China Watch – Goldilocks and the panda bears

by: Arjen van Dijkhuizen

  • Official growth 6.8% yoy in Q4 and 6.9% in 2017, first annual rise since 2010
  • Gradual slowdown in official and alternative growth measures to resume
  • Ongoing crackdown on excessive (financial) risk expected
  • Talks about China reducing US Treasury holdings probably a warning shot
  • Risks to base scenario remain – panda bears will continue chasing Goldilocks
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We expect China’s version of Goldilocks to stick around this year

As our Chief Economist Han de Jong explained in his Global Macro View for 2018, we expect global growth to remain strong this year while inflation will rise but not too much. That positive outlook is partly based on our rather constructive China view. China’s economy has surprised positively last year, supported by solid domestic demand and a pick-up in exports and with the rise of high-tech, new industries symbolic for the ongoing transition. Through their targeted tightening campaign, the authorities were able to cut excessive leverage within the financial sector (including in shadow banking) while keeping credit to the real economy flowing. We expect them to continue this balancing act in 2018 and trust they can do the trick again. We think Beijing can combine a further credit slowdown with a gradual GDP slowdown and do not expect a hard landing in our two-year forecast horizon. We assume inflation will rise but will stay below target. Moreover, we do not foresee a major trade war between the US and China, despite the regular flaring up of trade issues. We expect Beijing to remain in control regarding the capital account, with only a modest CNY depreciation versus USD foreseen in 2018. So, we expect China-style Goldilocks to stick around this year, but the three (panda) bears will continue chasing her.

 

December conference confirms ongoing crackdown on excessive (financial) leverage

In December’s annual Central Economic Work Conference (CEWC), policy makers set out the economic goals for 2018, giving direction to the general stage set at the October CPC Congress. In 2018, Beijing will put more weight to the quality of growth rather than to its speed and it will continue its fight against excessive financial risk, poverty and pollution. Supply-side reform will continue, with further capacity cuts scheduled in heavy industries such as coal and steel (82% and 55%, respectively, of the multi-year reduction targets for coal and steel had already been reached in late 2017). We expect Beijing to continue targeted tightening as well, while local government finances will be put under more scrutiny. Over the past weeks, various regulators have presented various tightening measures. That followed the PBoC’s 5 bp mini rate hike on its open market and medium term lending facilities last month, in the slipstream of the Fed. We anticipate the PBoC will use similar mini rate hikes, while keeping the benchmark 1-year lending rate at 4.35%. That said, the likelihood of a benchmark rate hike has increased as inflation rises (certainly if the Fed would move faster than expected). At the same time, the PBoC will keep safeguarding overall liquidity in the banking system, as illustrated once more by recent measures.

Official growth slightly better than expected in Q4, gradual slowdown to resume

Real GDP growth was stable at 6.8% yoy in Q4, similar to the level in Q3 and only slightly lower than the first half year (6.9% yoy). The tailwind from strong external demand supporting Chinese exports has compensated for headwinds stemming from a fading credit impulse on the back of Beijing’s targeted tightening campaign and a correction of real estate markets and measures to curb environmental pollution in late 2017. Full-year growth came in at 6.9% (2016: 6.7%), the first annual improvement since 2010. Looking ahead, we expect the gradual slowdown in official growth to resume this year, with average growth falling to around 6.5%.

We expect alternative growth measures to slow moderately as well

Obviously, variation in Chinese GDP growth is notoriously low, as was also memorized in a recent FT article. We should not forget that China’s economy is in a structural transition characterized by creative destruction, as fast-growing sectors such as high-tech and IT sectors coincide with old economy ‘overcapacity’ sectors that need consolidation. It should also be taken into account that the quality of China’s statistics is still in development (the results of a broad GDP revision with greater coverage of the new-economy sectors should be forthcoming next year). In any case, we follow a wide number of other indicators, to get a better feel of the cyclical state of the Chinese economy. One of those is the alternative monthly GDP growth estimate published by Bloomberg. This indicator – which has fluctuated between 6.8% and 7.7% this year – fell to an eleven month low of 6.82% yoy in December and averaged 6.9% yoy in Q4, so close to the official number.

December activity data quite a mixed bag

Despite the rolling out of several measures to protect the environment, the economy held up quite well at the end of 2017. The PMI data for December, on balance, showed an improvement. Caixin’s manufacturing PMI rose to a four-month high of 51.5 (November: 50.8), with output, new orders and export sales improving. Caixin’s services PMI jumped by two points to 53.9. The divergence between the official PMIs (with a stronger coverage of the larger, stated-owned companies) and Caixin’s PMIs (focusing more on SMEs and private companies) has now been reduced significantly. Regarding the hard economic data, growth  of industrial production edged up a bit, to 6.2% yoy (November: 6.1%). Fixed investment growth remained stable at 7.2% yoy ytd, meaning a slowdown last year to the lowest pace since 1999. Some data were weaker though. Import growth fell sharply (see below) and growth of retail sales fell to a three-year low of 9.4% yoy. The latest housing activity data also show a further slowdown, although a national house price measures showed stabilization in December for the first time in a year.

 

Imports growth drops to one-year low in December, but no reason for panic

In December, import growth in dollar terms fell to a one-year low of 4.5% yoy (November: 17.7%). Although this was far below consensus, we had anticipated such a low reading, as the typical year-end surge had taken place already in November last year. That said, in our base scenario we expect a material slowdown of import value growth in 2018, to 7% from 16% in 2017 (the slowdown will be much more moderate in volume terms). That partly reflects the fading of base effects, but also fits within our base scenario of a gradual GDP slowdown. The latest data also point to a further slowdown of China’s commodity imports. Meanwhile, export growth remains solid (December: 10.9% yoy), supported by the pick up in global growth and trade. Despite concerns about trade protectionism, exports to the US rose by over 11% in 2017. Export growth to most other countries/regions picked up as well in 2017. We expect export growth to slow moderately in 2018, compared to 2017. Despite the regular flaring up of trade issues, we do not foresee a major trade war between the US and China as both countries realise that that will create huge economic damage given strong mutual dependencies.

 

FX reserves continue to rise

After a 25% drop in FX reserves in 2014-16 added to China concerns, since early 2017 these have risen for eleven months in a row (by a cumulative 5% last year). That correction has been driven by an easing of capital outflows, reflecting fading CNY depreciation expectations (next to tighter capital restrictions). Partly responding to pressures from Washington, Beijing has tolerated an appreciation of the yuan versus the US dollar by more than 6% last year. Rising inflows, with sentiment versus EMs favourable and China being included in global bond and equity markets, also played a role.

Talks about reduction in US Treasury holdings probably a warning shot

Last week, rumours that China would slow or halt purchases of US Treasuries (later denied by the Beijing) contributed to a spike in US bond yields. That spilled over to other bond markets including the Chinese one: China’s 10-year bond yield rose towards the 4% level, following a sharp rise in 2017. Looking at the composition of FX reserves (allegedly, around 2/3 of China’s reserves are USD denominated), China obviously has some degrees of freedom to change that. Still, it would shoot itself in the foot if such adjustments would lead to a sharp rise in yields/weaker dollar creating valuation losses on FX reserves held in USD. Also, China would ‘spoil its own market’ by pre-announcing reductions in US Treasury holdings. In our view, all of this should be seen as a warning shot to the US government, against the background of a potential rise of trade tensions. Remarkably, Chinese credit rating agency Dagong downgraded the US to BBB+ (!) from A- this week – seven notches below the leading US agencies Moody’s, Standard & Poor’s and Fitch – following critical US remarks on its large bilateral trade deficit with China.

PBoC drops countercyclical correction factor, but liberalisation will remain gradual affair

Following a further CNY appreciation versus US dollar over the past weeks, the PBoC reacted on 9 January by tweaking the way it sets the daily yuan fixing. The central bank dropped the so-called counter-cyclical correction factor . This factor was introduced in mid-2017 to reduce yuan volatility, a move which was in fact not in line with the PBoC’s long-term goal of making the exchange rate regime more market oriented. The recent abolition of this factor may suggest that the PBoC remains committed to a more market oriented currency regime. However, in our view a more important lesson is that the Chinese ‘yin yang’ management style of allowing reforms as long as stability is not threatened – often characterized by ‘moving three steps forward and two steps back’ – will continue. All in all, we expect China’s capital account liberalisation to remain a very gradual affair.

Risks to base scenario remain – can Goldilocks outrun the (panda) bears?

Although we believe in a Goldilocks base scenario, the (panda) bears will continue chasing her, as key macro-financial and geopolitical risks keep surrounding China’s transition.  Domestic risks stem from high and still rising overall debt levels, rising inflation and interest rates, weak pockets in the financial sector (shadow banking etcetera), intransparency and data issues (highlighted by a recent FT article), local government financing pressures, remaining overcapacity and stretched real estate markets in some parts of the country. External risks stem from a potential rise of trade sanctions by the US, from sharper than expected tightening in advanced economies or from geopolitical risks (North Korea, South China Sea). Hence, also given China’s key role in the global economy/trade, the likelihood that financial markets will be impacted by negative surprises from China this year from time to time is high, even in a gradual slowdown scenario (as we have seen during the China wobbles in 2015 and early 2016).