual cost of financing to corporates, it has also sent a message to borrowers and potential borrowers that the authorities are now seeking to curb excessive credit risk taking in the financial system. A side effect of the rate rises is that the interest rate differential between China and the US will expand more slowly (the Federal Reserve is raising US interest rates); this is helping the PBoC manage the US dollar-renminbi exchange rate by stemming the flow of capital out of the country.

China’s authorities have stated that the marginal increase in lending rates does not represent a broad swing in monetary policy. However, it is increasingly apparent that with the global economy strong and domestic growth above the government’s target rate, they are increasing their focus on containing credit risks, rather than solely supporting growth. Nevertheless, we recognise the fact that Chinese interest rates are high relative to those of the country’s developed market peers and there remains significant room for policy to loosen if necessary. Further loosening of monetary policy could impact sentiment and the renminbi, however, and this presents a longer-term challenge for Chinese policymakers.

3. Higher fiscal spending on real estate and infrastructure

The rate of private fixed investment has been falling for a number of years, particularly since late 2014 when declining producer prices began to force industries in states of structural oversupply, such as steel production, into painful supply-chain adjustments. To combat this, the government enacted a large fiscal stimulus programme at the start of 2016. This boosted investment in some of the old-economy sectors that China’s authorities are seeking to transition the economy away from over the longer term, supporting overall investment. It also pushed out some undesirable private investment, helping further the longer-term adjustment process in a managed fashion.

With large supply-chain adjustments having now been made and China’s stabilisation having helped improve sentiment in global commodity markets, leading to higher commodity prices, Chinese producer price inflation has bounced back into positive territory (Figure 2). This catalysed a bounce in private-sector investment at the time that the effects of the government’s fiscal stimulus began to wear off. Although it is yet to be seen whether this increase in private investment is sustainable, particularly if the rate of credit creation continues to decline, we expect the improved global economic backdrop to provide some support. Positively, it is possible that new investment is of higher quality as China’s authorities are currently stepping up efforts to curb property speculation, while opening up access to previously off-limit sectors, such as defence.

Chinese investment

Figure 2: China enacted a large fiscal stimulus package at the start of 2016 to boost investment. As the effects of this package have worn off, rising producer price inflation has begun to revitalise private investment growth, offsetting impact on overall investment activity.
Source: Thomson Reuters Datastream

4. The devaluation of the renminbi

Another trend that supported private investment in recent years was the devaluation of the renminbi (Figure 3); this has boosted the international competitiveness of Chinese exporters. However, Chinese policymakers have held the trade-weighted renminbi relatively stable over the last six months and their rhetoric suggests that this will be the case for the foreseeable future. Although this stability has been beneficial for international trade, particularly in the Asian region, we see it unlikely that Chinese growth will be provided another significant foreign-exchange rate boost unless it is needed (which will mean the economy will have already deteriorated).

An additional consideration is that Donald Trump has made it clear he sees the renminbi as undervalued, even if he has stopped short of labelling China a ‘currency manipulator’ (Trump stated that he made this decision to align the two countries’ stances on North Korea). If he were to revisit the renminbi’s weakness (against the dollar), this could significantly damage investor sentiment; if the US dollar begins to strengthen again, we would expect this situation to become more of a problem (we note that it has so far been weak in 2017).

The renminbi’s strength

Figure 3: since mid-2015, China has weakened the renminbi against those of its trading partners to support its large export sector. However, since late 2016 it has kept the currency more stable.
Source: Thomson Reuters Datastream

5. Acceleration in global growth

The acceleration in global growth has supported demand from the developed markets and had a positive effect on China’s large export sector. Adjustments in global commodity supply chains have been a major factor boosting industrial commodity prices; in turn, higher commodity prices have underpinned the acceleration in Chinese producer price inflation which has supported private investment in the country’s industrial and manufacturing sectors.

Conclusion

Ultimately, we believe that China’s economic growth rate will continue to slow in time. As Beijing begins to prioritise deleveraging and risk mitigation, a slower rate of credit creation will inevitably impact growth, in terms of both consumption and investment activity. This will be the case whether the slowdown in credit growth is the result of higher borrowing costs, scarcer availability of credit, or restrictions on borrowing.

Nevertheless, we expect any adverse impact of slowing credit growth to be managed. The PBoC is unlikely to tighten monetary policy aggressively, with monetary policy already tight relative to that of most developed world economies. There are still many levers that can be pulled to support investment and consumption if growth slows too fast, although we are mindful weak credit demand could become a headwind.

Encouragingly, the Chinese government retains huge financial firepower and is able to provide large fiscal stimulus if slowing credit growth weighs too heavily on the economy. We are less certain that it will be able to further devalue the renminbi, as future foreign exchange market interventions could have an adverse impact on economic sentiment; most investors see further devaluation of the renminbi as a last resort.

Investors are faced with some important questions; when will China’s economic growth slow and by how much? It is clear that the government wants the decline in the country’s growth rate to be gradual and we are mindful that it is unlikely to want growth to slow ahead of the country’s 19th Communist Party Congress, which is due to take place in the autumn. However, with growth in the first quarter of 2017 having been well ahead of the government’s official target (6.5%), we see the authorities’ decisions to change tact on credit expansion as opportunistic and it is possible that growth will be allowed to slow more quickly later in the year.

Although China’s overall growth situation is largely understood by investors, any weaker-than-expected major economic data releases could adversely impact economic and investor confidence. With China a key driver of global commodity markets, and therefore the countries and companies that produce these, such incidents could lead to short-term bouts of global risk aversion. If such events become frequent, they could eventually cause the broader investment backdrop to deteriorate. Conversely, if growth beats expectations, as was the case in 2016, then China will continue to drive positive economic and investor sentiment.

 


This article was first published by Brookes MacDonald in 16th May 2017.