This article first appeared in The Edge Malaysia Weekly, on November 2 - 8, 2015.
DEVELOPMENTS in China are likely to be important market drivers in the coming weeks. The central bank has just cut interest rates and even more stimulus is likely soon. The Chinese renminbi is about to be formally inducted into the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) currency mechanism; new financial stresses are appearing in China; and the Chinese Communist Party’s fifth plenum is likely to make game-changing decisions on political renewal and China’s economic strategy going forward.
It is important, therefore, to understand what is going on in China and how it will affect the rest of the world. What we see is clear evidence of downside risks and an expanding policy response as a result. Consequently, the impact China has on the world economy will widen — the impact will be felt not only in terms of falling commodity prices but also in a whole range of areas.
Economy continues to decelerate, with just a few high-growth areas providing support
• Weakest GDP growth since crisis: Official GDP estimates show growth slipping to just 6.9% y-o-y in 3Q2015, the slowest since 1Q2009, when the global financial crisis was at its height. There is some debate on the veracity of these figures, with some analysts claiming that growth could be as low as 4% to 5%. But, virtually everyone agrees that the traditional mainstays of the Chinese economy — investments and exports — are losing momentum. Fixed asset investment is growing at its slowest pace since 2000, a serious concern since investment spending still accounts for about 46% of GDP. Weak domestic demand caused imports to slump 20.5% y-o-y in September, down from 13.9% and continuing a fall that began in November 2014, while also deepening the recession in the production of basic materials and inputs such as electricity, cement, flat glass, crude steel and coking coal.
• Deflationary pressures unabated: Producer prices fell 5.9% in September, its 43rd month of contraction. Falling producer prices are hurting industrial profits and cash flows: State-owned enterprise profits declined 8.2% y-o-y in January to September, accelerating from a fall of 6.6% in January to August. State-owned enterprises (SOEs) tend to be over-represented in the sectors mentioned above, which suffer from overcapacity. Given the high debt in the corporate sector, this decline in profits and therefore in cash flows is a concern.
• Sure enough, there is more evidence of financial stresses: China Minsheng Bank has warned of growing systemic risks after reporting a rise in nonperforming loans. A bank in Liaoning province disclosed that nearly a third of its lending to a troubled solar panel maker is at risk of default. One large SOE that produces steel has warned that one of its subsidiaries would struggle to repay principal and interest on its bonds. Another large SOE, this one in the energy sector, was reported to have narrowly averted default when its parent company said it would buy outstanding bonds from investors.
• But consumer spending is providing support: Retail sales remained resilient, growing 10.9% year-on-year (y-o-y) in September. A tight labour market resulting in strong wage growth is supporting private consumption spending as a key driver of economic growth. Resilient consumer spending provides the much-needed support to a weak economy, while also ensuring that the economy rebalances away from its excessive reliance on investment.
Policy reaction: What to expect and how effective can it be?
The People’s Bank of China has just cut deposit and lending rates by 25 basis points to 1.5% and 4.35% respectively, the sixth rate cut in the last 12 months. As a result of this series of PBOC measures, broad money is accelerating, rising 13.1% y-o-y in September, and growth in new renminbi loans is increasing to 15.8% y-o-y in September. There are also incipient signs that house prices are beginning to stabilise, at least in the biggest cities. We expect a small pickup in growth in the fourth quarter as some of the stimulus measures bear fruit. However, the headwinds remain strong and, unless there is a major recovery in export demand, the economy is likely to lose momentum again in 2016.
Consequently, it looks like more policy action is needed. Monetary policy will go beyond rate cuts to include a step up in the PBOC’s relending programme to allow financial institutions to use bank loans as collateral for PBOC funding and on-lend to favoured sectors. The government is also certain to announce more fiscal spending on infrastructure projects.
The question is how effective policy action can be. Bureaucratic gridlock owing to the strident anti-corruption campaign could mean that any planned pump-priming and infrastructure projects could be ineffectual. Decision-makers at all levels of government are reluctant to put their signature to any approval, terrified of being accused of corruption or other malfeasance. Moreover, the anti-corruption campaign continues to hurt spending on restaurants and luxury goods. Recent missteps in policy such as the botched shift in the management of the exchange rate in early August and the damaging intervention in the stock market that followed raise concerns over how well policy is being formulated.
Structural changes could be helpful
The fifth plenum of the Chinese Communist Party is about to convene and will make important decisions. First, we are likely to see more evidence of political renewal. President Xi Jinping is likely to promote more of his loyalists into key positions, both within the party structure as well as in the Central Military Commission. There could also be greater clarity on the leaders who will eventually succeed Xi in 2022. Second, more details of the next five-year plan are likely to be released, giving us a better sense of the government’s economic targets and the strategies it is likely to follow, including more information on Xi’s ambitious “One Belt, One Road” scheme to connect China’s economy with its Asian neighbours and Europe. An important positive signal would come if China’s leaders committed more forthrightly to step up reforms of the SOEs.
Another major development will be China’s impending entry into the SDR, which would in effect make the renminbi a global reserve currency, signalling China’s emergence as a global economic superpower. The IMF is reported by media sources to be close to making a final decision on this, perhaps as early as November, but certainly by the first quarter of 2016. Aside from prompting some limited flows into renminbi assets, the most immediate impact would be to give China more policy leeway in dealing with its current challenges — its keenness to secure SDR entry has made China’s policymakers cautious in the way it manages its exchange rate for instance. SDR entry may well allow the PBOC to be more aggressive in currency policy.
How will China affect the rest of the world?
China affects the world economy through many channels. Here, we want to highlight just the following:
First, China could export more deflation to the world. China’s economic deceleration has already dented commodity prices and its continued weakness will probably keep down the prices of oil and economically sensitive commodities such as base metals. This deflationary impact is now spreading to the prices of manufactured goods as China exports its overcapacity through price cuts and dumping. The Financial Times reported that reduced foreign buyer interest at the recent Canton Fair forced Chinese producers to cut prices and offer much better payment terms in order to secure buyers on a whole range of manufactured goods.
Excess capacity in China was already causing prices of industrial goods such as steel products to fall and more cases of dumping by Chinese exporters in foreign markets. With external demand remaining weak, we expect deflationary pressures to spread and be exported to the global economy as Chinese producers cut prices to maintain demand.
Second, global imbalances could worsen, prompting a possible rise in protectionism. The current account balance as a share of GDP — the broadest measure of how China trades with the rest of the world — is essentially the difference between the investment rate (investment share of GDP) and the savings rate. The current trajectory of China’s economy points to a near-certain fall in the investment rate, while it is unlikely that the savings rate would fall as much. So, it is highly likely that China’s current account surplus will expand substantially in the coming couple of years after having fallen significantly since the 2008 global crisis.
On the other hand, the US current account deficit is set to widen, to the consternation of US policymakers, politicians and the chattering classes. A strong US dollar coupled with a US economy growing faster than other developed economies such as Japan and the eurozone will probably inflate the US deficit with the rest of the world. The coming year, 2016, is an election year in the US — a growing external deficit could well prompt growing demands for protectionist measures against China.
Bottom line: A riskier world
In short, after a short rebound, there is probably more downside risk to Chinese growth. That, in turn, is likely to create more deflationary pressures in the world economy and possibly result in more protectionism, something that the export-oriented economies of this region will not welcome.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy