China: Slowly stabilizing Global Economic Outlook, Q3 2017

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​China’s economy appears to be stabilizing gradually, boosted by rising industrial production and higher foreign currency reserves. However, questions loom large over its market status and sovereign risk rating.

Stable growth

The latest economic indicators from China reveal an economy that appears to be stabilizing at a moderate rate of economic growth.1 Here are some details:

  • • Fixed asset investment in the first five months of 2017 was up 8.6 percent from a year earlier, roughly similar to the past year. Prior to 2016, fixed asset investment was growing at a much more rapid pace. In the most recent five months, foreign-funded investment declined 1.3 percent from a year earlier, while domestic-funded investment was up 9.4 percent. Government-funded investment fell 10.2 percent from a year earlier.
  • • Industrial production in China was up 6.5 percent in May versus a year earlier, the same rate of growth as in the previous month. Output by manufacturers was up 6.9 percent. This is a pretty strong rate of growth and is not consistent with the relatively weak purchasing managers’ indices (PMIs) for the Chinese manufacturing sector, published recently. The PMI for May indicated declining activity, while the PMI for June indicated growth, but just barely.
  • Chinese retail sales were up 10.7 percent in May versus a year earlier, roughly in line with that reported in the past year.
  • The value of outstanding loans in China increased by 12.9 percent in May versus a year earlier. This was actually a relatively slow rate of growth compared with that of the past several years. The volume of new credit, both in and out of the banking system, grew more slowly in May than in recent months. Evidently, there is a deceleration in the growth of credit, reflecting the government’s concern about a potentially excessive rate of credit expansion in recent years. This, in turn, is reflected in the slowdown in the growth of the broad money supply. In May, the broad money supply was up 9.6 percent from a year earlier. Moreover, in recent months there was barely any growth at all. Clearly, the central bank has tightened monetary policy in an effort to stem the rise in credit. The pattern in recent years, however, has been alternate tightening and easing of monetary policy. The tightening took place when the central bank was concerned about debt, while the easing took place when the central bank was concerned about growth.
  • Producer prices were up 5.5 percent in June versus a year earlier. Consumer prices were up only 1.5 percent. Thus consumer-facing businesses likely saw a decline in profit margins. More importantly, the low level of consumer price inflation suggests that the central bank has plenty of wiggle room should it need to stimulate the economy. The bigger risk for the central bank is that the easing of monetary policy is likely to stimulate more credit market activity, at a time when many analysts are concerned about the high level of debt in the Chinese economy.
  • In the first five months of this year, foreign direct investment (FDI) into China fell 0.7 percent from the same period a year earlier. In May alone, FDI was down 3.7 percent from a year earlier. Outbound FDI, which had increased faster than inbound FDI in 2016, has fallen sharply in the first five months of 2017. This partly reflects government capital controls intended to stifle outflows of capital, which had been putting downward pressure on the currency. Indeed in April, nonfinancial outbound FDI from China was down 71.0 percent from a year earlier. In the long run, this will not be helpful for the globalization of Chinese companies.
The pattern in recent years has been alternate tightening and easing of monetary policy.

Rising reserves

China’s foreign currency reserves have increased for the fifth consecutive month. In June, reserves rose to their highest level since October, although the increases in the past several months have been very modest. Still, this is a big change from what transpired from early 2014 until early 2017. During that period, reserves declined by about $1 trillion, reflecting the fact that there was a sizable outflow of capital from China, which put downward pressure on the value of the currency. In order to prevent a sharp depreciation of the currency, the central bank massively sold reserves. However, in the past year, the government imposed new capital controls, meant to prevent outflows of capital. This has evidently worked: The currency stabilized, and the central bank was able to purchase new reserves without worrying about a declining currency. Yet imposing capital controls means postponing the time when China’s capital markets become more fully integrated into the global economy. China’s leadership had wanted to move the country’s currency toward being convertible, for it to be seen as an important global currency for trade and wealth preservation. As long as capital controls remain in place, and as long as investors rightly fear the possibility of more controls, the currency will not become a major global player.

Is China’s market status set to change?

The chief trade negotiator for the Donald Trump administration, Robert Lighthizer, has warned against a potential decision by the World Trade Organization (WTO) to label China a market economy.2 Such a decision would make it more difficult for other countries to seek damages from China based on unfair trade practices. The decision would presumably be based on the determination that most product prices in China are based on market conditions and that government interference in markets is minimal. China has been lobbying for such a change, but the United States strongly disagrees. Lighthizer said, “I have made it very clear that a bad decision with respect to the non-market economy status of China would be cataclysmic for the WTO.” This was interpreted as a suggestion that the United States might exit the WTO. Although Trump has eased public pressure on China with respect to trade following his meeting with China’s President Xi Jinping, Lighthizer says that serious issues between the two countries remain. He noted that the US trade deficit with China “still hasn’t come down.” Of course it would be unrealistic to expect it to decline in just a few months. Moreover, a bilateral trade imbalance between two countries is not necessarily of economic significance. Nor does a trade deficit reflect trade rules. Rather, it is arithmetically due to a country investing more than it saves.

Sovereign risk rating

Ratings agency Moody’s has downgraded some of China’s sovereign debt, the first such action in almost 30 years.3 Moody’s pointed to slower economic growth and rising debt as a potentially dangerous combination that could increase the probability of default. The agency said that “the downgrade reflects Moody's expectation that China's financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows.” However, the Chinese government took umbrage at this action, saying “Moody’s views that China’s nonfinancial debt will rise rapidly and the government would continue to maintain growth via stimulus measures are exaggerating difficulties facing the Chinese economy, and underestimating the Chinese government’s ability to deepen supply-side structural reform and appropriately expand aggregate demand.” Moody’s, however, acknowledged that China is engaged in a reform process. Still, it said that “while ongoing progress on reforms is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in contingent liabilities for the government.” Moody’s also said that, because of continued outflows of capital and the resulting depreciation in the currency, the Chinese central bank will be constrained in its ability to provide easier monetary policy. Indeed if, to stem outflows, the central bank were to tighten monetary policy, it could exacerbate difficulties in servicing debts.

Moody’s pointed to slower economic growth and rising debt as a potentially dangerous combination that could increase the probability of default.

Following the announcement of the downgrade, the Chinese currency briefly fell in value before rebounding. Likewise, yields on Chinese government bonds initially rose before falling back. The muted reaction to the ratings change reflects the fact that domestic investors in China rarely pay much attention to foreign ratings, as most sovereign debt in China is sold to domestic investors. In addition, Moody’s conclusions about the risk from rising debt hardly represents new information for investors. The problem of debt has been well publicized. Notably, the problem is not central government debt, which remains at a modest level of less than 40 percent of GDP. Rather, Moody’s is concerned about the off-budget special purpose vehicles established by local governments to provide funding for infrastructure investment. Moody’s is also concerned about the rising debt of state-owned enterprises, which are seen as quasi-sovereign and potentially creating a liability for the government. Nevertheless, many observers have expressed concern about China’s debts, which could remain a key issue for China in the coming years.