China Watch – Year of the Rooster will not be boring

by: Arjen van Dijkhuizen

  • Year of the Rooster challenging under a Trump presidency
  • External trade faces risks from rising protectionism
  • Growth in Q4 picked up a bit to 6.8% yoy, annual growth is slowing gradually
  • Real estate market correction has started
  • Capital controls and weaker USD support CNY in run-up to Inauguration Day
  • Negative but also positive surprises possible in 2017

 

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Year of the Rooster promises to be challenging

Today, Donald Trump will be inaugurated as the 45th President of the United States. And on 28 January, China’s lunar Year of the Rooster will start. A politically challenging year, that will bring rotations in the highest policy committee and will come with rising external risks under a Trump-presidency.  Talking about the Chinese Zodiac, Donald Trump (born in 1946) is a Dog, whereas China’s President Xi Jinping (1953) is a Snake. According to some horoscopists, “both signs have strong convictions and their disapproval of some of each other’s ways may prevent a close relationship. However, although not perfectly matched, they could work together if they are both realistic in their expectations of one another”. Taking that as a starting point, the Year of the Rooster will likely not be boring.

Risks to external trade from anti globalisation moves

We expect global trade to accelerate modestly this year on the back of a pick-up in global manufacturing, but there are risks stemming from the rise of anti globalisation sentiment. In fact, President Xi Jinping turned out to be the most prominent defender of globalisation at this year’s World Economic Forum meetings in Davos, reflecting that China has been the world’s biggest beneficiary of globalisation in this millennium so far. Trump will bring a more assertive US foreign policy. He has appointed a couple of ‘China hawks’ (e.g. Navarro, Lighthizer, Ross) in his administration. While trade disputes will possibly accelerate, our base scenario assumes a ‘moderate Trump’ who will not start a full-blown trade war with China, given the balanced power relationship between the two. However, markets may well be spooked from time to time by twists in the US-China relationship.

Imports are recovering, export growth still disappoints

Meanwhile, imports have rebounded during 2016 thanks to the firming of domestic demand on the back of fiscal stimulus. In December 2016, imports grew by 3.1% yoy. We export this recovery to extend into 2017, although import growth of certain commodities (particularly metals) could well cool due to the correction of the real estate market (see below). China’s exports have also risen in recent months, although annual growth in dollar terms has remained negative so far, despite yuan weakening in real effective terms. That reflects subdued global trade, despite signs of a pick-up in late 2016.

China Jan17 Chart 1 China Jan17 Chart 2

Growth in Q4 picked up a bit to 6.8% yoy, annual growth is slowing gradually

Real GDP growth in Q4-2016 picked up a bit to 6.8% yoy, a touch better than consensus expectations of 6.7%. This confirms that the economy has been steadying during 2016 on the back of stronger fiscal stimulus, after hard landing fears had flared up in 2015.  On an annual basis, growth continues its gradual slowdown, falling from 7.3% in 2014 to 6.9% in 2015 and 6.7% in 2016. The services sector remains the fastest growing sector (7.8%), followed by industry (6.1%) and the primary sector (3.3%). Although remarks made by a provincial governor recently may feed doubts about the quality of official data, Bloom-berg’s alternative GDP estimate points to an average growth of 6.9% in 2016, slightly above the official number. Meanwhile, the latest activity data show a more mixed picture. The forward-looking PMIs have clearly risen in the second half of this year and were generally strong in December. Retail sales accelerated further in December, to 10.9% yoy (November: 10.8%). However, growth of both industrial production and fixed investment dropped by 0.2%-point in December, to 6.0% yoy and 8.1% yoy ytd, respectively.

Real estate market correction has started

Underpinned by supportive policies, the housing market has shown a sharp recovery in 2016. New house prices in 70 large and medium cities rose by 12.4% yoy in 2016 compared to +1.6% in 2015 and a drop of 4.3% in 2014. In several cities, housing markets have shown more signs of overheating. With the economy steadying, the authorities have felt more confident to address this issue. In the second half of 2016, local governments in cities with signs of overheating have not only tightened regulation for home buyers, but also for property developers. This has been visible in a slowdown of mortgage loan volumes and property developers’ funding. These measures are resulting in e.g. a slowdown of residential floor space sold as well as in a correction of nationwide house price indices. House prices have fallen in mom terms in the last months of 2016 and the annual increase fell to 12.4% yoy in December, the first such drop since March 2015.

Trump/Fed-related capital outflows lead to further drop in FX reserves

In December 2016, FX reserves dropped by around USD 40 bn to USD 3.01 trillion. While the monthly drop was lower than in November (USD 69 bn), it marked the sixth one in a row. FX reserves have now lost almost 25% compared to the June 2014 peak. Still, they remain very high, covering three times total external debt. The decline in FX reserves is driven by rising net capital outflows, next to FX interventions and valuation effects, although these remain below the late 2015/early 2016 levels. Their increase was triggered by a Trump and Fed related rise of US bond yields and a USD strengthening, causing domestic residents to rebalance positions on rising expectations of yuan depreciation.

China Jan17 Chart 3 China Jan17 Chart 4

Beijing reacts by tightening capital controls further

Despite rising external risks (see our previous China Watch, External risks are rising in a Trumpian world), we still think Beijing will be able to keep the situation under control. In line with our expectations, Beijing has “solved the impossibile trinity” (or Trilemma: a country cannot have a  fixed exchange rate, free capital movements and an independent monetary policy at the same time) by tightening capital controls. In recent weeks, the authorities have tightened regulation for outward direct investment, suspended foreign acquisition of non-industrial assets (such as real estate), and tightened conditions for FX purchases by individuals. They have also issued new reporting regulations regarding large/suspicious financial transactions. Last but not least, they squeezed liquidity on the offshore CNH market to punish short sellers and readjusted the CNY fixing.

In the run-up to Trump’s inauguration, yuan has appreciated sharply versus USD

These measures triggered an upward correction of the CNH and, to a lesser extent, the CNY versus USD. The yuan correction gained further strength due to the recent USD weakening, partly reflecting statements by Trump that ‘the dollar is overvalued while China is keeping its currency artificially low’. Since 4 January 2017, the CNH has regained around 2% versus the US dollar and the CNY around 1%. Meanwhile, the PBoC broadened the yuan basket from thirteen to 24 currencies as of 1 January 2017, reducing the US dollar weight in the basket from 26.4% to 22.4%. Against the background of our expectation that the US dollar will strengthen across the board this year, we forecast a modest deprecation of the CNY versus USD to 7.15 per end-2017.

Producer price inflation jumps to five year high, headline inflation still modest

After years of deflation, PPI inflation has become positive again, jumping to a five-year high of +5.5% yoy in December. This is mainly driven by sectors such as mining and raw materials, on the back of a commodity price recovery and overcapacity reduction. CPI inflation fell back to 2.1% yoy in December, remaining below the 3% target. Core inflation is rising gradually but remains low (at 1.9% yoy) as well. We expect the PBoC to keep the key policy rate on hold this year, with stimulus having shifted to the fiscal front, although we still see some room for RRR cuts. Problems at a small broker firm triggered a squeeze of interbank liquidity in December, but this was resolved by PBoC actions rather quickly.

China Jan17 Chart 5 China Jan17 Chart 6

Deleveraging has not started yet

Despite recent measures to stem credit growth including shadow banking, China Inc is still leveraging up. Growth of aggregate financing and M2 money supply slowed down on balance during 2016. Still, total credit growth including government bond issuance was over 15% yoy in 2016, outpacing nominal GDP growth by a wide margin. Hence, credit levels are rising further to around 260% of GDP, with two third outstanding to corporates (including SOEs). From the Central Economic Work Conference held in December one can read that keeping financial risks and real estate sectors in check remains a policy priority this year. However, we think Beijing does not want risk to put the hard-won stabilisation at risk in the politically important year 2017. Hence, we believe that they will ensure that the effects of a credit tightening will be compensated – or the tightening will be softened or even reversed – if needed to keep overall growth at reasonable levels.

To conclude, the Year of the Rooster can bring negative and positive surprises

Although we do not expect a hard landing, we expect China’s transition to remain bumpy, given the prevailing risks. In 2017, the combination of a more hawkish Fed and rising rates in the US and a “belligerent” Trump could lead to more downward pressure on the CNY and a sharper drop in FX reserves. Another negative surprise could come from a sharper than expected correction of the real estate markets and a stronger than expected impact on the economy and commodity markets. Another negative surprise could come from debt and financial sector issues. With the marginal productivity of credit falling, NPLs are rising and so is the number of credit events. As China’s debt is mainly domestic and both fiscal and external buffers are high, we still think Beijng has time to engineer a gradual and orderly deleveraging. However, the risk of mismanagement remains, so China could be faced with a disorderly deleveraging and a stronger than expected fall in GDP growth. Growth could also surprise on the upside, for instance if a rebound in global trade lifts Chinese exports and Trump’s approach to China proves to be relatively benign.

China Jan17 Table