China is navigating unchartered waters as it moves towards a consumption-driven economy. With some support, economic data have gained strength in the second half of the year, after growth slipped in the first half. It has also been a year since the leadership transition, and the authorities have been trying to stamp their footprint on the reform agenda. November’s four-day Third Plenum remained true to tradition by giving only guidelines for future reforms. The final decision released a few days later gave a more concrete overview of the reform areas. We expect policies and details of how they will be implemented to become clearer, however, over the coming year. There are upside risks to our GDP forecast of 7.5% for 2013. Our forecast for GDP growth of 8% in 2014 hinges on stronger global demand, while domestic demand will remain solid. As the reform agenda takes shape in 2015 and growth in credit moderates, we expect growth to slow down to 7%.
Stronger growth in the second half of 2013
Economic growth in the second half of the year has been robust, mainly thanks to the global recovery. Exports to the US and the eurozone have been gaining momentum, with negative growth rates now clearly a thing of the past. Exports to the US rose by an average of almost 6% over the past four months, while exports to the EU increased by an average of 4%. Growth in industrial production and retail sales has been picking up at a moderate pace, with the former increasing by 10.3% yoy in October (up from 10.2% yoy, and the latter remaining unchanged at 13.3% yoy). Growth in investments in fixed assets meanwhile edged down to 20.1% yoy in October, down from 20.2% yoy. These figures suggest that infrastructure and real estate investments are slowing, making way for investments in manufacturing.
Forward-looking indicators such as the PMI point to a strong fourth quarter. Both the official and the HSBC/Markit PMI have been trending upwards and are now at their highest levels since the end of 2011. Overall, activity data point to upside risks to our GDP forecast of 7.5% for 2013, while supporting our forecast of a firming of growth to 8% in 2014.
Monetary policy tightening …
Housing and consumer price inflation rates have been rising this year. The year on year growth rate of house prices in the past four months averaged 8%, while consumer price inflation rose to 3.2% in October from 2.5% at the end of last year. These developments, combined with high levels of corporate debt, have put China’s central bank on guard. In October, however, total social financing, which is seen as a broad measure of loans, fell to RMB 856bn after several months of robust growth. This suggests that new loans fell across the board, including short-term corporate loans, where demand had previously been particularly strong. This is likely to be in response to the central bank’s somewhat more prudent monetary policy in recent months, as well as the authorities’ goal of reducing excessive credit growth in the less-regulated shadow banking sector. Although the central bank has been trying to refrain from liquidity injections in the past few months, it has had to rethink this strategy on two occasions, given the sharp rises in the seven-day repo rate. We expect to see a slight shift towards monetary tightening over the coming period in order to neutralise the rising capital inflows.
…as capital flows increase
China has seen increasing net inflows of capital in the past few months, and the summer turmoil did nothing to reverse this trend. The combination of capital controls, a managed exchange rate and a current account surplus is likely to remain supportive of capital inflows. And if the economy gains momentum, it will attract even more inflows of capital. This, together with the Chinese currency’s role as a safe haven during the recent turmoil, has resulted in the RMB rising sharply in recent months, and indeed faster than any other currency in the region.
The path towards more sustainable growth
The timing of the stronger data was positive in setting the momentum of reform. A communiqué published after the Third Plenum outlined some general guidelines for China’s reform path over the coming years. These guidelines included a larger role for the market to determine key prices and emphasised the need to clarify the government’s role, as well as mentioning plans for rural reform, environmental protection and more openness for the economy. The communiqué confirmed the clear preference of China’s President Xi for reforming the role of the government. Perhaps these new elements reflect the emphasis being placed on property rights and the view that farmers should participate more equally in the process of modernisation and that the dual urban/rural structure should be disbanded. This should pave the way for ‘new’ urbanisation. Meanwhile, there is still a large question mark surrounding the future of state-owned enterprises (SOE). The dominant role of public ownership was re-emphasised in the communiqué. At the same time, SOEs will have to transfer capital to a social security fund and in the long-run profits to public finance. We do not expect any changes in the structure of SOEs in the short run, but the gradual liberalisation of prices could be the start of moves to make this sector more cost-efficient. The communiqué mentioned that a central committee would set up a ‘leading group’ to examine further structural reforms. A long-term measure announced after the plenum is the further easing of the one-child policy. Couples are allowed to have two children if one of them was an only child. This may not be a revolutionary decision for demographics, since fertility rates in Asia are in general low, but it is positive for social liberalisation. Estimates suggest that this would represent 1-2 million births per year over 20 years. Another measure announced is that local government’s performance will now focus on pollution, debt and not only GDP growth. We expect policies and details of how this all will be implemented over the coming year.
Outlook for 2014 and 2015
Despite the improving economic data, we do not expect a strong rebound in the coming year. Industrial production and consumption will support domestic demand, while the pace of growth in infrastructure investments will continue gradually declining. The coming year will be decisive in respect of the guidelines set by the authorities during the plenum. We also expect to see further steps to support the internationalisation of the RMB (e.g. a widening of the channels for inward and outward RMB flows), as well as more liberalisation of trade and services (for example, more specific details on the Shanghai Free Trade Zone). This implies that China will not undertake any controversial reforms that could have an adverse impact on growth in 2014. In 2015, however, we expect to start seeing the implementation of reforms that will rebalance the economy more forcefully (such as property rights for rural land owners), and this is one of the reasons why we are forecasting that growth that year will slow to 7%.
Risks to the outlook
Although the direct financial impact that the Fed tapering has on China should be slight, its indirect impact could be more noticeable. If the Fed’s tapering strategy is not clearly communicated, the weaker countries in the region are likely to face uncertainty and volatility. This could have an adverse effect on China, given its trade and financial interlinkages with these countries. Meanwhile, the RMB’s sizeable appreciation (around 26%) against the USD since 2005 carries the risk of a loss of competitiveness if the RMB continues to appreciate against the currencies of China’s major trading partners. If wages continue increasing in China vis-à-vis other Asian countries, a stronger currency will only add to its loss of competitiveness. In fact, exchange rate liberalisation has been announced as part of the Plenum priorities. Finally, we believe there is now some urgency to the reforms, if the rebalancing strategy is to succeed. Property price rises, for example, have accelerated in the absence of reforms to the financial system to allow interest rates to be liberalised and a broader range of investment alternatives. All in all, China is moving in the right direction, but timing is critical when reforms are imminent.