China: Constructive Outlook, Despite Rating Downgrade

Qinwei Wang is an Economist.

One of the biggest uncertainties for the global economy and investors has been China – its economic transition and the implications of President Trump’s protectionist policies since late 2016. Just this week, Moody downgraded China’s long-term local currency and foreign currency ratings to A1 from A3 and changed their outlook to stable from negative, mainly due to concerns of high leverage.

That said, we believe that macro risk related to China has eased somewhat into 2017 and we are now looking at China in a more constructive way. We believe that in order to understand China, and its impact on the global economy going forward, we need to answer three key questions .

1) What is China’s current economic situation?

China’s economy seems to be holding up relatively well through the first half of 2017, with growth drivers appearing more broadly based rather than just stemming from infrastructure spending.

• Exports have shown some more convincing signs of recovery.
• Property markets have surprised on the upside, with relatively strong new starts and sales, despite targeted tightening in larger cities.
• There are some burgeoning signs of a mild recovery in private investment, which has been downbeat for several years.
• Car sales have cooled after tax benefits were reduced, but consumption elsewhere has held up relatively well.

The inflation picture also appears benign. China’s Central Bank’s monetary stance has shifted slightly, with a marginal tightening bias that has likely been set for the purpose of de-risking financial markets rather than cooling the economy. However, there are no convincing signs of serious tightening ahead just yet. Overall credit growth has been slowing (albeit moderately), due to this tighter stance alongside stronger regulations.

Meanwhile, external risks seem to have eased. Capital outflow pressures have decreased markedly, helped by US dollar (USD) weakness so far this year.

2) What can we expect from policy makers?

We expect that growth is peaking and could cool later this year. Policymakers see no incentive for a further economic rebound, given lingering concerns about high leverage. The annual National People’s Congress (NPC) revealed a lower growth target of “around 6.5%” with a slightly slower credit growth target relative to 2016. Nonetheless, we think the landing could be longer and softer than widely expected, as there is still ample policy space and meaningful supply-side adjustments that have been made in recent years. Where have these supply-side adjustments been most evident?

• Property markets: de-stocking has taken place in a wide range of regions, as well as in large cities where inventories have dropped to relatively tight levels
• Commodity and manufacturing sectors: Low investment and capacity cuts have limited downside price pressures. Such efforts seem to have helped supply and demand move towards more balanced levels.

Such supply-side adjustments, if continued, could help limit downside risk for the overall economy, as we believe 1) deflation pressures would be smaller; 2) there would be less depression on private investments, and 3) demand policy would likely be more effective.

Ultimately, nominal growth could remain higher-than-average, borrowing costs (as has been the case recently) to keep non-performing loans (NPL) under control, to help ease pains from existing debts.

Currently, China is making more determinate and coordinate efforts in strengthening financial regulations, which tends to prevent generating new risks.

Figure 2: Nominal Growth has Rebounded Above Average Borrowing Costs, Helping Ease the Debt Burden and Keeping NPLs Under Control; This Could Continue.

China Nominal Growth vs Borrowing Costs (%, Quarterly Average)

Source: Pioneer Investments, CEIC, Bloomberg. Data as of April 1, 2017.
Notes: Average borrowing costs are weighted average of interest rates for different forms of borrowings in total credit (TSF), including loans, trusts, entrusts, bills, corporate bonds and Government bonds.

Moreover, if the recent synchronized recovery of global demand were sustained, it would be easier for China’s policymakers to manage a potential slowdown. Risks ahead may come from policy mistakes – such as excessive monetary tightening or abrupt financial regulation – which could threaten broader financial stability.

External risks continue to relate to US policy uncertainty and the recent heightening of geopolitical tension with North Korea. Nonetheless, the improved communication emerging between Presidents Trump and Xi could lead to more comprehensive negotiations, thereby reducing the probability of serious accidents and, thus, tail risks.

3) Reform: where do we stand?

There seems to be no change in reform agenda. Structural reforms remain a top political goal, widely regarded as key for the medium-term outlook for the country. Among the priorities for this year, we expect the focus to be on the following areas:

• • Strengthening of financial regulations: We think this is necessary to keep systemic risks under control following the significant financial liberalization seen in recent years. We expect to see more coordinated actions from regulators to target shadow financing, as well as possible signals about how they plan to achieve a more integrated regulation system.
  • Efforts to cut over-capacity: We see a focus on the closure of “zombie” companies in favor of more reliance on markets and regulations, such as stricter environmental and safety requirements. This looks to be already underway.
  • Efforts to improve access to onshore bond markets for global investors: This is expected to be achieved through the China Interbank Bond Market (CIBM) and, the newly announced Bond Connect program via Hong Kong. The inclusion of Chinese onshore local currency bond markets in major benchmarks may come faster than people expect.
  • More signs of reform for State Owned Enterprise (SOE): Mixed ownership and local SOE reforms are, potentially, the key areas to watch.
  • Progress in the implementation of reforms regarding rural land, ‘Hukou’ (household registration system and urbanization )
  • The ongoing Foreign Exchange (FX) regime shift: This started in 2015 and continues to be one of the most important reforms to monitor . We continue to believe that a large devaluation of the Chinese yuan (RMB) is unlikely, assuming there are no major surprises in the USD. We expect capital control measures to be gradually eased if capital outflow pressures remain under control. However, policymakers might try to allow greater flexibility for RMB , when the timing is right, but this is unlikely to trigger systemic risks.

Considering the ability of the reform momentum to transform the economy, and the benign (domestic and global) economic outlook, we are positive on Chinese equities. We believe investors should consider sectors that could benefit from the strengthening of domestic consumption in the transition process of China to more balanced growth.