Just over a year ago, global markets were unsettled by concerns over China’s decelerating growth. Investors focussed on the mounting leverage in the economy. Commodity prices plummeted. Relatively minor (albeit abrupt) changes to the currency basket were viewed as precursors to a devaluation. Many fretted over the declining foreign exchange reserves, and believed that a “hard landing” of the economy was inevitable.
One year later, it appears markets have come to the opposite assessment. Economic growth surprised positively. Commodity prices rallied following some cuts in domestic supply. New prudential regulations, and a tightening of financial conditions, have been instituted to promote deleveraging in the financial system. Foreign exchange reserves increased following a tightening of capital controls. There is little talk of devaluation.
It is tempting to view the dramatic turnaround in sentiment as driven by an equally dramatic shift in risks and fundamentals. We believe that recent policy measures have been somewhat adequate to smooth China’s economic transition away from investment-led growth, but fall short of anything that can significantly reduce medium term risks.
The government outlined its recent reforms and planned policies at the People Congress earlier this month. At first glance, it appears there is little change in fiscal and monetary policy. But as it is often the case in China, details are what matters most.
The much-anticipated GDP growth target was lowered to 6.5%, but unlike previous years, this was presented as a floor, suggesting that they would aim to do better in practice. The fiscal deficit is expected to remain unchanged at about 3% of GDP, but the government is raising the ceiling on the amount that local governments can borrow by issuing new bonds from 0.6% to 1.1% of GDP. This government is also enacting tax cuts and reducing fees to help revive private investment.
Monetary policy also appears unchanged. The primary tool for monetary management is growth in money supply (M2) rather than interest rates. By setting the target at 12%, which is above expected nominal GDP growth (real growth of 6.5% plus inflation of 3%), monetary policy will remain accommodative. This is incongruent with recent measures by the PBOC to raise interest rates on its lending facilities. This is because the central bank is trying to achieve two objectives: supporting growth, while also promoting reduced leverage. It is tempting to achieve the latter objective by increasing the funding costs to financial institutions and tightening regulations on off-balance sheet business.
Structural reform is the area where the government appears to be making headway. The pledge to enact further reductions in coal and steel production capacity this year has received much attention, and has been a driver behind the improved market conditions for some commodity producers. They are also undertaking significant reforms in the housing market (increasing supply of land in some cities, while encouraging destocking in others), and reforms to mixed ownership of state-owned enterprises in many sectors. But a key priority of structural reforms are the regulatory changes directed at managing financial risks.
Financial leverage in China is rightly a source of concern. Financial assets are now about 440% of GDP, growing fastest in the areas that are least regulated. Since 2008, credit growth has been about 25% higher than the level consistent with historical trend. This is pattern is not much different than observed in Japan, Thailand and Spain shortly before experiencing financial crises. Recognising this issue, the government is looking to introduce a new regulatory framework that would effectively increase the coordination between the various financial regulators within the system. But regulatory reform is not a quick fix. Reforms take time to develop, and implement. In the meantime, little has changed in terms of non-performing loans.
While all these policy measure are important, it is difficult to argue that they make a meaningful change to the outlook. A gradual deceleration of growth is expected, given the rebalancing of the economy away from investment-led growth. But it is difficult to engineer a deleveraging of the economy without impacting growth. Hence the risk of a sharp deceleration in growth has not declined. Arguably, as regulations are changing, and the central bank tightens liquidity conditions, the risk of inadvertently triggering a debt crisis is increasing.
China’s transformation has important implications for the global economy, particularly for emerging markets. Not only is growth in China becoming less commodity intensive, but the imported value-added of China’s exports is also declining rapidly. This implies continued moderation in the demand for commodities. Some supply-side adjustments may have temporarily supported prices in recent months, but the medium term structural trends will continue to weigh on prices. The decline in imported-value added of Chinese exports has important consequences. China’s exports are moving up the value-added chain, increasing competition to countries such as Korea, Taiwan, and Japan, that have so far been net beneficiaries of exports to China.
What does all of this imply for investors? Last year, we felt that markets were far too pessimistic and, consequently, so were all other (emerging) markets that are dependent on trade with China. Today, we feel that markets have become far too optimistic. The risks of the debt overhang remain the same. Additionally, the potential of trade frictions with the US cannot be underestimated under the Trump administration. As a result, we are not comfortable taking a positive view on all emerging markets. Rather, we prefer to focus on countries where markets are likely to be driven by improvements in the reform momentum. These include India, where substantial changes are under way, despite the challenges of the banking system, and Brazil, where long-overdue reforms to pensions are increasingly likely to improve debt sustainability.
- Log in to post comments
