At the closing ceremony of the Chinese Communist Party’s 19th five-year National Congress, President Xi Jinping’s banner term “Thought on Socialism with Chinese Characteristics for a New Era” was written into its constitution, taking its place among the formal ideologies of his predecessors. Meanwhile, there are suggestions that he may remain in power past the traditional ten years, with a notable lack of successors appointed to the Politburo’s seven-man standing committee. These developments provide evidence of Xi’s dominant position in Chinese politics and suggest that his ability to reform has strengthened ahead of his second five-year term. Nevertheless, questions remain over his propensity to use this power to address China’s structural problems at the expense of near-term growth and the government looks set to retain its central role in credit creation and resource allocation.
Chinese GDP growth data has come in at the higher end of the government’s official target range of 6.5%-7.0% so far this year, beating market expectations (Figure 1). There have been a few major drivers of this outperformance. Firstly, changes in the country’s foreign-exchange policy and the acceleration of global growth have supported the country’s exports (Figure 2). The economic benefit of the government’s early-2016 fiscal stimulus programme has also persisted for longer than expected. Meanwhile, the performance of China’s second and third-tier cities’ property markets has been better than expected, offsetting the adverse effects of property purchase curbs in its first-tier cities.
Chinese consumption and production growth
Figure 1: Bucking the longer-term trend, Chinese GDP growth has actually accelerated in 2017 as the government has enacted stimulus to help the economy transition from investment-led towards consumption-driven growth. Nevertheless, it is expected to continue to slow over the course of the next twelve months. Source: Thomson Reuters Datastream
Foreign exchange policy and Chinese exports
Figure 2: At the start of 2014, the Chinese government began weakening the renminbi to support the country’s large export sector. Although the renminbi has been allowed to strengthen against the US dollar in 2017 as the latter has weakened, it has been kept relatively stable against the currencies of china’s other major trading partners. Nevertheless, the appreciation against the dollar may weigh on China’s export sector over the coming year. Source: Thomson Reuters Datastream
Although these trends have helped the economy beat expectations so far this year, they all face headwinds that are likely to diminish their efficacy in time. Although we expect global growth to remain positive, supporting demand from overseas, China has allowed the renminbi to strengthen this year and this could weigh on export growth over the next twelve months. We would also expect the economic benefit of the government’s fiscal stimulus to decline in time, notwithstanding further fiscal stimulus. More pertinently, we expect activity in China’s large property sector to slow as its authorities act to prevent overheating in its second and third-tier cities via restrictions on speculative activity, as they already have in its first-tier cities (Figure 3). This will also weigh on activity within associated sectors, such as construction, steel production and mining; we note that China still has some way to go to address structural overcapacity in many industries.
The Chinese property market
Figure 3: There are signs that China’s housing market is beginning to come under cyclical pressure while the government is acting to stop it from overheating. This has wide ranging implications for growth and investor sentiment. Source: Thomson Reuters Datastream
he rate of credit creation continues to outpace the rate of GDP growth in China and this is unsustainable over the longer term. China’s authorities are aware and have already begun to act to control the rate of credit creation by increasing the rates at which certain firms and individuals can borrow. Nevertheless, more will need to be done to create a sustainable environment whereby the rate of credit creation is below the rate of growth. Unfortunately, by slowing the rate of credit creation, the government could start a vicious cycle whereby slowing growth will require further cuts to the rate of credit creation. The controls that have already been implemented have already begun to affect investment, which will weigh increasingly on growth over the next twelve months.
Although the rate of credit creation will have to fall in time, there are still options for the government to support economic growth and avoid a vicious cycle. It still retains significant firepower to enact new fiscal stimuli if it chooses to and we are cognisant that it has done this in the past as and when required. It also has other levers to pull, such as devaluing the renminbi; however, we note that this policy has drawn a concerned reaction from investors in the past.
With many policy levers still at hand, we believe the government will continue to be successful in managing China’s economic slowdown. However, the country’s authorities have taken a pragmatic view in setting its official growth target in the past and now that Xi Jinping has consolidated his power as President ahead of a second five-year term, it is possible that he will be more aggressive in tolerating slower growth to allow the implementation of reforms.
It has become increasingly difficult for inefficient government entities to facilitate economic growth through debt. However, by reducing fiscal spending, relaxing access for foreign investors and implementing market-oriented reforms of the financial system and exchange rate, the government could transition the economy towards more effective private investment.
As well as signs that the government is ready to act to control the rate of credit creation following the significant build up of corporate debt that has occurred over the past decade, China has a number of other problems which also need to be addressed. For example, the President is expected to strive to contribute to the success of the Paris Climate Accord by cutting environmental pollution. He has also promised to improve public services, strengthen the military and increase patriotism through a focus on Chinese culture. These commitments indicate that Beijing is unwilling to achieve economic success while ignoring social problems.
President Xi’s philosophy aims to fulfil the long-term goal of developing China into “a great modern socialist country that is prosperous, strong, democratic, culturally advanced, harmonious, and beautiful” in two stages by 2050. Such broad, vague long-term goals make predicting shorter-term targets such as annual growth expectations difficult. However, we are encouraged that the governor of the People’s Bank of China (PBoC), Zhou Xiaochuan, has stressed that he is keen to address any build up in economic tensions before problems arise, in particular problems associated with the build up of corporate debt. This leads us to believe that the government is open to restructuring troubled areas of the economy, such as bank lending and the property market, imminently, even at the cost of slower growth.
Underlying demand for housing remains encouraging, while the global economic backdrop is supportive of Chinese export growth. Likewise, corporate profits have been boosted as producer price inflation has bounced back this year and this will provide some support to investment, even if it has been impacted by the recent clampdown in corporate borrowing. We note that industrial and manufacturing growth remains robust, while consumption growth is even higher (Figure 4), backed by China’s strong labour market and consumer optimism. These traits provide China’s authorities room to make progress in reforming problematic areas of the economy while also maintaining a robust overall growth rate.
Chinese consumption and production growth
Figure 4: Although Chinese retail sales and industrial production growth are structurally slowing over the longer term as the economy grows, they have held up well in recent years as the government has used reforms and stimulus to support activity. This presents an opportunity to combat structural problems facing the economy. Source: Thomson Reuters Datastream
What does this mean for investors?
China’s better-than-expected economic performance has improved investor sentiment globally, particularly in the emerging world, Asia and within global commodity markets. However, the trends that have driven its outperformance look unsustainable over the longer term.
So far in Xi Jinping’s tenure, he has shown a willingness to confront China’s structural problems, but not at the expense of growth. Nevertheless, he may show a higher tolerance for slowing growth now that his second term has begun and we believe this raises the possibility of investor disappointment, either with the government’s growth target or as actual growth slows faster than expected. However, we still expect the government to maintain its desire to keep economic growth robust as the country continues its transition from investment-led towards consumption-driven growth. Importantly, it retains the ability to do so.
Investors are particularly wary of China’s debt problems and any growth disappointments could be perceived as associated with authorities losing control over the credit-fuelled economy. This could adversely impact global investor sentiment, as China remains the world’s major growth driver. However, it is no secret that the country’s authorities are moving to slow the rate of credit creation and over the longer term, we believe such adjustments are necessary to bring China onto a more sustainable long-term growth trajectory. Furthermore, China has shown a willingness to act to contain risks to maintain stability, as have central bankers elsewhere in the world.
This article was first published on the Brookes MacDonald blog 0n 14th November 2017.