China Watch – Views from Shanghai

by: Arjen van Dijkhuizen

  • Takeaways Shanghai trip: no major change in views, but some new insights
  • Growth resumed gradual slowdown, but hard landing unlikely in coming years
  • … despite number of key risks, also highlighted by downgrade Moody’s
  • FX reserves up since February on capital controls and firmer CNY
  • MSCI decision 20 June on inclusion China A Shares could be key milestone
  • Growth imports and exports in May exceeds market expectations
  • ‘Yin yang’ approach of targeted tightening, safeguarding liquidity to continue


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Takeaways Tokyo/Shanghai tip: no major change in views, but some new insights

Last week, I participated in a trip to Tokyo and Shanghai with a dozen of professionals working in the Dutch financial sector. In Tokyo, we visited the IMF, the Dutch Embassy, a number of Japanese (financial) firms and several foreign (financial) firms active in Japan. In Shanghai we visited Bloomberg, Moody’s, MSCI and several other representatives from the public and private sector, both Chinese and foreign institutions. The findings of the trip do not lead to major changes in our views on the economic outlook, but do add some nuances and some new insights. For instance, our view was confirmed that China in some ways is comparable to Japan about thirty years ago (debt build-up, deterioration of banks’ asset quality, urgent need for SOE reform). By contrast, China’s GDP/capita is much lower, its private sector more dynamic and the role of innovation stronger than in it was for Japan in the late 1980s. Moreover, China still has a closed capital account and lacks a free floating currency. However, due to the one-child policy of the past, ageing is expected to set in at an earlier development stage and faster than in Japan (this is an interesting topic for future thematic research). We will refer to some other takeaways from the Shanghai trip in the remainder of this monthly China Watch.

China risks confirmed by Moody’s downgrade, but hard landing not likely

Our base scenario assumes that China’s economy will resume a gradual slowdown, with Beijing willing and able to prevent a hard landing. This view was confirmed in Shanghai. Obviously, China faces quite some downside risks. This was confirmed by Moody’s decision on 24 May to downgrade China from Aa3 to A1, while changing the outlook from Negative to Stable. Moody’s is now at par with Fitch and one notch below S&P, who still has a negative outlook. As Moody’s explained in Shanghai, the downgrade relates to rising concerns on China’s medium-term credit standing. Fiscal strength will erode, as fiscal stimulus is used to close the gap between falling potential growth and Beijing’s growth target. Meanwhile, contingent liabilities are rising given developments at Local Government Financing Vehicles and SOEs in overcapacity sectors. However, as foreign funding is very low and saving ratios are very high, the capital account is controlled and the government is taking steps to reduce the debt burden for local governments and SOEs, Moody’s does not think that a systemic banking crisis and a hard landing is likely in the next two to three years.

Capital outflows ease and FX reserves up thanks to capital controls and firmer CNY

Over the past year, Beijing’s aim to safeguard macroeconomic and financial stability has been complicated by rising net capital outflows and a drop in China’s FX reserves (by around 25% since the peak in June, to around USD 3 trn). The authorities have reacted in late 2016, tightening capital controls by making it harder for companies and individuals to transfer foreign currency abroad (the effects there of were clearly highlighted by several of the institutions that we visited in Shanghai). In addition, as yuan depreciation expectations have proven to be an important driver of capital outflows, Beijing also took steps to support the yuan such as steering money market rates higher and – more recently – changing the currency fixing by adding a so-called ‘counter-cyclical factor’. These measures have helped to strengthen the yuan versus USD (the timing of the latest moves also had to do with the coming Fed meeting in our view) and to stem capital outflows, with FX reserves rising for the fourth consecutive month in May.


MSCI decision on 20 June on inclusion China A shares could be key milestone

In addition, measures taken to support capital inflows (e.g. opening onshore FX derivative markets and interbank bond market) and the gradual introduction of China in global bond and equity benchmarks will also help keeping net outflows in check. Next week is an important one in that respect. In Shanghai MSCI confirmed that it will announce on Tuesday 20 June whether China A shares will be introduced into its equity benchmark. MSCI explained  that the criteria for inclusion had been changed and that the list of potentially eligible shares to be included had been cut sharply. This seems to have increased the likelihood that MSCI will decide positively now, in contrast to previous years, although the jury is still out. While the share of these Chinese stocks in the index will be small initially, inclusion of A Shares would nevertheless be a symbolic step and would likely bolster future foreign demand for the Chinese stocks concerned.

Beijing’s stepping up of targeted tightening …

With growth stronger than expected in Q1, Beijing has stepped up targeted tightening policies aimed to prevent asset bubbles and to contain financial risk, by reducing risky leveraged position-taking and shadow banking and by cooling overall credit growth. The PBoC hiked the rates for its open market operations and short-term and medium-term lending facilities by 10-35 bps in early 2017, guiding interbank rates higher. The authorities also strengthened regulation regarding shadow banking activities including wealth management products (WMPs), local government financing and real estate buying and financing. These policies have resulted in a slowdown of shadow banking and WMPs, to a gradual cooling of overall credit growth and to a general rise in mortgage interest rates. All in all, the impulse from credit growth on the economy – as measured by Bloomberg – has started to fade since mid-2016 and has become negative in March and April (for the first time since August 2015).


… is visible in a gradual slowdown (and no collapse) of economic activity

These tightening moves have started to impact the real economy to some extent, shown by Q2 data so far. Caixin’s manufacturing PMI fell further to 49.6 in May, the first below-50 reading since June 2016. And fixed investment slowed to 8.6% yoy (April: 8.9%), driven down by infrastructure and property investment. The slowdown of the real estate sector seems to have accelerated recently, with real estate being an important contributor to domestic demand. Moreover, car production and sales have fallen compared to the levels seen in late 2016 (that certainly reflects the expiration of a favourable tax treatment).

We should add that the May data were overall not that bad compared to the previous month and in some ways exceeded market expectations (whereas the data for April were clearly weaker than for March). The official manufacturing PMI published by NBS remained stable at 51.2, while both the NBS non-manufacturing PMI and Caixin’s services PMI rose in May.  Moreover, retail sales (10.7% yoy) and industrial production (6.5% yoy) were flat in May compared to April. Exports and imports data for May also outbeated expectations (see below). All this is also summarised by Bloomberg’s monthly GDP estimate, which was stable in May around 7.15% compared to April. All in all, we still believe that economic growth has peaked in Q1 and has resumed a gradual slowdown from Q2 onwards, but a growth collapse is not on the cards.


Growth of imports and exports in May exceeds market expectations

Growth of China’s imports has started to slow compared to the start of this year. That slowdown is in line with our expectations and partly reflects strong base effects and a natural cyclical correction from a very strong Q1. In fact, at 14.8% yoy in May (above consensus expectation), import growth is still at high levels, certainly compared to the average monthly decline of 5.6% yoy seen during 2016. As we expect domestic demand to slow and also taking into account base effects, we expect import growth to cool faster than real GDP growth this year. Export growth also did better than expected in May         (+ 8.7% yoy), having recovered from the -7.6% yoy monthly average during 2016. This stronger export performance relates to a pick-up in global growth and trade, as well as the lagging effects from a more competitive yuan. We do not expect a damaging trade war between China and the US at short notice, as the Trump administration needs China in containing North Korea and has not labelled China a currency manipulator so far (despite Trump’s election rhetorics on this point). Bilateral relations have improved after the Trump-Xi Jinping summit in April, which resulted in a 100-day action plan on trade.

Beijing will keep safeguarding liquidity and not tolerate major instability

Chinese headline inflation has fallen sharply in early 2017, driven down by food prices who reached deflationary territory. With food price deflation becoming less pronounced in May, CPI inflation bounced back to 1.5% yoy, up from the trough of 0.8% in February. Producer price inflation fell to 5.5% yoy in May (April: 6.4%) and is likely to ease further in the course of this year as strong base effects are fading. We expect headline inflation to rise to around 2% this year, remaining clearly below the PBoC’s upper bound target of 3%. Against that still moderate inflation backdrop, we still expect the PBoC to keep the one-year benchmark rate steady at 4.35% as to mitigate the risks of higher interest rates for debt-burdened SOEs and local governments. Despite the targeted tightening measures taken, we still think Beijng does not aim to pull the monetary brakes aggressively. In fact, recent actions have shown that Beijing keeps safeguarding liquidity in the interbank markets by using its lending facilities. After all, the Chinese government is highly stability-oriented and in this politically important year (with major rotations scheduled in the Politburo Standing Committee), tolerance for instability will remain low. So, Beijing’s balanced yin yang  approach of trying to reduce longer term risks while aiming to safeguard macro-financial stability will most likely continue.