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China: What concerns are relevant?

September 2, 2015

Concerns with lower growth and a challenging rebalance are relevant, but risks of financial crisis remain low.

Please see the attached file for all graphs.  


• Expectations have worsened due to a combination of factors: weak activity, despite government stimuli; falling stock prices; capital outflows; and uncertainties over the new exchange rate policy.

• We expect growth to slow down in the next years (2014: 7.4%, 2015: 6.7%, 2016: 6.2%). Growth composition is particularly unfavorable to metal commodities.

• The economic rebalancing process is challenging, creating the risk of a steeper deceleration. 

• However, risks related to a financial crises or sharp currency depreciations remain contained.

Expectations worsened due to a combination of factors

Expectations for China have worsened in recent months due to a combination of four factors:

Signs of weak growth in 3Q15, despite stimuli. Economic activity slowed down again in 3Q15, with sluggish indicators in July and signs that deceleration will continue during the rest of the quarter. Concerns have intensified because the government announced several fiscal and monetary incentive measures (three cuts in reserve requirements and five cuts in interest rates since November 2014). There was some gain in GDP in 2Q15, but under the influence of an atypical contribution from the financial sector.

Reversal of the bubble in the stock market. The Shanghai Composite Index climbed 155% between the end of the first half of 2014 and June 12, 2015. The hike materialized without any evidence of improvement in the outlook for the earnings of listed companies. Since reaching its peak, the index fell 43% (see Chart 1). Initially, the government adopted measures to limit the decline, but recent signs indicate that the government will no longer increase its positions in the stock market (through state-owned enterprises and pension funds). Without direct intervention, the fundamentals suggest that the stock market will continue to slide, as it is up by 45% year over year, notwithstanding the recent tumble.

Capital outflows since June 2014 estimated at USD 389 billion. International reserves decreased 9% (USD 342 billion) between June 2014 and July 2015. Some of the drop is explained by the strengthening of the U.S. dollar, which affected the USD value of bonds held in the reserves, which are not dollar-denominated, but capital outflows (USD 97 billion) also played a role. The remainder was offset by a surplus in the current account (USD 291 billion in the last four quarters).

Change in the exchange rate policy. On August 12, the government announced a change in its currency policy, in which the daily fixing set by the central bank (allowing the currency to rise or fall 2% from the fixing level) would be more influenced by the closing of the spot market and other market conditions. Since then, the renminbi weakened 2.9% against the U.S. dollar, but the change intensified uncertainties regarding the direction of the exchange rate and the pressure for capital outflows. In fact, the fixing is indeed being set near the closing price of the previous day, but there is evidence that the government is intervening in the spot market to prevent sharper depreciation.

Which concerns are significant and which are overblown?

Concerns about economic growth and the impact on the commodity market are relevant, but risks of a financial crisis or sharp exchange rate depreciation seem exaggerated.

1) Slower growth and a challenging rebalance

The outlook is for slower growth. We revised our GDP forecast downward, to 6.2% from 6.6% in 2016. The revision incorporates limits in the government’s ability to fine-tune economic growth and little incentive for a very expansive policy, as the labor market is sustaining job creation levels. Our forecast for 2015 is unchanged, at 6.7%, implying a deceleration in the second half after 7.0% growth in 1H15.

Government’s increasing inability to avoid the slowdown is visible in Chart 2. Monthly indicators suggest a slowdown in GDP in 3Q15 (we anticipate 6.2% qoq/saar from 7.0% in the previous quarter), meaning that the set of stimuli in the current cycle (more comprehensive than in 2014) was able to keep growth above trend for just one quarter.

Excessive leverage in the economy limits credit expansion following cuts in interest rates and reserve requirements. Aggregate financing to the non-financial sector is at around 210% of GDP (Chart 3). Several sectors face a combination of high leverage and spare capacity, so that demand for loans is unlikely to react much to the credit supply.

Excessive leverage in the economy may also lead to a sharper slowdown in investments. According to our forecasts, investment will increase 6% in 2015 and 5% in 2016, vs. 9.6% on average in 2010-14. The historic ratio of credit expansion to gross fixed capital formation (Chart 4) suggests that this scenario is consistent with nominal expansions of 10% and 8% in these variables, respectively. However, if financial conditions lead to a steeper slowdown in credit, investments may decelerate to 2%-4%, leading to smaller GDP growth.

The reduced ability to micromanage the economy is also partially a consequence of the ongoing rebalancing, a process with multiple goals: reduce investments (and the savings rate) and strengthen domestic consumption; boost the Service sector, reducing the role of the Industrial sector; reduce government intervention; and liberalize transactions in the financial account of the balance of payments. This process becomes even more challenging because it must take place without a weak cycle in the labor market and without a very intense economic slowdown that would lead to defaults and deterioration in bank balance sheets.

The rebalancing process involves several changes in growth composition. From the demand standpoint, the slowdown occurs most noticeably in investments. On the supply side, there is a reduction in the role of the manufacturing industry and an increase in the role played by the Service sector. GDP figures show these adjustments have been taking place since 2013, as both investments and manufacturing posted sharper deceleration than GDP.

Changes in growth composition are less favorable to demand for metal commodities, which respond more to fluctuations in the industrial segment and in fixed investments[1]. Demand for steel (and iron ore) is an example: the annual growth in apparent consumption receded from 10% in 2013 to 2% in 2014, and it now stands at -0.2% in the year-to-date figure (Chart 5). Iron ore imports have not slowed that much, but the steel produced is now exported, so that Chinese mills affect demand for iron ore in other nations.

A successful transition of the economy also requires productivity gains, which depend on improved governance among state-owned enterprises (particularly banks). There was little advance in reforms in that sense, despite high expectations since the change in top government officials. This difficulty is explained by resistance from the elites tied to the government, who benefit from the current system. Improved governance among state-owned companies is essential to reinforce expectations that the rebalancing process will work. Investors expect signs of progress on this front to be presented soon.

Reforms may be needed in the medium term, but they also reduce the ability to intervene in the economy. One example is the partial liberalization of deposit and loan rates offered by banks, which reduced the effect of changes in the benchmark rate. Another example relates to financing restrictions imposed on local governments since late last year. The measure may improve governance in terms of local government spending in the medium term, but it limits the authorities’ ability to accelerate investments in a short period of time.

Market reactions to the new exchange rate policy and the stock bubble are examples of medium-term adjustments that had undesired effects in the short term.

Adjustments in the daily fixing rate quickened capital outflows and created an aversion to emerging market assets (nations that would be more vulnerable to a sharp depreciation in the renminbi), forcing the government to use reserves to intervene in the exchange rate market.

The hike in stock prices may have been caused by easier rules for IPOs and margin accounts in late 2014. The goal was to expand financing through stock issuances, but amid financial market imbalances, the result was an unsustainable advance in stock prices. The impact of stock losses on activity will likely be mild, but the fact that a bubble was formed and burst so quickly is a sign of difficulty in reconciling so many conflicting goals.

Despite having a milder impact, the government stimuli can still play a role. One example involves the real estate market, which has been showing some reaction to the relaxing of rules and to the monetary easing. Housing sales are picking up, with rising prices in the largest cities, which will likely boost investments in the sector late in the year, following a reduction in unsold inventories.

There is still room for more stimuli. Real interest rates are positive (Chart 6) and the ratio of reserve requirements is high compared with the last decade. We expect another 25-bp cut in the benchmark interest rate this year, and at least one more 50-bp reduction in the reserve requirements ratio. On the fiscal side, recent measures, such as strengthening policy banks and expanding the debt swap program, should provide some stimuli in the next months (but not enough to accelerate overall growth).

However, we see no reason or government willingness to provide large incentives because job creation remains robust. Concerns over the quality of growth linger. Despite the slowdown, a larger base and higher share of the Service sector sustain a constant pace of job creation in the cities, of around 13 million per year (3 million above the government’s annual target). Authorities signal that this target is more important than the annual GDP target. As the population no longer expands, maintaining a gross number of new jobs is enough to ensure a heated labor market and rising wages (one of the characteristics of economic rebalancing). Finally, there is an emphasis on growth quality, without aggravating the situation of excessive capacity in sectors that used to receive incentives (for example: steel and cement production).

2) Risk of financial crisis or sharp currency depreciation remains low

Despite short- and medium-term difficulties, we believe that the risk of a financial/banking crisis remains contained.

First, sudden stock losses did not lead to contagion in the financial market because banks had no exposure to the stock market, and the central bank intervened in the state-owned enterprise that granted loans to margin transactions.

In structural terms, a liquidity crisis is unlikely because banks have a broad deposit base, and they depend very little on the interbank market or external funding. For instance, the ratio between loans and deposits is approximately 68%. Deposits represent 60% of bank liabilities, while external funding represents approximately 1%.

Additionally, the weight of so-called shadow banking mechanisms has been declining since 2014 (Chart 7). This sector was a source of concern in the past due to less regulation and more leverage. In recent years, however, the government curbed its expansion, and the liberalization of deposit rates offered by banks once again attracted funds to the traditional banking system.

The property sector also seems less troublesome because households have little leverage, and the local market lacks financial instruments that have led to crises in other nations.

The biggest problem may be asset quality in the Banking sector because of fast credit expansion in recent years, but there is fiscal room to absorb bank losses. Public debt equals around 50% of GDP, including indirect debt by local governments.

Lastly, sharp currency depreciation also seems unlikely.

The external balance is comfortable, as international reserves are much higher than foreign liabilities: international reserves total USD 3,690 billion, while foreign liabilities amount to USD 2,225 billion (excluding direct investment). When combined with a current account surplus of 2.7% of GDP, reserves prevent capital outflows from causing financing restrictions. Sectors that accessed external financing, such as construction companies, are managing to migrate to domestic financing.

We also doubt that China will seek to go back to an export-led growth model by using aggressive exchange rate depreciation. The share of exports (or added local value to exports) has been shrinking since 2008, so that the impact of the export sector on the economy is softer in the short term. In the medium term, however, the 2003-08 cycle showed that the benefit provided by more exports is offset by deterioration in the terms of trade. All in all, China is too big to follow the example of Japan and the Asian Tigers, which managed to achieve high income levels through a growth model based on net exports, and it will probably not attempt aggressive devaluation of its currency.

However, it is reasonable to expect China to slow down the pace of effective exchange rate appreciation in the face of so many challenges. The renminbi has advanced 4.6% REER per year since late 2004 (see Chart 8), and it has been following the strengthening of the U.S. dollar against other currencies since 2014. After this long adjustment and the ongoing economic slowdown, it makes sense for China not to continue the process of real exchange rate appreciation. Hence, we expect some further depreciation in the next quarters.


Artur Manoel Passos


Please see the attached file for all graphs.  


[1] See Macro Vision “China: Impact of a New Growth Model on Brazil”.


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