CHINA'S BALANCING ACT: CONTROLLING DELEVERAGING WHILE MAINTAINING STEADY GROWTH
MACRO: REGIONAL - CHINA
June 2018 - PIMCO, Isaac Meng & Stephen Chang - "China’s Balancing Act: Controlled Deleveraging and Steady Growth Ahead"
Unique among major economies, China is renowned for its long-term economic planning, and for the most part, Chinese policymakers have succeeded in delivering their key objectives since the 1980s. What we aim to achieve in this article is a much more modest undertaking: uncovering the relevant secular trends and implications for investors as China evolves.
Long-Term Policy Goals
To begin, what are China’s key objectives? At the 19th National Congress of the Communist Party last October, President Xi Jinping announced an ambitious three-stage development plan for the next three decades. Xi strives to realize “a Chinese dream of national rejuvenation,” or as an insightful speaker put it at our Secular Forum in May, “China’s unstoppable and unambiguous rise.”
- In the first phase, during President Xi’s second five-year term (2018-2022), the strategic objective is “building a moderately prosperous society.” Xi laid out a quantitative target of doubling GDP per capita between 2010 and 2020. With average annual growth of 7.6% during the past seven years, that goal would entail 6.3% annual growth on average over the next three years.
- From 2020 to 2035, Xi looks for a stage in which, “socialist modernization is basically realized.” In this phase, China’s economic and technological strength will increase significantly, and China will become a global leader in innovation. Effectively, China would hit escape velocity from the “middle income trap” plaguing most emerging economies and reach developed economy status by 2035. Implicitly, China’s economy, technology and national strength should approach those of the U.S.
- By 2049 (the 100th anniversary of the People’s Republic), the plan is for China to become “a great modern socialist country” and the global leader in national strength and international influence.
Base Case for China
With these long-term policy goals as background, our base case for China over the next three to five years calls for:
- A powerful central leadership aiming for an institutional revamp with a long-term structural focus
- Less emphasis on GDP growth as the economy is rebalanced toward consumers and services
- An orderly mitigation of credit and debt risks amid a mildly reflationary environment
- Avoidance of a full-blown trade war and major geopolitical conflicts, despite sensational headlines
- Average GDP growth slowing from 6.9% in 2017 to 5%−6% in 2018−2022, reflecting the secular influences of an aging labor force and lower productivity gains; benign inflation around the government’s 3% target
- A gradual transition in the policy framework by the People’s Bank of China (PBOC), with the yuan increasingly flexible under a managed “dirty float” versus a basket of currencies for the next few years
- Adoption of repo rates as a policy framework by the PBOC as well as further opening of the Chinese bond market and integration into the wider global bond market
China’s upside potential: the BULLISH scenario
Having the most powerful leadership in decades creates the potential for many positive developments in China. Overall, strong leadership could further reinvigorate structural reforms in a decisive, top-down fashion. Coherent macro policies are already strengthening control of the financial system and helping to revitalize state-owned enterprises. The strong rebalancing toward a consumer- and services-oriented economy over the past five years could accelerate further. Despite opposition from the U.S., concentrated investment in research and development (R&D) and mass deployment of technology in the industrial, services and household sectors could also raise productivity. In this optimistic scenario, a strong revival in productivity and animal spirits would support stronger real GDP growth of 6.5%−7.0%.
As the surprising events surrounding North Korea this year illustrate, a grand strategic bargain between China and the U.S. is possible on trade and geopolitics. With its long-term orientation, China’s leadership can accommodate tactically, while the transaction-oriented Trump administration is focused on short-term election cycles.
In this bullish scenario, surging foreign portfolio investment and an increase in central bank allocations would boost the yuan’s role as a reserve currency and keep it strong.
Key risks to watch
The bullish scenario notwithstanding, China faces several risks over the next few years.
Elevated debt levels − President Xi promoted “controlling debt risks” to the number-one priority this year. Since the global financial crisis in 2008, China’s non-financial debt has jumped 120 percentage points to 250% of GDP. Corporate debt increased to 130% of GDP, while various direct and contingent local government liabilities amounted to more than 50% of GDP. Shadow-banking excesses further compound China’s systemic vulnerability.
We are encouraged by the appointment of credible technocrats such as Vice Premier Liu He, who is in charge of the new Financial Stability and Development Commission (FSDC), as well as new PBOC Governor Yi Gang and China Banking Regulatory Commission Governor Guo Shuqing, who are leading a top-down program to tackle the debt challenge. However, the moral hazard of assuming no defaults in opaque and legally ambiguous local government financing vehicle (LGFV) bonds and the likely rise of corporate defaults into the next cyclical slowdown do raise concerns.
Property downturn risk − Household debt at 53% of GDP in 2017 is not high in absolute terms, but its rise in combination with property reflation raises some red flags. In the past 10 years, household debt has jumped 700% from US$830 billion to $6.3 trillion as property prices increased by 300% in major cities. In 2017 alone, annual property sales hit $2 trillion, or 16% of GDP compared with 10% of GDP in 2008. Measured against urban disposable income, household debt rose to 1.4x from 0.6x. If this pace is sustained over the secular horizon, property reflation and household debt may reach alarming levels. We note, though, that current housing inventory is low and tight government policy has plenty of room for relaxation.
Thucydides’ trap: an intensifying China-U.S. rivalry – Already, the potential for a major trade war between China and the U.S. has been a rude awakening for the market in 2018. China and the U.S. represent competing economic models, conflicting geopolitical interests, and contrasting ideologies and political systems. The past 20 years of deepening China-U.S. interdependence may no longer be viable, but a stable strategic equilibrium has not yet emerged, and the risk of a strategic miscalculation is significant considering the volatile policies of the Trump administration.
Our pessimistic scenarios include stagnation and stalling market reforms in China; the unwinding of the China-U.S. interdependence in trade, investment and financial markets (with the potential for foreign exchange instability since China is the biggest U.S. Treasury bondholder); and possibly other “new cold war” conflicts.
Opportunities and investment implications
As coherent reforms progress under new policymakers in China, one of the interesting developments for global investors is the accelerated financial integration of the onshore yuan-denominated bond market. We expect debt issuance by Chinese entities both onshore and abroad to remain robust over the next few years. The increased cross-border activity is also deepening the liquidity of the yuan.
Much has changed since August 2015, when the PBOC allowed the yuan to float more freely against the dollar, effectively devaluing it, and unleashed a major shock in global markets. After much fine-tuning, the PBOC has established a credible managed dirty-float regime referencing a host of currency baskets. In the past 12 months, the central bank has also largely refrained from regular intervention, further normalized foreign exchange policies and liberalized capital account regulation. The yuan has remained strong versus both the dollar and trade-weighted currency baskets due to strong portfolio inflows and increasing reserve allocations to the yuan by global central banks.
The PBOC has made clear its commitment to increasing flexibility in the yuan in the next few years, which would pave the way for investors to take active positions in the currency. We are looking to positions in the yuan versus other Asian currencies to play a bigger role in our portfolio construction.
Issuance in both the onshore yuan and offshore dollar credit markets has been brisk. The investment universe has continued to expand, with new sectors, debut issuers and instruments across the capital structure. However, we expect credit performance to diverge markedly among sectors due to varying industry dynamics and the policy mix. Liquidity may ebb and flow as China aims to deleverage the financial system while maintaining broad stability. Corporate defaults will likely increase, and implicit guarantees for local government financing vehicles and state-owned enterprises are likely to fade gradually.
We remain very constructive on China’s consumer, technology, and services sectors in the new economy and plan to spend more time on the ground in China looking for credit investment opportunities over the next several years.