China Forecast Updates, Q3 2017
Source: Euromonitor International Macro Model
General Outlook: GDP Growth Remains on Track, but Financial System Risks Are Still Growing
Chinese GDP increased by 6.9% year-on-year during the first half of 2017, but is expected to slow down in the second half, leading to 6.6% growth for the whole year. Annual GDP growth is expected to decline towards 6% in 2018-2019, though consumption is still likely to increase by 7% annually due to the rebalancing of the economy away from investment.
The government has continued to tighten financial regulation and credit conditions. Interbank borrowing rates declined in the summer, but they remain significantly higher than at the end of 2016. Money supply growth has fallen to the lowest level in the last 10 years. However, non-financial sector debt has continued rising faster than GDP. While corporate debt growth has slowed down, household debt growth has accelerated, raising new financial system risks.
In the July meeting of the Politburo (a group of the top Communist Party leaders), China’s leaders announced an acceleration of structural reforms and repeated their commitment to containing financial system risks in 2017-2018. Inefficiencies in the State Owned Enterprise (SOE) sector remain an important drag on growth. According to IMF estimates, SOE productivity is on average 25% below comparable private sector firms. As a result, the bias in the 2008 fiscal stimulus spending towards SOEs, and the more general bias of Chinese banks towards financing SOEs has had a significant negative impact on growth. Productivity growth in Chinese manufacturing declined from 2.6% annually in 1998-2007 to barely above zero in 2008-2016.
The IMF estimates that implementing a comprehensive structural reforms could boost annual productivity growth by 1 percentage point. This would allow China to sustain fast economic growth despite lower investment rates and slower labour force growth. For now, the government is planning a wave of mergers and acquisitions among state-owned enterprises (SOEs) to eliminate weaker “zombie” firms and increase the efficiency of the SOE sector. However, deeper corporate governance reforms and increased market access to competitors are also likely to be required to significantly improve productivity. While the government has introduced plans for mixed state-private ownership, these plans are still very preliminary and private sector investment in SOEs remains small. Progress on increasing competition in industries dominated by SOEs has also been slow.
The main downside risk remains a credit crunch, due to a fast decline in real estate prices or excessive credit tightening by the government. A loss of confidence and worsening liquidity in interbank and non-bank financial institutions funding markets, would also contribute to worsening credit conditions. In such a scenario GDP growth would decline to 3.5% in 2018. We assign this scenario a 10-20% probability over a 1-year horizon. A more severe risk is a hard landing scenario. The hard landing scenario would combine a larger credit crunch with a lower long-term potential growth rate, reducing annual GDP growth in 2017-2021 to 3.7% (compared to 6.1% in the baseline forecast). We assign this scenario a 5-15% probability over a 1-year horizon.
On the upside, faster than expected credit growth and increases in private sector confidence could push output growth to 7.6% in 2018. We assign this scenario a 15-20% probability over a 1-year horizon.
Output and Economic Activity: Growth Momentum Is Slightly Above Expectations, but a Slowdown Is Likely in the Second Half
China’s GDP increased by 6.9% year-on-year in Q2 2017, identical to the Q1 rate and slightly above expectations. Nominal fixed assets investment growth declined, but still beat expectations at 8.6% year-on-year for the first half of 2017. Exports rebounded after a weak first quarter, on the back of stronger global demand.
Rebalancing towards services and consumption continued, with the services sector growing by 7.7% year-on-year, while industry and construction only increased by 6.4%. Retail sales continued their fast expansion, with a growth rate of almost 10% year-on-year. The shift to a more consumption oriented economy was backed by per capita disposable income growth of 7.3% year-on-year, and a continuing rise in consumer confidence.
Economic data from July is consistent with a slowdown in Q3. Year-on-Year industrial production growth declined to 6.4% (compared to an average of 6.8% so far this year), and nominal fixed assets investment growth fell to 8.3% year-on-year. Nevertheless, the good performance of the economy in the first half should allow the government to be more aggressive in controlling credit growth and in cutting excess industrial production capacity during the second half of 2017.
Capacity cuts in mining and manufacturing are progressing well, at least according to official measures. Total employment in the coal and steel sectors has declined by 25-30% since 2013. However, there’s still significant excess capacity in other industries such as aluminium and cement, that the government has only started tackling recently.
Financial Markets and Monetary Policy: Credit Conditions Tighten in Some Sectors, but Credit Growth Is Still Faster than GDP Growth
The People’s Bank of China (PBC) left its main lending rate unchanged during the summer, announcing it would maintain a neutral monetary policy stance in the short-term. However increases in other PBC rates have led to rising interbank borrowing rates which are still around 1.5 percentage points above their level at the end of 2016.
In signs of tightening credit conditions, banks have raised interest rates significantly on wealth management products (the most popular form of investment in China’s shadow banking system), and local governments are relying on riskier off-balance sheet debt funding issued through partnerships with the private sector.
Other measures of credit conditions are sending conflicting signals. Money supply growth declined in July to 9.2% year-on-year, still above GDP growth, but much lower than the 10-year average. Chinese bank debt/GDP declined from 72.6% at the end of 2016 to 71.2% in March 2017. However, lending volumes have increased by 12.9% over the previous year in Q2, with growth rising to 13.2% year-on-year in July. This is similar to the growth rate in 2016, and still exceeds nominal GDP growth of around 11.5%.
The recent credit tightening has reduced flows to non-bank financial institutions and investment products, but the impact on overall non-financial sector debt has been modest so far. Non-financial sector debt increased from 234.2% of GDP at the end of 2016 to 237.5% in March 2017. Corporate debt still accounts for around 2/3 of total non-financial sector debt, but its growth rate has slowed down to 8% year-on-year in the first half of 2017. However, household debt has expanded rapidly, rising 24% year-on-year in the first half of 2017 and is now close to 100% of household income. For now, it is too early to tell if the government’s new official commitment to controlling financial system risks will stabilise or even reduce China’s excessive reliance on debt.
China’s foreign reserves have increased back above 3 trillion USD, and capital outflows have stabilised in the first half of 2017. The Chinese Yuan has appreciated by 4% against the US Dollar so far in 2017. However, the real exchange rate (RER) against all of China’s trade partners has continued to depreciate. Despite an increase in capital outflows in 2016-2017 and the resulting devaluation, the Chinese RER is still significantly above its average for the last 10 years. In general, the exchange rate has appreciated significantly since 2007, and the current account balance has declined substantially. This to a large degree reflects the growing focus on economic expansion through higher domestic demand and a more consumption oriented economy, with a lower savings rate.
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