Top View | China 2012 - Holding tight amid uncertainties
Published 16 Dec 2011 11:15 by media
The latest policy meeting confirms no major change of macro policy stance, although the cautious tone is notable. Domestic demand will be the pillar of the economy, but the government needs to tread carefully the growth/inflation trade off. The “loose fiscal, prudent money” policy mix continues although we expect the net effects to be less stimulating. Monetary policy may maintain a “holding stance” for longer, but a substantial easing may increase the entangled fiscal and financial risks. Growth is expected to cool further. Watch out for higher rates as inflation risks linger and greater exchange rate volatility as global turmoil continues.
Economic outlook
No rebound of exports given the global conditions, but on the positive side the impact of exports on the economy has also declined. Given the relative shrinkage of the tradable sector we estimated that a 1 ppt drop in the growth of advanced countries (a significant shock considering the weak baseline) would now shed 0.7-0.9 ppt from China’s GDP growth, a more manageable magnitude than the growth impact of a similar shock before the Lehman crisis. The diversification of China’s trade destination also helps, with exports to emerging and developed economies now accounting for 40% of the total. We expect export volume to register a moderate growth in 2012 as in 2011 (about 8%), on the assumption of a sluggish, albeit very slow recovery in advanced economies (especially as US outlook improves) and higher emerging/developing market growth, but downside risks clearly remain as seen from the November data. More broadly, the role of foreign demand to drive growth would stay much more muted in the years ahead.
More crucial to the near-term growth is whether domestic demand can hold up as in the last three years. In our view, while housing investment is likely to stay weak through 2012, a number of factors are supportive:
1) Fiscal policy remains expansionary. Budgetary spending and expenditure have both expanded continuously since the global crisis and could rise further. Beyond budget, public investment projects (social housing and agricultural infrastructure, for instance) are set to continue or pick up.
2) Agricultural and manufacturing investment will remain strong (accounting for about 40% of the total), supporting the overall investment. The strength of manufacturing investment through the latest monetary tightening cycle was particularly notable, reflecting strong enterprise profits.
3) Tax policies that aim to increase the income of households and small businesses should help household consumption, although the immediate impact may be limited. Overall we expect growth to moderate to an average of about 8.5% next year.
Meanwhile the government will stay guarded on inflation risks. While inflation trend has been improving in the last two months thanks in part to base effects, the inflation reading is still elevated and social impact of food inflation can’t be ignored. More broadly, as we argued before the inflation-growth nexus has become less favourable and non-tradable sectors such as food supplies and services could face particularly strong price pressures due to supply constraints. As of late there have been improvements in supply conditions in some areas but the broader supply response is likely to be an uneven process. We expect inflation to moderate but remain above 4% (the stated target) next year.
Downside risks could stem from a sharper than expected slowdown in property and infrastructure investment which, if not promptly offset by rising public sector investment, means investment will materially slow (property and infrastructure investment account for 20% and 10% of total investment, respectively, or about 15% of GDP). Global development is also a key risk particularly if the European debt crisis deteriorates sharply (at present RBS projects a technical recession).Though there is policy scope to react, including by accelerating the social housing construction, there is the possibility that policies are not put in place sufficiently quickly. Inflation risks also mean that policy loosening in response to a growth slowdown will likely be more prudent than in 2008/09. In such a case, growth could falter more than expected. But this is very different from a hard landing scenario resulting from a financial crisis. In our view such a sharp retrenchment is not yet a major risk, given the strong balance sheets of the public and private sectors. Moreover, high savings and the broadly accommodative policy environment, including the low interest rates, is likely to see investment to rebound should policy signals be reversed.
Constrained policy support
The latest economic policy meeting for next year gave few surprises. Amid global flux and uncertainties the government reiterated its commitment to stable growth using the “loose fiscal, tight money” policy mix and emphasized the role of structural tools. In general policy makers are operating within more limited policy scope than 2008. Although with an eye towards the medium-term growth, the “targeted” macro policy support is also a reflection of such restrictions.
On the fiscal side, tax measures (tax relief to households and small and medium sized enterprise) and greater contributions to the social safety nets have been given prominence. These elements are beneficial for structural adjustments, but the stimulating impact on the near-term growth is likely to be more modest than spending (tax cuts tend to have a smaller multiplier than spending increases). On the spending side, social housing and agricultural related infrastructure are key areas. However, the spending increase is likely to be more paced in our view – the protracted nature of a weak global growth means the government needs to be more deliberate in utilizing the available fiscal space than in 2008.
Monetary policy is constrained in easing. First of all, in 2012 and subsequent years, the large outstanding credit as a result of the 2009/10 expansionary policy will force the government to continue reining in credit growth while gradually diversifying risks away from banks. Even with the recent slowdown, bank financing is estimated to stand at around 153% of GDP, similar to that in 2010 but 35ppts higher than in 2008. Although the sectoral balance sheets are still healthy as we argued before, the concentration of risks with banks is a concern and deterrence for broader interest rate reforms. In 2012 as some of the local government borrowing will be falling due we expect initiatives to convert some of the debt into explicit government liability, which would alleviate bank risks. The recent pilot scheme of local government debt is one example. In the meantime the banks’ further balance sheet expansion will be put under continued tight watch.
Second, the already low interest rate means that interest rate cuts are unlikely. Indeed, the contrast between the low return from deposits and rising real rates on the back of the expansionary fiscal will continue to put pressure on bank disintermediation. At the margin, the flourishing “wealth management products” banks use to attract deposits means effectively higher rates than the benchmark. We maintain our call for further benchmark rate hikes to narrow the gap with the effective rates and economic returns of investment. However, such rate hikes will likely be delayed by the ongoing global turmoil.
Third, this leaves RRR as an instrument to show policy support. In early December, and for the first time in three years, the central bank cut RRR instead of the usual liquidity injection through open market operations. While technically this was prompted by the decline in balance of payments inflows in recent months, we argued that liquidity squeeze was not as tight as implied by foreign reserve losses, and the onshore liquidity conditions are still supported by trade surplus and the yield differentials. The actual impact of the RRR cut on bank lending may be limited as well. In principle a RRR cut would allow banks that are constrained by liquidity ratios to expand lending. However as the overall credit is controlled by other prudential requirements it’s not clear the cut will actually lead to more lending. Indeed, the excess reserve ratio already recovered to 1.4% of total deposits at end-September, so the cut in RRR could well be reflected in a further rise in the excess reserve ratio. We believe the latest and possible additional RRR cuts are more important for signalling purposes as other forms of monetary loosening are constrained.
Market implications
Interest rates could still face upward pressures as inflation risks remain. The policy mix of fiscal expansion and tight money could also put pressure on rates. Compared to previous years, fiscal expansion will likely be financed more through bonds than through monetary easing and credit expansion, due to the shift of fiscal expansion from spending to income measures (easier to finance through bonds), and the unease to further expand banks’ balance sheet disproportionally.
The 1-year interest rate swap – which tends to follow the benchmark interest rates and the central bank’s bond issuance rate – has dropped much below both in recent weeks, as market expects monetary easing similar to that in late 2008. Such expectation for policy support may fall short: inflation expectation is still elevated as seen from the diffusion index of CPI, and growth is more immune from external shocks. In contrast, when substantial monetary easing was rolled out in 2008, both the actual inflation and inflation expectation had firmly come down, negative real interest rates had been largely corrected, and industrial production had dropped to historical lows due to the greater reliance on exports back then.
On exchange rate, we maintain our call that CNY is no longer a one-way bet. First, the undervaluation story is being eroded by the continued slide of China’s external surpluses and faster real appreciation. In fact, as the economy shifts towards a domestic-demand driven growth, and non-tradable sector continues to grow faster than the tradable sector, we expect the internal exchange rate to continue appreciating. Second, from a technical perspective, the opportunity to trade off FX price differentials between the onshore and offshore markets means onshore fixing is no longer the only driver of the CNY. Through arbitrage pressures in the offshore market could be felt in the onshore rates, albeit incompletely. The government is likely to increasingly take the cue from markets in its fixing, and allow greater two way volatility to avoid an overshooting. At the same time, the currency is still supported by the country’s strong net foreign asset position and should show relative strength to currencies of other emerging markets that are net borrowers from the international markets. Experience from 2008 suggests that countries with net borrowing positions from the international markets saw their currencies weaken the most.
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