As part of the preparation of our quarterly outlook process, our team went on an in depth research trip to China to meet with a wide-range of policymakers, business leaders and industry experts earlier in the month. It was also an opportune time for us to get a download on the macro and political environment surrounding the annual National People’s Congress as they deliberate the 13th Five Year Plan.
Overall we foresee a cyclical stabilization in growth while medium term risks are increasing. Stimulus measures will continue to support the near term picture. Monetary conditions have been conducive with government and corporate yields on a downward trajectory. Chinese government bond yields are 60-100 bps lower than a year ago across the curve with narrower credit spreads. Local government swaps (which we discussed in a previous post last summer) allowed for refunding of previous Local Government Financing Vehicle (LGFV) debt at lower rates which relieved the near term interest burden significantly. We are also getting clarity that the central government will target 3% fiscal deficits to help cushion the economy in this calendar year, along with acceleration of investment projects.
However, financial instability is rising and potential growth is slowing. China has experienced a rather significant loss of FX reserves of late, despite having a large trade surplus due to capital outflows and repayment of existing dollar debt. The market perceives further depreciation pressure of the currency ahead. The targets for GDP growth have been set at above 6.5% not only for 2016 but also for the next 5 years. In the context of weak external global conditions, declining working population, and overcapacity in a number of industries, we view these targets as aggressive and requiring further leveraging up of the economy that introduces additional systemic risks. Especially in light of the implicit support that is inherent for a large number of state owned enterprises (SOEs), on 2nd March, Moody’s downgraded the credit rating outlook for China based on 3 main factors of 1) contingent liability, 2) FX reserves, and 3) policy credibility. On 31st March, Standard & Poor’s also downgraded China’s sovereign rating outlook to negative from stable on expectations of gradually increasing economic and financial risks to the government’s creditworthiness and that the pace and depth of SOE reforms may be insufficient to attenuate the risks of credit-fueled growth.
As China aims to balance these short and medium term issues, our quarterly roadmap entails the following investment implications: