Three Supporting Factors and One Major Concern for 2017

Qinwei Wang is an Economist.

China’s economy has held up relatively well so far, after strong concerns one year ago. We expect some slowdown in 2017, but this should be less painful than in 2015. Let’s see the three supporting factors for China in 2017 and the major risk to watch.

A more benign commodity outlook: There has been a more visible recovery in nominal growth, with Producer Price Index (PPI) inflation back to positive territory after declining continually for nearly five years. This has been supported by rising global commodity prices in the wake of China’s reduction in overcapacity. Consumer Price Index (CPI) inflation has remained in a relatively comfortable range.

A stabilized real estate sector: Property sales started to cool recently following targeted policy tightening in some large cities to prevent potential asset bubbles. That said, downside risks in property investments should be manageable given already meaningful destocking. Meanwhile, affordability has largely improved over the last few years with relatively solid income growth.

Fiscal Stimulus: Meanwhile, the impact of policy support has become more visible, with a shift of focus from monetary easing towards fiscal spending. The effects of fiscal policy were relatively muted in 2015, due to controls imposed on local government financing. That said, the fiscal side appears to have become more effective in 2016, with more infrastructure spending through budget deficit, an expansion of the policy banks’ balance sheets, and the recent acceleration of Public-Private Partnership (PPP) projects. This implies that if any downside risks emerge, China could still use fiscal measures to soften the pain.

China Budget Fiscal Balance (12m Rolling)

Sources: Pioneer Investments, CEIC. Data as of December 15, 2016.

Monetary conditions look to remain roughly stable going forward. The People’s Bank of China (PBOC) seems reluctant to ease further, given concerns around asset bubbles and capital outflows, and will likely remain wary of tightening, given underlying economic conditions still look fragile, with relatively high uncertainty from overseas.

While a hard-landing for the economy is less of a concern, worries about capital outflows have resumed recently. Such risks could still be manageable in the near term, but the challenge is how to manage the ongoing transition to a more flexible renminbi (RMB) regime in a strong dollar environment.

Risk to Watch: China FX Reserves

Sources: Pioneer Investments, Datastream. Data as of January 12, 2017.

We continue to think expectations are the key, rather than the country’s fundamentals. The recent pickup of capital outflows seems to be principally due to a stronger US dollar rather than RMB devaluation. Expectations of global investors have been relatively anchored, with Chinese yuan (CNY) being kept relatively stable against its currency basket. But locals appear to watch the dollar closely and have become more nervous.

Looking ahead, a risk would be if the dollar strengthened again at a fast pace. Further tightening in capital account management could help. That said, if the dollar’s strengthening moderates, outflow pressures could ease.

Beyond RMB levels, a more important focus would be when and how the PBOC could achieve greater RMB flexibility without triggering systematic risks, which would be a major step in financial liberalization.