Dark clouds have been hanging over China in the past few months, but the situation seems to be improving. Normally, we are cautious in drawing strong conclusions from the economic data reported in the first quarter of the year, as it is to some extent distorted by the Chinese Lunar Year. Still, it clear that China’s economy has lost momentum. Efforts to curb shadow banking and to reduce high debt have hurt sentiment and are weighing on economic activity. Even fears of a hard landing, which return now and again when China’s economy slows, have resurfaced. We think that these fears are overstated. Indeed, authorities remain committed to maintaining a growth target of around 7.5%, unchanged from 2013. We think that this target will be achieved, albeit with the support of some stimulus. Meanwhile, in early April authorities opted to speed up certain projects which were positively embraced by investors. We maintain our growth forecast of 7.5% in 2014 and 7% in 2015.
A bumpy start to 2014, but GDP growth will be defended
Most of the high frequency indicators in the first quarter of the year, including fixed investment and industrial production, have shown a slower pace of growth compared to the first quarter of 2013, while price pressure continues to be absent. GDP growth in the first quarter of 2014 was 7.4% yoy compared to 7.7% the previous quarter. We think that weaker domestic activity reflects the negative impact of stricter reforms, including measures to contain high debt, cut overcapacity, control pollution and rein in corruption. But despite this eagerness to rebalance the economy, the government announced during the 12th National People’s Congress that it wants to maintain the target of GDP growth at 7.5% in 2014. But it has also become clear that the GDP growth target is not the only priority. Environmental issues and deleveraging (the reduction of debt/GDP) are part of the ambitious agenda.
Reform momentum is accelerating…
China’s leaders have proven to be hard-line reformists. During November’s Third Plenum, a comprehensive reform agenda was presented that was more ambitious than expected, while the Report on the 12th National People’s Congress in March highlighted more details surrounding the reforms. In the context of financial reforms, deleveraging is taking the lead, complemented by actions that should smoothen the process, including the deposit insurance schemes, which are to be established before the end of the year, the widening of the FX band, increased accountability regarding the budget and local government, tax breaks for SMEs as well as lowering the barriers for State-Owned Enterprises (SOE). Premier Li also called for orderly progress on urbanisation and cautiously pushed for pilot land reform.
In our view, the pace of reforms has accelerated in the past few months. Announcements are now turning into actions. The fragilities of the financial system are forcing authorities to give solid signals that all is going as planned. For instance, SINOPEC, the Chinese refining giant, is now allowing private capital, while China National Petroleum Corp has raised capital through joint ventures. Moreover, the FX band widened in March, a move that gives the currency more flexibility in preparation for greater openness in the capital account. This should reduce the speculative capital that was in search of a strong currency, but it should also favour export growth. Another reform, the “New-Type Urbanisation Plan” announced in March is likely seen as a way to speed up infrastructure investment. This could reverse the negative sentiment and support the economy, but it could also push authorities back into the habit of relying on investment projects for achieving higher growth.
In the past decade, urbanisation policies encouraged wasteful investments funded by large debts. We therefore agree that the focus should be on a different type of investment in urbanisation. This should include greater involvement of the private sector in funding large projects and higher incomes for migrants to stimulate consumption, while enhancing growth quality. Another set of measures reported by the state media suggest that several Chinese cities may relax restrictions on home purchases that have been used to rein the property prices.
…while a new round of “mini” stimulus is on the way
The uncertainty mainly surrounding deleveraging has impacted investor sentiment and concerns of a hard landing have increased. Most analysts assumed that support was needed to ensure that the economy was on track. After the urbanisation plan was announced, during a State Council meeting in early April, Premier Li mentioned that the Cabinet would accelerate construction of railways in the central and western parts of the country and support the financing of low-cost housing through the China development bank. This “mini” stimulus seems like a repeat of last year’s support, small in scope but sufficient to shift market confidence. Indeed, last year’s investment in the railways was complemented by tax breaks, which was enough to put the economy on firmer footing. So far, markets have responded with optimism to the measures announced by the authorities.
The outlook: no hard landing
Although the reform process, particularly deleveraging, has increased the downside risks to our 7.5% growth forecast, China has certain special characteristics that make it an unlikely candidate for a hard landing. First, the role of the government is so embedded that if economic conditions deteriorate, the government can oblige banks to lend and state-owned enterprises to invest. Second, the government has sufficient firepower. Spending is possible because the government has both current account and fiscal surpluses, and debt and inflation are low. Third, the economy is going through a rebalancing process that favours consumption in which there is plenty of room for other sectors to grow, including the service sector (health industry), which could mitigate the impact of sectors that are downsizing (manufacturing). Fourth, China’s financial system has an extraordinary buffer in the form of a high savings ratio, which was around 50% in 2013. Given the limited alternatives for investment, including controls on capital outflows, this source of funding seems rather stable. As for monetary tools, the People’s Bank of China has room for manoeuvre. Reserve requirement ratios and interest rates are high. Aside from these characteristics, advanced economies have shown a steady pace of recovery. The US and eurozone are important trading partners for China and the growth in their external demand should support China’s export growth. We expect GDP growth to gradually increase through the rest of the year. Investment growth will continue to pick up somewhat in the second half, while exports and consumption will help the economy maintain its dynamism and avoid escalation of the deleveraging process.
Risks to the outlook: deleveraging and the property market
Although we have incorporated the impact of some reform-related volatility in our growth forecast for this year, there is always the risk that sentiment could deteriorate abruptly during the deleveraging process. At around 170% of GDP, China’s corporate debt is among the highest in the world. The corporate sector includes state-owned enterprises and real estate investors. In the case of the former, many are facing overcapacity and it is unclear whether their earnings will be sufficient to service their debt. Many SOEs, at least those that are strategic, benefit from strong implicit government support, which suggests that the process of deleveraging could be orderly. Meanwhile tightening of credit growth has made the future of real estate developers more uncertain. Indeed, property investments have been weak in the first quarter of the year. Moreover, many companies in the property sector are financed by trust funds, a segment of shadow banking. Shadow banking is shrinking and this could affect the supply of loans for the sector or possible rollovers. The question that surrounds the property market now is twofold: how profitable have investments been in the past and will property demand continue to grow this year, thus avoiding an oversupply problem. Construction accounts for around 7% of GDP, while the indirect contribution of the property market to GDP has been estimated at around 16% of GDP. Given the linkages within the economy, this could have broad spillover effects if the deleveraging process is disorderly.
All in all, China’s leaders have the potential to exercise policy flexibility and the means to support the economy, but in this process authorities must not forget their search for better quality growth. Otherwise, they will simply be postponing dealing with a situation that is only becoming more complicated to solve.