From Barclays late yesterday came the following excellent note:
Premier Li has yet to fully detail his policy framework, we expect Likonomics to consist of three key pillars – no stimulus, deleveraging and structural reform. If we are right, this implies further downside risks for the economy and markets in the coming year. But we view such policy measures as necessary steps for China to take now in order to avoid much more disruptive outcomes in the future.
Premier Li obtained his bachelor’s degree in law in 1982 and his doctoral degree in economics in 1994, both from Peking University. His prize-winning economics dissertation analysed the three-sector economy of China in the 1980s and 1990s – agriculture, the township and village enterprises (TVEs) and the urban sector. In his analysis, structural change is a constant source of productivity growth and economic development. During the past five years, Li was the first Vice Premier in the Wen Jiabao government. Wen’s economic policy is regarded as strong on growth but weak on reform. Public sentiment is now especially negative about the CNY4trn stimulus package adopted in 2008 for causing overcapacity in certain infrastructure areas, significant fiscal risks due to reckless local government borrowing, inflation, asset bubbles and potential bad debts following the huge expansion of credit. During the past few years, we think economists and policymakers have reached a consensus that China should now tolerate slower growth and focus on structural reforms. This is the foundation of the three pillars of Likonomics.
No stimulus. On 13 May in a speech broadcast to officials around the country, Li said: “To achieve this year’s targets, the room to rely on stimulus policies or government direct investment is not big – we must rely on market mechanisms.”
This is because relying on government-led investment for growth “is not only difficult to sustain but also creates new problems and risks.” In fact, many heavy industries, such as steel, cement and aluminium, are already struggling due to serious overcapacity problems. Recently, the government delayed the planned urbanisation conference in order to revise the official document to downplay the importance of fixed asset investment in China’s new urbanisation drive.
The hard truth is that the days of 10% annual growth are over for China. Growth potential is now around 6-8%, we estimate. Of course, the government is not completely passive in this regard. Government-led infrastructure spending on energy, water and transportation has been accelerating since the beginning of 2012. But the scale is much more constrained compared with earlier programs. As long as the unemployment rate and CPI do not surprise, we would not expect the government to adopt any new stimulus measures to boost growth. The minimum acceptable growth rate has also shifted down, from 8% at the beginning of last year to 7% now. It could fall further in the coming years.
Deleveraging. Li Keqiang said at a State Council meeting recently that banks must make better use of existing credit and step up efforts to contain financial risks. Following implementation of the previous stimulus package, China’s total credit had increased from USD9trn in 2008 to USD23trn by early 2013. As a proportion of credit-to-GDP, the growth has been from 75% to 200%.
…The PBoC’s recent move to curtail the credit bubble in the interbank market underlines the authorities’ desire to deleverage and reduce future financial risks. Their actions are a clear warning signal to financial institutions. While the authorities are likely to intervene to stabilise the market if needed, we think interbank rates could remain elevated for a long period. Policymakers probably also hope to strengthen market discipline as a preparatory step towards interest rate and capital account liberalisation. This implies that deleveraging is likely to continue and some of the smaller and weaker financial institutions may fail in the coming year.
Structural reforms. Since taking office, Premier Li has advocated reform as likely to pay the biggest policy dividends for the Chinese economy. While investors are anxiously waiting for the Third Plenum in the autumn for a clearer outline of economic policies, current policy discussions point to reforms in the areas of financial liberalisation, the fiscal system, factor prices, land use, administrative controls, monopolies, income distribution and the household registration system. Importantly, many of these reforms, including the VAT on services, do not necessarily have to wait for the Third Plenum to be approved. In particular, financial liberalisation is seeing renewed momentum, and we expect changes, such as greater flexibility on deposit and lending rates, and in the deposit insurance system, in the coming months.
Likonomics has some distinctive features compared with Abenomics in Japan. Abenomics is about ending deflation and restarting economic growth. Likonomics is about deceleration, deleveraging and improving growth quality. Both Abenomics and Likonomics have also slightly different approaches with regard to their respective implementation of fiscal and monetary adjustments. But it is structural reforms that will determine success or failure of Abenomics and Likonomics. With the Chinese government actively preparing a wide range of reform measures, it will be up to the new premier to prove that he is a decisive leader.
So what does all this mean for markets? First, we think the new government’s economic policy is exactly what China needs to put its economy on a more sustainable path. It is positive for the longer-term outlook of the economy. Unless the economy and markets face imminent risk of collapse, we do not expect policymakers to engage in aggressive fiscal or monetary expansion. Second, in the short run, such rebalancing and deleveraging point to further downside risks for both economic growth and asset prices, including the exchange rate. Based on an increasingly likely downside scenario, we think Chinese growth could experience a temporary ‘hard landing’, which we would define as quarterly growth dropping to 3% or below, within the next three years. But such a slowdown would only be cyclical, and we would expect growth to bounce back dramatically afterwards. Finally, while we do not agree with the view that Chinese policymakers do not know what is going on in the economy, we are aware of the downside risks, as deflating an asset bubble is never easy and rarely orderly.
