I recently traveled to Beijing to follow up on macro assessments of China. After visiting the region last spring, it’s amazing what a few months have done to (local) sentiment! While much improved, sentiment alone will not drive growth and there are still issues to tackle.
Currently, economic activity is in a cyclical recovery and off the lows, but in a structural downward economic trend with still significant headwinds ahead. Economic data in the short-term may actually continue to surprise to the upside by beating expectations. Most (supply) indicators point to recovery, yet there is modest demand side performance; so we are far away from calling this a sustainable medium term rebound. The recovery in the last months is an inventory (re-stocking), infrastructure, and property led recovery — driven by government fine tuning its policies with a mini “targeted” stimulus*– precisely the same engines China has been relying to support growth: back to the same old tricks! However, the positive news is that unlike 2009, the main source of funding is directly from the central government, generating a much more efficient (and very welcomed) use of existing resources. Just as importantly, most of these projects are aimed at sectors (information infrastructure, railway, environmental, nuclear) and away from those sector which suffering over-capacity problems (such as cement, steel, iron ore). Bottom line: growth in the near term can continue to surprise to the upside.
Total credit in the system, and more importantly property, remains a key issue, and is China’s Achilles heel. Is leverage excessive? Is real estate a bubble? If yes, are we close to seeing it burst? Can China become less credit dependent, and solve the structural over-capacity sectors? All these are key issues and too long to write here. Suffice to say that property is the single most important risk given the interconnectivities it has to all other sectors. A significant correction would undoubtedly lead to a quite harsh financial scenario. It is hard to pinpoint timing, but I worry more than the “average”. Such a correction can potentially be triggered by the People’s Bank of China (PBOC) hiking rates, a fast opening of the capital account leading to significant outflows, or a combination of the two. The speed at which the capital account is opened and how much (and when) PBOC tightens will determine the speed and softness of the property/credit adjustment. One note to highlight: the government does have the assets and balance sheet to deal with a potential clean up of disruptive non performing loans (NPL), but the cost would be meaningful. This drag is what makes the China growth recovery capped to 7%.
An important event to watch in November will be the Chinese Communist Party (CCP) leadership meeting. This meeting called the Third Plenary is significant as this is often the forum to unveil the party’s policy plans and priorities and to launch political and economic reforms. So far the government’s action plan has been one of “testing the waters” with mini step reforms, aimed at improving efficiency, red tape. All have moved towards generating increased private investment confidence, but none have yet proven to be bold enough. We’ll see how bold, particularly the timing of them, will be.
What can lead to faster cyclical (and even structural) growth ahead?
One word – Exports. This is perhaps the most important and encouraging one (not only for China but for Asia and Emerging Markets). The strength of this sector will determine whether Q4 and into Q1 14 will continue with a cyclical rebound. Secondly, faster growth will be possible if there is an increase in private sector involvement; however, that is dependent on whether or not the November reform agenda is perceived as credible and bold enough. A looser monetary stance could also push a stronger cyclical upswing, but that is much less likely as monetary and credit stance will remain rather tight. The credit slowdown is likely to continue, and more geared to banking loans and away from “shadow banking” activities (again a positive).
What can derail current recovery?
From the domestic perspective, one thing that could derail the current recovery would be another policy induced error similar to the June liquidity crunch. However, this is less likely as authorities acknowledge those mistakes and are thus less prone to repeat. A stronger risk would be a negative event in the financial system, such as a failed “non-bank” intermediary, which could generate contagion risk.
On the external front, China is not immune to both emerging market issues and possible negative impact of the U.S. Federal Reserve’s future tapering of its quantitative easing, but contagion through capital flows is much less likely given their closed capital account. Another risk is weakness in the export sector as developed economies’ growth remains tepid.
* The inventory restocking adjustment is due to stronger sentiment and government fine tuning policies, after June’s (badly handled) liquidity crunch episode. The current infrastructure and property recovery is due to the central government’s “mini-stimulus” package, as well as the lagged effect of very loose credit growth during the first half of this year.