China: stability, but not at any cost
One of the surprises of 2016 was the stability of the Chinese economy. Relative calm in financial markets along with a good dose of policy stimulus contributed to a strengthening in economic activity as the year progressed, to the extent that GDP growth came in bang on target for the calendar year.
That’s not a bad outcome when you consider all the angst of the prior year. Regular readers know our view that while the Chinese authorities have considerable resources at their disposal during times of economic weakness that does not guarantee they will always make the right decision. Indeed, the credibility of policy-makers was dealt a serious blow during the 2015/16 equity market correction and the poorly managed Renminbi (RMB) depreciation which raised concerns that policymakers had lost control and that a hard landing was imminent.
The biggest risk in China is a policy mistake. That’s why we have watched efforts to stabilise the economy closely. While those efforts have been seemingly successful, the recovery has been firmly centred in the ‘old economy’ with the property market contributing significantly to the recovery. At the same time, expanding credit growth has increased risks to financial and economic stability.
Stability is paramount to the Chinese leadership. That will remain the case in 2017 as we head into the 19th Communist Party Congress later this year. Economic weakness that risks rising unemployment and social unrest would be unhelpful to the current leadership as it looks to set the agenda at that gathering for further structural reform over the next five years.
We expect the Government will want to keep growth above the 6% level. At the same time, we believe the Government will also want to ensure broader financial stability and avoidance of asset market booms and bust. That was confirmed with the increase, albeit small, in the repo rate last week.
Some degree of tightening in monetary condtions had been obvious since late last year, though initially through the quantity rather than the price of the funds the People’s Bank of China provides. The repo rate hike is the most obvious sign of a tightening in monetary conditions and while the Government will want to ensure economic stability this will not be at the expense of financial stability. This is a positive sign.
The desire for stability extends to the exchange rate. Despite the generally stable GDP profile over the past 12 months, funds have continued to flow out of China as gross inflows have weakened and outflows have accelerated.
Over the past two years or so the net outflow has exceeded the value of China’s current account surpluses, the end result being a run-down in foreign reserves. Indeed, the value of China’s foreign reserves has dropped from around US$ 4 trillion in mid-2014 to around US$3 trillion today. In other words, the Chinese authorities have spent about US$1 trillion propping up the value of the RMB. Acknowledging they can’t keep intervening forever, the Government has more recently introduced a range of capital controls to help stem the outflow.
Given the desire for stability, we don’t expect much will change with respect to exchange rate policy this year. The authorities are likely to continue selling reserves and using capital controls to manage the decline of the RMB. Furthermore, any precipitous decline risks inflaming already tense relations with the new US administration.
Unfortunately the desire for stability means probably no real action on dealing with high corporate debt levels, and in particular the large indebted and inefficient State Owned Enterprises (SOEs). Some reform seems likely to continue such as the state-directed mergers (which just seems to us to create even bigger inefficiencies). There have also been steps towards repackaging SOE debt into equity through major Chinese banks to create domestic assets that savers can invest into. However, more meaningful reform including ownership may have to wait until 2018.
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