After a recent research visit, TT’s Head of Emerging Markets and Chief Investment Officer explain why a soft landing in China is achievable.
China's industrial overcapacity and deteriorating demographics will mean the country continues to experience a secular slowdown, but with clear and sensible policy action, a soft landing should be achievable.
China recently announced that it will attempt to make the first landing on the dark side of the moon, but can its policymakers also engineer an economic soft landing? Niall Paul and Tim Tacchi embarked on a weeklong research visit to find out. The trip involved meeting policymakers, academics and companies in Beijing and Shanghai. Conversations were dominated by recent FX developments, but notably absent from the discussions were last year’s fears over the state of the property market and the impending non-performing loan crisis. Perhaps this reflects the market’s inability to focus on more than one systemic issue at a time!
Since 2012 the Chinese economy has been slowing steadily; a secular downturn punctuated by shorter-term cyclical swings in activity. 2016 will be no different. Economic policy is geared towards managing the fallout from this slowdown rather than preventing it. Whilst it is clear that policy initiatives are targeting the right areas, the gradualist approach to economic decision-making means that the resulting deflationary adjustment will be protracted. Risks of policy errors are considerable, with key decisions around stock market reform and currency management setting a worrying precedent. These decisions are symptomatic of an insecure bureaucracy, seemingly unable to grasp the fact that there are often unintended consequences of policy changes.
Excess capacity and poor demographics mean persistent future deflation. No figure speaks more to this than the 46 consecutive months of annualised PPI deflation. Falling prices can only be reversed in the medium term by painful supply-side reforms. To this end, policymakers will attempt to reduce industry overcapacity, in part by allowing selected defaults, whilst trying to manage the inevitable widening in credit spreads that will accelerate non-performing loans. This, rather than currency depreciation, is the main risk to fragile sentiment in 2016.
Indeed, we believe that fears over Rmb depreciation versus the dollar are overblown. The currency is now loosely pegged to a trade-weighted basket. It will progressively weaken in tandem with the Euro, Yen and other Asian currencies during the last phase of the dollar bull market. However, reserve depletion looks set to continue in the short term at a rate that will be uncomfortable for many.
In sum, China will continue to be a mild deflationary force in 2016, and is unlikely to be a catalyst for a reacceleration of global economic activity. For our investments, this means a renewed focus of secular growth areas, increased caution on balance sheet stress, and an understanding that with policy uncertainty comes higher equity risk premia in China and Emerging Markets as a whole.
Secular economic slowdown, shorter-term cyclical stability
Meeting with Zhiwei Zhang – Chief Economist, Deutsche Bank
China’s rebalancing away from fixed asset investment to consumption continues apace. 58% of growth now comes from consumption, versus 51% in 2014. Unsurprisingly, industrial activity has been decelerating, but anecdotal evidence suggests that the new economy is also experiencing a slowdown. Jobs51, a recruitment agency with over 80m candidates on its books, pointed to a slowdown in recruitment activity, and a near halving of wage growth in the last few years. This recruitment slowdown was spread across the new and old economies. Though employment numbers for China as a whole look healthy (4.7% unemployment), growing job losses represent the biggest risk to growth as they will begin to weigh on consumer spending and corporate capex.
China’s corporates face very challenging conditions. If there is one statistic that sums up the situation, it is the fact that annualised PPI has been in deflation for 46 consecutive months. Outside global economic shocks, deflation on this scale and duration is unusual, with the last bout occurring in the 1990s. Clearly this is a huge drag on company margins and, according to Zhiwei, it has more than offset the stimulatory effect of the recent interest rate cutting cycle. The most likely explanation for such deflation is the severe excess capacity across the economy. Cement, steel and property are well known trouble spots, though the latter is showing some tentative signs of improvement. Sofun, the ‘Rightmove’ of China, recently reported robust growth in property transactions in Tier 1 and 2 cities. Once exclusively focused on new build primary transactions, Sofun is now turning its attention to the growing secondary market. Like Sofun, China Resources Land was keen to emphasise the solid state of the Tier 1/2 property sector. We could certainly discern visible improvement in activity and prices in their results during 2015. However, Tier 3/4 cities are still weighed down by an enormous amount of unsold inventory, which could take at least a decade to absorb. One economist we met from the PBoC half joked that policymakers had actively discussed a programme of using this excess inventory to convert into retirement homes for the poor! Aside from property, several company meetings pointed to strong latent growth in other service sector areas like I.T., healthcare, insurance and pensions. These industries are partly supported by government policy, but also clearly benefit from demographic changes. Encouragingly, for every percentage point that the service sector contributes to growth, it creates 30% more jobs than the manufacturing sector.
Despite the many challenges facing China, we continue to expect near term stabilisation in macro data. There are several reasons for this:
- Land sales accelerated further in December and are now positive in value and volume. This should ease funding pressure on local governments.
- Q1 last year was a very low base so YoY the pick-up might be more visible. Q1 credit growth contracted in 2014 and 2015, but will not in 2016.
- Zhiwei suggested that we are coming to the end of industrial destocking, as measured by official industrial enterprise inventory. Since 2000 there have been four down cycles, normally lasting between 15-17 months. We are now 14 months into the current cycle.
So 1H16 should see slightly better economic data, visible in retail and property sales, and investment activity. However, it is unlikely to see a reacceleration of growth, and as last year’s stimulus wears off, a relapse seems inevitable. Consequently, we anticipate additional policy responses. These are likely to include:
- Reserve Rate Requirement cuts, the next of which is expected by Chinese New Year in
early February, mostly to offset the impact of capital outflows and help in
liquidity management for the economy.
- Tax cuts. These should have a significant impact, helping
to stimulate demand and investment. In 2016
we should see more cuts in social security taxes. Workers currently pay a 2%
tax for unemployment insurance and 5% for other social security
costs. These rates are excessive.
- Rising fiscal spending and bond issuance. This will come in two forms. Firstly, an
extension of local government debt swaps on a similar scale to last year's
quotas. We expect 3 trillion Rmb to help reduce the debt payment burden and
secure funding for ongoing projects. Secondly, ‘policy bank’ bond issuance to
set up private equity funding for targeted areas such as rural broadband connection,
power distribution and rail. Almost 1
trillion Rmb has been raised so far. Other focus areas for fiscal spending will
be infrastructure and social welfare. The fiscal deficit will continue to creep
up and will end 2016 in excess of 3% of GDP.
Demographics and pension considerations
Meetings with: Dr Hans Rosling – Professor, Karolina Institute Susanna Yang – Investment Relations, CPIC
The working age population in China peaked in 2011. Labour supply is now expected to decline by an average of 6m every year for the next 30 years. Meanwhile, the number of people aged above 60 is set to reach 300m in the next ten years, up from 212m in 2014.
Dr Hans Rosling, an expert in analysing economic statistics, pointed out a very obvious fact: as life expectancy rises across the globe, birth rates fall. There is no longer a large distinction between Emerging and Developed countries, all are trending towards a birthrate of below 2 per woman. This has certainly been the case for China, where birth rates per woman have fallen to 1.7.
It could be argued that trends such as these alter China’s economic imperative. No longer is it about producing 6% growth to absorb urbanisation. Now China needs to maintain reasonable GDP growth for revenue generation to prevent a pensions funding crisis. A paper in China’s Economic Review seems to support this conclusion. The funding gap equates to 2 trillion Rmb until 2020 and 71 trillion Rmb by 2050. Another report published in December by the Chinese Academy of Social Studies argued that, without adjustments, pension deficits would appear by 2030, and that by 2050 the accumulated shortfall would amount to 90% of China’s GDP. Pension reform will undoubtedly move up the priority list as the heavy financial burden begins to loom large. The retirement age is currently 55 for women and 60 for men. Officials are expected to raise these ages before 2020.
Though poor demographics put pressure on the economy, there are certainly opportunities here. Consumption patterns for retirees will look somewhat different to those of the younger generation. China Pacific Insurance emphasised the growing demand for pre-protection healthcare products such as anti-cancer cover. When coupled with the rise of the middle class and doubts about the state’s ability to fund its social security obligations, the latent growth in non-banking financial products looks very promising.
FX and monetary policy
Meeting with a Senior Economist at the PBoC
Unsurprisingly, the research trip was dominated by concerns about another round of competitive currency devaluations, caused by China. The fact that a senior economist from the PBoC was allowed to talk to investors spoke volumes about how seriously the authorities regard the current situation. As an additional anecdote, Jing Ulrich, JP Morgan’s Asia Managing Director, suggested that she had a media engagement during the week, for which she had received a friendly reminder that it would be helpful to avoid negative comments on recent policy changes, namely the introduction of circuit breakers and the new currency regime.
The new regime began back in August, when Chinese authorities attempted to introduce more market-based pricing into the setting of the FX rate. This was to satisfy the IMF’s demands for China to loosen its controls over the currency in order for the Rmb to be included in the IMF’s SDR currency basket. Unfortunately, the authorities failed to provide definitive guidance about the new currency regime. Consequently, investors found it very difficult to determine currency policy. This created uncertainty and undermined credibility, leading to cross-asset volatility. The announcement of a new trade-weighted basket in December was intended to help re-anchor expectations, but again little detail was provided on the FX management around this basket. Couple this with an unexplained 1% depreciation against both the basket and the dollar, and investors were left scratching their heads whilst heading for the exit. Foreign currency reserves fell by almost 10% of GDP in Q4; what appeared to be a comfortable capital position began to diminish rapidly.
Thankfully, we expect volatility in the FX market to subside over the coming months. According to the economist we met, decision makers have reached a consensus that the basket is the right way forward, and also agree that communication to the market has to be much more consistent. This is encouraging. Also encouraging is the fact that the Chinese authorities have the tools necessary to control the direction and speed of the exchange rate move. These include:
- A trade surplus currently generating $60bn per month. For context, China's
exports fell 2% last year versus a decline in world exports of 11%. Its trade
surplus was up 56% in 2015, despite a supposedly overvalued exchange rate.
- A corporate sector that will readily respond to policy initiatives.
These could include the repatriation of overseas US$ earnings (1/3 of which is
believed to be held offshore) and a slowdown in outward bound investment.
- Monetary policy that can respond to changes in flow dynamics, and a very high Reserve Rate Requirement (17% of
GDP) that can be adjusted if capital outflow pressures persist.
- The ability to open up the bond market to foreign investment. Euro investors experiencing negative yields may
well be tempted to get a 3% yield from Chinese bonds, especially if they are
convinced that the Rmb will not depreciate by more than the Euro.
- Scope to change the terms of China’s policy to allow every citizen to
convert $50,000 per year from Rmb. This is the absolute pinch point for reserve
depletion and capital outflows. A mini
run on reserves could in theory be created if there was the expectation of an
imminent devaluation. But this could be mitigated by altering the terms of this
Despite these important shock absorbers, it is clear to us that reserves will continue to come under pressure until a suitable amount of time has passed to demonstrate that the new regime is here to stay. In the meantime, any drastic tightening of the capital account would represent a partial failure for this administration. Our sense is that we have gone through the worst in terms of policy uncertainty, but that the market will still remain jittery until reserves stabilise.
As an aside, the economist we met argued that the impossible trinity (countries cannot control their exchange rate and interest rates at the same time with an open capital account) does not apply to China because of the unique position of its capital account. However, in some ways we see the current policy dilemma as a direct result of this. The priority last year shifted from the capital account to the exchange rate. If the Rmb has now been given more flexibility to adjust then the capital account loopholes must be closed to prevent reserve depletion and pressure on rates.
Meetings with: Jia Kang – Head of China Academy of New Supply-Side Economics, MoF Huang Yiping – Professor, National School of Development Peking University, member of the MPC of the PBoC
China is very experienced in demand-side economics, but supply-side reform is different. It deals with shorter term pain for longer term gain. The successful exponents of such reforms have always been strong leaders. A case study on successful supply-side reform comes from the late 90s. China was in big trouble during this period, particularly in the textiles and home appliance segments. Capacity utilisation at this time was about 50%. Zhu Ronji took drastic action, ordering closures that led to 18m SOE employees being dismissed over the following 5 years. At the same time, the property sector was allowed to develop, which helped to absorb the economic fallout. WTO membership also boosted export growth.
Today China faces similar problems with overcapacity. However, it seems to us that there is a lack of conviction in the abilities of the current leadership to implement reform. Most people that we met felt that the administration is insecure due the corruption purge and the economic slowdown.
One notable exception was the senior economist at the PBoC, who claimed that the government recognises that many sectors are still not exposed to full competition and that the market needs to play a more decisive role. Allowing defaults will be a key part of this strategy. Of course, allowing some major SOE bankruptcies will be a serious issue and could lead to greater volatility, but the participation of the PBoC and others should help manage risk. The absolute priority for policymakers is to avoid a situation where a major default pushes up yields so high that healthy companies struggle to borrow money. Pushing up yields by 100bps is seen as acceptable, but officials do not want to raise spreads further than this.
Since the time of Deng, and especially since 2008, Chinese policymakers have been seen as shrewd and skilful economic managers. This reputation has been damaged by the inconsistent currency and stock market policies implemented over the last 12 months. While policymakers clearly face significant challenges in managing the economy’s transition from an export-led growth model to one based on consumption, we believe China’s problems are manageable as the country can use its vast wealth to secure a soft landing. Indeed, China’s FX reserves may have fallen, but they are still $3.3 trillion. Meanwhile, fiscal deposits at the MoF are Rmb 3 trillion, central government debt to GDP is just 35%, and the current account is in surplus by 3-5% of GDP. Thus, with clear and sensible policy action, a soft landing should be achievable and cross-asset volatility should eventually subside.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).