The Boao Forum for Asia 2017

China 2017: resilience in the face of uncertainty

2017 presents both challenges and opportunities for China as the economy moves from an investment and export oriented model to a consumption and services oriented one. Such a transformation inevitably results in a slower growth rate and this could create a certain financial ''fragility'' in the short term. The good news, however, is that domestic demand has held up even in the face of a slowing economy, which is in itself a consequence of the continued and successful transformation of the Chinese economy into an urbanized, consumer oriented one.

The challenges facing China this year come from politics: the possibility of a rising tide of protectionism sweeping over the world, trade friction with the US, and possible black swan events such as the imminent French elections, are some examples. The reality is that while China's domestic demand is growing, it's trade sector still accounts for about 40% of GDP and 2017's current account surplus is likely to be around 2-3% of GDP. Concerns over protectionism and trade friction with the US might quite possibly constrain China's capacity and/or desire to allow a depreciation of the RMB. There are clear signs already - Chinese leaders have been playing down the chances of an RMB depreciation since last December and at the same time carefully deflating housing and financial bubbles. This has put a greater burden on fiscal stimulus, the only remaining tool they have for promoting growth in the economy. Hence the emergence of a certain financial fragility in the Chinese economy. In fairness, the roots of this financial fragility lie in the large fiscal stimulus of RMB 4 trillion in late 2008 and the continued debt build-up that followed which was the result of a policy bias towards a high economic growth rate. So the real challenge this year is not so much protectionism or trade friction with the US but whether or not policymakers will tolerate a slower growth.

• Trade friction between China and the US - Our baseline scenario is that that there will not be a full- blown trade war between the two largest economies in the world but the risk of a certain significant trade "friction" cannot be ruled out. The Trump administration seems to be quite serious about reducing its trade deficit which it says is a result of "unfair trade". Indeed, China's trade surplus with the US (over USD 250billion in 2016) has dwarfed bilateral trade imbalances between the US and other major trading partners. The fact that the US Treasury will probably not follow through on President Trump's campaign pledge of dubbing China a "currency manipulator" suggests that the Trump administration is likely to push China in other areas such as market access.
• Financial risk - China's progress on deleveraging has been slow in recent years. By 2016, debt/GDP ratio had ballooned to roughly 270%, potentially undermining the soundness of the financial system. One indicator of the stress on the financial system was late last year's mini crisis in the bond market. The best way of mitigating financial sector risk is to reduce leverage, (mainly state-owned enterprises (SOEs) and local government debt) but that also means a slower economic growth rate.

A strong labor market reduces the need to ''reflate'' the economy
Given the robust labor market, there is no need for China to stick to the overtly ambitious target growth rate. Of course there will be concerns over unemployment and social dislocation but the reality is that China’s labor market is tight and rural surplus labour has reached the Lewis turning point and labour no longer transfers to cities in large numbers. Moreover, China’s population is aging and hence the labour force to population ratio in trending downwards. In addition, a vibrant new economy is generating many jobs although not much GDP in a traditional sense. Why? Service sector in China is under-developed but improving services such as better experience of travel may not generate much GDP even though many jobs will be created.

Take the RMB's "weakness" in stride
One major challenge faced by China is the acceleration of capital outflows which is exacerbated by depreciation expectations. China's foreign exchange reserves have come down from USD 3.23trillion in January 2016 to USD 2.9trillion in January 2017. Declines of foreign reserves is the result of corporate external debt repayments, their desire to acquire relatively under-valued overseas assets and a diversification of consumer preferences. The Government, understandably, wants to stabilize both the RMB exchange rate and foreign reserves. However, given that China is the world's largest trading nation in the world and at the very center of global supply chains, certain draconian means of capital controls may result in adverse effects on financing and even normal procurement for firms operate in China. In addition, these measures, although temporary, could deter foreign direct investment (FDI) because companies are concerned about the risk of profit/dividend repatriation.

Though muddling through has proven to be the optimal strategy in the past thirty years, where the RMB exchange rate is concerned, we feel the current situation may call for something bolder. This is because, political factors aside, several challenges await China in 2017, the toughest one being a sooner-than-expected monetary tightening by the Fed which could make the dollar even stronger. Tax cuts in the US will, in all likelihood mean that the dollar will become even stronger, prompt the Fed to react in a more forceful way in view of a full-recovery of the US economy. Therefore, it would be wise for policymakers to accept sporadic overshooting of the RMB exchange rate instead of running down reserves.

Dynamics of future growth
Let us look beyond 2017. What does the future hold for China? There are several prospects for growth. Here are four possible trends:

1. The rising tide of urbanization
   Since the government in 2014 unveiled its new urbanization program which aims to transform rural workers into urban dwellers by offering them urban dwellings, more than a dozen new city clusters have emerged across the country. These city clusters are part of the so-called ''one-hour economic circles'', linked by high-speed rail and extensive underground subway systems, and have substantially strengthened the transportation and trade links between villages, towns and cities. Migrant workers, a large population group who have long been neglected, should also be integrated into the urbanization program as they are already urbanized and have great potential as future consumers.
2. Servicing China's aging population
   China's population aged rapidly with 15% of its population aged over 60 in 2013. This proportion is projected to grow to 18.5% or 280 million by 2025. With changes in the demographic structure, there will be a growing demand for pension, medical services, healthcare insurance, asset management and tourism in China.
3. Technological/Internet innovation
   Every major technological breakthrough serves as a catalyst for industrial revolution. From big data and cloud computing to artificial intelligence and virtual reality, emerging technologies are disrupting business in unprecedented ways. But technology is an industry game changer only when it acts as a tool that enables companies to cut expenses and increase productivity. We remain cautiously bullish on every new technology and the changes it brings about.
4. Industrial automation and artificial intelligence
   The fourth industrial revolution is expected to see more human jobs replaced by robots. The Chinese government is keen to promote automation in its vast but inefficient manufacturing industry as a way to cope with increased competition and rising labor costs. China has seen its working age population shrinks and fewer young people willing to work on assembly lines as their parents did. In a global context, China needs to shift from a labor-intensive goods exporter to a high value manufacturing powerhouse. As the cost of industrial robots continues to fall, we expect to witness a mass adoption of automation in China's manufacturing.

Conclusion
Notwithstanding various challenges such as exchange rate management and possible external shocks, China still has many policy options. It would be wise to lower the GDP growth target and to focus on the quality of growth rather than on numbers. Indeed, the group on overall economic reform seems to be well aware of this. Recently, in the run up to the annual NPC and CPPCC Sessions (1st week of March), they announced that the key goals for 2017 are – addressing over capacities, mitigating financial risks, and upgrading the manufacturing sector.