Our Economic Outlook for China
China’s gross domestic product (GDP) growth for the first quarter was a whopping 6.9%―an acceleration from 6.7% in 2016—and supported by all engines of growth: Exports, retail sales and fixed investment were all strong. The recovery started in the third quarter of 2016 as the five-year-long deflation in producer prices reversed course.
Since 2012, the Producer Price Inflation (PPI) has averaged -2.8% per annum and decimated industrial profits and private investment in the process. With substantial government spending in infrastructure and a strong rebound in housing, the ensuing reflation brought back industrial growth, and private investment is picking up again. Consumption, which has accounted for the lion’s share of growth, remains supported by low unemployment and robust household income growth. External demand is also playing its part for the first time since 2015; both the pickup in demand from developed markets and the upgrade cycle in consumer electronics—especially cell phones—have led export growth to surge to above 16% in the first quarter, turning net exports to a positive contributor to GDP growth for the first time in six quarters.
Despite this rebound, there are no signs of inflationary demand pressures. Even the PPI inflation appears to have peaked in February and the Consumer Price Index (CPI) remains at 0.9%, way below the central bank’s target of 3%. Meanwhile, capital outflows have stabilized following a tightening of capital controls both on households and official direct investment abroad.
No “Hard Landing,” But…
This “Goldilocks” picture is a big contrast to the prevalent concern that has existed since 2015 about a hard landing for China’s economy that would derail global growth. Is it time to leave that concern behind? For 2017, we think the answer is “yes, but only for now.” We ground our belief in the following main reasons:
1. First, China’s domestic political calendar dictates stability in 2017. In the coming fall, the Chinese Communist Party is having its leadership conference, held twice every decade, at which the next generation of leaders will get selected. This meeting is seen as the most important one for the remainder of President Xi’s term when he is expected to further consolidate his power. Hence, if any weakness in GDP growth is more than expected and south of 6.5%, which is the self-imposed growth target, the regime will reignite its stimulus machine selectively to ensure growth stability.
2. Second, after a multiyear economic adjustment, we see a broader recovery in developed and emerging markets. Even if this recovery isn’t totally synchronized and assured to be sustained, we believe it will reinforce a positive external demand outlook for China.
3. Third, this cyclical stabilization comes at the cost of increasing leverage in the economy, and not as a result of a meaningful change in fundamental growth dynamics. Therefore, none of our long-term concerns about the unsustainability of the Chinese growth model have changed. The underlying incentives for further leverage—as fanned by a suppressed domestic financial system and regulatory arbitrage—remain intact and have the potential to create even more asset bubbles. If anything, over the past decade, complexity in China’s financial sector has increased tremendously with the fast pace of credit expansion (Exhibit 1).
This increase is a direct outcome of a very high domestic savings rate (Exhibit 2)—the highest in the world, at 48%—that cannot shift abroad because of capital controls.
These savings are a kind of elephant trapped in a china shop, where risk pricing is lacking because of government subsidies and implicit or explicit guarantees. As a result, they tend to inflate asset prices, undermine efficient allocation of capital, and provide incentives for overleveraging.
High leverage poses a threat to financial stability—and Chinese policymakers are increasingly more vocal about this concern. However, their action is expected to be gradual in order to ensure a gradual pace of deleveraging while maintaining growth stability. The government’s recent tightening measures in the housing market and money markets are attempts to address this concern, and have been encouraged by stabilizing growth. We think they will aim to reduce the pace of credit expansion (which is also heating up the housing market), and to improve supervision of off-balance-sheet investments of banks that have fuelled interbank leverage. However, we do not believe they will aim for outright deleveraging in a politically sensitive year.
Finally, external risks are always present, and this year they are perhaps a bit more convoluted. Although the risk of an outright U.S.-China trade war seems to have dissipated with a quiet U.S. Treasury report on currency manipulation following the amicable first meeting of the two countries’ presidents, both countries now appear to be entangled in a geopolitical mess known as North Korea. Using foreign policy and trade policy interchangeably could be appealing to politicians—but they don’t seem to mix well with the threat of nuclear war. Of course, the prospect of such a war is not our baseline. Instead, we see selective tariffs on some products as the most likely outcome, along with a long-overdue opening up of Chinese markets to U.S. companies—especially in the auto, agriculture and financial services sectors. Such a move may actually be quite helpful in bringing competition and foreign investment.
Looking Beyond 2017
After 2017, the big question is whether the country’s leadership will consider more fundamental changes to China’s growth model after the Party Congress. Although there has been substantial rebalancing from investment to consumption and from manufacturing to services, the process remains guided by planning rather than being market-driven. If the government’s “Made in China in 2025” initiative1 is a guide, cherry-picking sectors and nurturing them through subsidies remain favorite methods to generate growth in China. However, there is also the possibility that the Party Congress, which will bring a younger generation to leadership roles, may change course. Either way, we will be keeping a watchful eye on developments.
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1“Made in China 2025” is an initiative to comprehensively upgrade Chinese industry and in the process raise domestic content of core components and materials to 40% by 2020 and 70% by 2025. It identifies 10 priority sectors: (1) New advanced information technology; (2) Automated machine tools and robotics; (3) Aerospace and aeronautical equipment; (4) Maritime equipment and high-tech shipping; (5) Modern rail transport equipment; (6) New-energy vehicles and equipment; (7) Power equipment; (8) Agricultural equipment; (9) New materials; and (10) Biopharma and advanced medical products.
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