China’s annual Government Work Report is known to contain important indications of how Beijing views its economy—and what its future plans are.

Released earlier this month, the 2016 report didn’t contain many big surprises. It came out with more supportive macroeconomic policies to cushion growth and a gradual reform agenda. Yet it’s an encouraging report if you consider other factors, such as China’s recently more open communication with the financial markets; hopefully, better oversight of China’s financial sector through new regulatory leadership; the recent relative stability of the yuan; and a modest recovery in the housing market there. Given these factors combined, we may see growth beginning to stabilize.

The big news in the report was the target range for gross domestic product (GDP) growth (6.5%‒7%)—rather than a point target. We think this will be good for everyone who has been uber-hyped about the quality of data in China.

We find the report’s overall tone to be dovish and believe that further cuts in interest rates and required reserve ratios (RRR) are likely. The report includes a first-ever target for total social financing (which encompasses a broad definition of lending in China beyond what the banking sector provides). We think this shows the increasing importance of non-bank financial institutions in China and their potential financial risks. There has been a recent surge in lending especially coming from unregulated online platforms, which the authorities are now trying to control, but we believe that maintaining financial stability will remain a key challenge.

The fiscal policy outlined in the report is also more supportive of growth. The deficit target is raised to 3% of GDP from 2.3% in 2015, but we expect this year’s deficit to be closer to 4% of GDP. Given that the actual deficit was estimated at around 3.5% of GDP in 2015, the additional support to the economy from fiscal spending will likely not be significant.

The true deficit in China, in our opinion, should include quasi-fiscal spending and numerous off-budget items, which we believe was in the range of 10% of GDP this year. A lot of this spending in 2015 was targeted toward infrastructure investment via state-owned banks. We hope this spending continues in 2016 and believe it would slow down the deceleration in fixed capital investment. Another positive aspect to the report is a business-friendly mix of policies in the budget. Tax and fee cuts are the main reasons behind the higher budget deficit and they will help reduce the cost of doing business.

The reform of state-owned enterprises (SOEs) and the reduction in steel- and coal-production capacity seem to be structural policy priorities for China, but these are likely to proceed slowly—perhaps over a number of years—in order to mitigate their effect. We may see more mergers and restructuring rather than bankruptcies and factory closures, because job losses in the coal and steel sectors are locally concentrated and could reach two million. The government is planning to offset the negative impact on displaced workers through budgetary spending.

The report contained a slightly faster urbanization target, which would also support economic growth and help with the ongoing recovery in the Chinese housing market. The government set a target to increase urban residents’ share of the population to 60% by 2020 (up from 55% in 2015), and to increase the share of the population with an urban “hukou” (the registration that migrant workers need for such rights as buying property or enrolling their children in local schools) to 45% (up from 36.9% in 2014). It plans to grant urban hukous to 100 million people in the next five years and build underground infrastructure facilities to help improve urban planning and reduce pollution. These can be positive factors for productivity growth, the services industry, housing demand and infrastructure investment. Housing policies have been supportive since last year and we have seen a jump in home prices recently in Tier I cities, but the destocking of excess supply in Tier II and III cities has been slow.

Overall, we expect these policies to help cushion the blow from the slowdown in growth in China as it rebalances its economy toward a more consumption-based model, which is a multi-year project.

Investment Implications

While we believe that the direct portfolio implications are not significant, the indirect implications are very important. The positive effect from a more stable China on risk sentiment globally—particularly in Asia—could be significant. We may express this view in our portfolio by considering increases in rate, credit and FX exposures in Asia and other EM countries that are directly and indirectly impacted by China.

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