The first batch of economic data in 2017 indicates that China has started the year on stable footing. Investment modestly improved but remains in a decade’s low range. Factory output is stable. Consumption numbers were weaker on lower auto sales as government-backed incentives ended. My models hint at early 2017 growth around 6.7 - 6.8%. The obsolete “Li Keqiang” index - often cited as proof that the government was hiding a hard-landing a year and a half ago - is running around 10.5%, enough to keep many hard-landing doomsayers at bay for the time being. China’s current economic state appears sound by most measures released so far this year.
Economic stability has taken hold in spite of headwinds. Overcapacity plagues a number of large, key industries that still contribute a great deal to overall economic growth. Analysis, including research from Capital Economics, suggests that sectors with overcapacity problems contribute roughly two-thirds of industrial output – which equates to roughly 27% of all economic output - and employs 80 million people. Add to that a debt burden for the corporate sector that has grown massive, which has resulted in a number of zombie firms, stuck in a cycle of increasing indebtedness to support unprofitable operations. Credit growth is still higher than nominal GDP growth, indicating that the debt burden is growing. The corporate debt burden is roughly 150% of GDP, well above the EM country average of 80%. Leaders in Beijing will eventually have to get serious about fixing those problems, and when they do, they risk driving up unemployment and stunting industrial output. As mentioned in previous blog postings, China's debt troubles are not a high financial system risk. Central government, local government, and household debt levels are low by most measures. The country's high debt load is a serious problem for specific key industrial sectors, and that poses a risk to growth. Here is my last blog posting on the debt burden: debt. A weak global trade backdrop remains another headwind, and as protectionist policies rise around the globe, outlook for global trade is not bright.
To understand where the economy will go from here, we have to understand why economic prospects turned upbeat last year. There are three primary reasons - two of which are intertwined - for China’s economic stability in the face of growing headwinds and its ability to easily beat its 6.5% growth target floor last year.
Reflation policies
Government reflation efforts were a primary contributor to 2016’s stable growth. Monetary policy shifted towards an easing bias in late 2015. The PBOC cut reserve requirements five times in the year leading up to February 2016. Central bank officials also embarked on a series of cuts to benchmark deposit and lending rates leading up to 2016, with the last cut in October 2015. Those policy moves drove lending rates to some of the lowest in the last decade, and helped limit rate volatility. Aside from monetary stimulus, the fiscal budget deficit was roughly 3.8% of GDP in 2016 - well above the 2.3% in 2015. Direct monetary and fiscal boosts traditionally help heavy industries via investment in shovel-ready activity like infrastructure projects and construction. Beyond official reflation, state-affiliated firm investment was up 18.7% in 2016, compared to 3.2% for private firms. A question to ask is how those levels of investment can be sustained when GDP is growing at a third of that rate, and many state-affiliated firms have overcapacity and debt problems to contend with. Looking forward, 2017 will likely bring a more hawkish PBOC given the rising inflation numbers. The money supply target for 2017 was reduced to 12% from 13% last year. The budget deficit target was set at 3%, after rising to 3.8% last year. Most reflation efforts from the past few years have either started to reverse, or will likely reverse or end in 2017.
Renewed housing boom
Central government reflation had a direct impact on China’s 2016 housing market rebound. But there are other reasons for the healthy property market, like a reduction in the required down payment for mortgages, the diversion of household savings into property and away from the turmoil-stricken stock markets, and the modest reduction in housing inventory in 2014 and 2015. Mortgage issuance was up an eye-popping 46.5% in 2016 from the previous year. The housing boom not only improved overall growth in 2016, after a weak housing market dragged the economy down in previous years but also had an indirect impact. Improved housing markets had the added benefit of saving officials in Beijing from making hard choices to cull the herd in the debt-burdened, overcapacity-ridden industrial sector. Construction and real estate development are the primary sources of demand for many large overcapacity-ridden industries, like cement, steel, and copper. Doomed firms in industries plagued with overcapacity and debt have been given a temporary reprieve by the booming real estate market. The real estate portion of GDP in 2016 was up 8.6% after rising a paltry 3.8% in 2015. Future weakening in housing markets would directly limit the economy’s upside, and would also compel the government to start culling the industrial herd in sectors that contribute two-thirds of China’s industrial output and employ 80 million. So far in 2017, housing data has been mixed but mostly positive. Monthly prices have already moderated and some tier-one cities have already seen monthly price declines.
Economic transition and innovation
The last primary reason for stable economic prospects in 2016 was unrelated to China’s traditional economic drivers. Innovation, policy moves, and animal spirits have allowed modern industrial sectors and underdeveloped services to thrive and absorbed labor and output from decelerating traditional industries. The underdeveloped service sector, roughly 52% of economic output, outpaced overall growth at 7.8% in 2016. Industrial robot output, semiconductors, and electric car production in 2016 grew at 30%, 21%, and 40% respectively. Over the last few years, Beijing tax breaks and the success of tech firms like Alibaba and Tencent have spawned a wave of new tech start-ups. Tax cuts of $46 billion for entrepreneurs and start-ups in 2015 further boosted the start-up trend. According to the Wall Street Journal, by the end of 2014, there were 1,600 tech incubators in China with start-up projects employing roughly 1.75 million people. China Daily reported that 10,000 start-up firms were being set up every day in 2015. Venture capitalists poured a record $37 billion USD into start-up firms in 2015, more than twice the tally in 2014. For more information see my blog post here: innovation. China’s ongoing transition toward more service-oriented growth and the solid contribution from modern industries is well known and well documented. Continued robust growth in underdeveloped services and rapid growth in modern industrial sectors should provide a bit of a stabilizing presence should we start to see significant slowing in the more traditional industrial sectors beset by overcapacity and debt.
What to watch in 2017
There are four indicators that will hold important clues to the direction of housing and reflation policies that helped put 2016 growth on a stable footing, and whether those factors are reversing. The first is monthly housing prices. Development and construction eventually follow price movements. We have already seen prices weaken and turn negative in some tier one cities. The second is new construction starts. New construction has done well recently, and that should keep construction activity going in the short term. Weak construction numbers would not bode well for traditional industries like cement production and metal smelting. Money supply and SHIBOR vs. adjusted inflation should give some insights into monetary policy. Lastly, state-affiliated investment can help gauge whether Beijing is still applying pressure on firms to put resources to work in order to keep overall growth on track.
All in all, it is likely that we see growth moderate in 2017 given the shift in monetary and potentially fiscal policy, as well as the mixed housing data. But, it is hard to guess just how much weaker it will be. Robust growth in underdeveloped services and modern industries should add some stability should other sectors falter. But, we should not forget that the most important factor of all in 2017 is the leadership turnover taking place late this year, so a deep economic slowdown is probably not in the cards this year. See my blog posting: leadership