Elliot Clarke, CFA Senior Economist
Frances Cheung, CFA Head of Macro Strategy, Asia
At the beginning of 2018, we outlined a growth view for China that would underwhelm the expectations of both the market and Chinese authorities. Against the official 2018 benchmark of 6.5% growth, we forecast 6.3% for 2018 then 6.1% in 2019. Given looming trade tensions, it is time to revisit our view.
At June 2018, annual headline GDP growth remained robust, printing at 6.7%. However, the six-month annualised pace moderated to 6.4%, just a tick above our full-year forecast. Critical to this deceleration has been persistent weakness in investment. Importantly, this is not because businesses are unwilling to invest, but rather as authorities are seeking to shift credit and investment from large unprofitable state-owned enterprises (SOE’s) to new industries that will drive growth in the long term. This is an abrupt change for the economy, one that will take time to work through.
Behind this trend is a wholesale change in credit supply. All banks are being encouraged to lend to up and coming sectors that hold promise (including households); large banks are also being incentivised to enter into debt-for-equity swaps with large, leveraged businesses – to improve their balance sheet health – and to purchase debt securities to aid market liquidity. At the same time, growth in non-bank credit has been halted. Not only then is new credit better aligned to authorities’ long-term vision, but it is also backed by strong lending standards and capital.
Complementing the change in credit policy has been the central government’s more stringent assessment of local government infrastructure investment, particularly for utility and transport projects. This is not to say that authorities have taken away support for infrastructure investment; rather, the tougher stance has been introduced to improve the quality of new projects and assure those that go ahead are in the national interest.
With the above actions successful in realigning activity and expectations, and the deceleration in credit and investment likely having gone as far as authorities are comfortable with, incremental additional support is now being offered. Examples of this include: Reserve Requirement Ratio (RRR) cuts and liquidity injections to bolster credit supply and alleviate upward pressure on market interest rates; tax cuts focused on R&D; and greater support for local government infrastructure financing. A fuller discussion of this nascent shift in stance is provided below.
These measures won’t bring about a rapid acceleration in activity, but they do mean that a base will form, particularly if, as we expect, authorities continue to ease through further cuts in the RRR and by providing additional liquidity to the market. Incorporated into our forecast of 6.3% growth in 2018 and 6.1% in 2019 is a modest uptrend in investment growth from the current historically low levels. With the investment outlook benign but uninspiring, consumption’s importance to GDP is set to grow.
At June, total consumption’s contribution to growth was unchanged from March at a heady 5.3ppts. Evident here is households’ confidence in the domestic outlook, increasing their willingness to spend out of savings to improve their quality of life. The reforms made to credit and the promotion of future investment in the most profitable sectors will aid household incomes, but only with a considerable lag. Notably, employment has underperformed production based on the PMI data. It is for this reason (and authorities’ caution over leverage) that we believe growth in consumption will slow in the second half of 2018, and thereafter maintain a more modest pace in 2019.
To the above views, a further escalation of trade tensions is the key risk. The focus of our concern is investment given it is clearly susceptible to a shock. Any initial impact on investment would extend to employment and consumption in time, and could see growth print below 6.0% for a protracted period – absent a fiscal response. This is why authorities will remain vigilant of domestic momentum. It is also why China is likely to respond to the US’ trade ire by improving relations with other nations. In time this will create a capacity to outperform via stronger investment; incomes and consumption, fulfilling President Xi’s vision for prosperity.
Policy and Markets
In recent weeks, there has been a concerted effort to support credit expansion, in addition to money market liquidity. Earlier in the year, RRR cuts targeted diverting liquidity to designated areas. The 50bp RRR cut in January was to support inclusive finance. The majority of the liquidity released from the 100bp RRR cut in April was used for early repayment of the MLF (medium-term lending facilities), with the remaining diverted to support small and micro enterprises. We argued back then that these policies did not represent a broad-based easing.
The game changer has probably been the change of wording by the PBoC regarding its stance towards money market liquidity, from keeping liquidity “appropriate and stable” to keeping liquidity “appropriate and sufficient/ample”. Here, policies went beyond money market liquidity. Eligible collateral for MLF has been extended to include lower-rated bonds, SME bonds and loans, etc. There are also reportedly MLF-incentives for banks to buy low-rated bonds. The CBIRC expressed a desire to lower financing costs for small and micro firms. And finally, the asset management product (AMP) rule introduced is less restrictive compared to the April draft. On the fiscal side, the State Council announced a slew of small-scale stimulus measures.
This policy mix aids the wholesale change in credit supply mentioned above. The authorities are preparing banks with higher capability to satisfy the demand for loans, as shadow banking activities continue to be compressed. During the first half of this year, the shadow banking segment – proxied by the sizes of trust loans, entrusted loans and banker’s acceptance under aggregate financing – shrank by CNY1.25trn, while new yuan loans increased by CNY8.75trn. The support to liquidity and credit is arguably still part of the de-leveraging campaign, although this campaign appears to be getting less aggressive.
CNY rates have been falling since the start of the year, as expectations for a less-tight policy environment built in view of the downside risks to growth. The RRR cuts and trade tensions supported this expectation. The softening of stance towards liquidity and credit is sustaining the bullishness in the CNY rate and bond market. Local currency sovereign bonds have garnered extra support from sustained foreign inflows looking to increase exposure to Chinese bonds. Foreign investors increased holdings of onshore CNY bonds by CNY110bn in June, or CNY88bn excluding NCDs, the biggest monthly increase according to Chinabond and Shanghai Clearing House data. The majority of the inflows were into CGBs (China Government Bonds). Foreign flows have been diverted into CGBs from PFBs (Policy Financial Bonds) – arguably new investors prefer to allocate funds to government bonds before becoming familiar with the onshore market.
The easing backdrop has contributed to CNY weakness, in addition to speculation that China may use FX as a response to ongoing trade tensions as China cannot easily match tariffs by quantity. Our view remains that China is unlikely to deliberately weaken the yuan, being mindful of the capital outflows seen during 2015/16. The latest re-imposition of the 20% risk reserve requirement on banks’ FX forward sales business shows that the authorities are not comfortable with the recent pace of RMB depreciation. The least the authorities want should be one-way depreciation in the yuan which leads to disorderly outflows. The June FX settlement data already suggests corporates might be becoming less willing to convert USD receipts to CNY. This is a situation authorities will closely monitor.