Some downside risks to China's 6.3% GDP forecast for 2018 are worth talking about

Beijing has spent the past three years promoting quality growth over quantity. Indeed, President Xi himself again stressed the importance of a “quality-oriented” growth model at the 19th Party Congress last year. How it manifests in policy, matters. Accepting slower growth is a critical prerequisite for Beijing to rein in local government and SOE debt. So, it has been particularly interesting to note that the provinces, most of which have recently convened or concluded their own economic work conferences, have also stressed quality over quantity.

Looking ahead, an important signal will emerge at the NPC meeting in March. Here, the national growth target for 2018 will be set. The outright abandoning of the target looks unlikely – even though it would be the right move. Perhaps a target of “around 6%” through 2020 is on the cards. We know that China needs to average growth of 6.3% over the next three years if China is to double 2010 GDP by 2020. Its plausible, but not our base case. We actually expect growth to drift lower this year, from 6.7% in 2017 to 6.3% in 2018, but to slip below 6% in 2019 and 2020.

The slowdown is inevitable – especially because deleveraging is likely to pick up in 2018. De-risking in China’s financial sector is just getting started. Again, that was the official message communicated at the Politburo meeting in December. There, Xi Jinping highlighted that “preventing and defusing major risks” in the financial sector is the first of three “tough battles” on the economic front in 2018. That means the ongoing regulatory storm which gathered pace last year is not going to abate any time soon.

Overall, the priorities for 2018 are likely to similar to last year: de-risking the financial sector; supporting corporate deleveraging; - especially SOEs; cutting excess capacity; taming animal spirits in parts of the housing market, whilst dealing with the inventory overhang elsewhere; and environmental protection. It suggests relatively tight monetary policy – although ample liquidity will be made available but at elevated funding rates – along with a focused, yet still somewhat supportive, fiscal policy.

It is worth noting that for all intents and purposes, 2017 can be seen as a macroeconomic success for the Xi administration, but downside risks loom large, and complacency would be a mistake at the juncture. Connected to this, an important risk for this year is that policymakers overtighten. Indeed, interbank rates are relatively elevated – SHIBOR has averaged around 2.85% since October – and has been trending higher throughout the past year or so, and we are on the guard for spikes. Sharp increases in funding costs could point to real stress in the financial sector. Related to this is the issue of bank funding: banks have certainly made tremendous progress in reducing their reliance on wholesale funding, but deposit growth has slowed materially. At some point (sooner than later), this issue will come to a head; a message that the banks themselves highlighted in late 2017.

The risk of overtightening can easily be extended to the housing market too. Last year the resilient real estate market provided a tailwind to the economy (along with robust global trade growth). However, the long-anticipated slowdown arrived in Q4:17 as investment grew by only 3.2% y/y in October – down from 6.2% in September. Of that, investment in real estate eased to 5.6% y/y – down from an 8.2% average in the first nine months of the year. This year more severe and draconian restrictions on purchases will dent housing construction, but it could also knock prices, hurt consumer confidence and consumption, and encourage capital outflows.

This issue would come into sharp focus should rates in the US rise more quickly than anticipated, undermining the central bank’s grip on the value of the Renminbi. At the very least it is difficult to imagine the PBOC following the US Fed with three hikes in the policy rate in 2018, so we are already expecting the interest rate differential to narrow in 2018. Meanwhile, another cause for concern is that China’s fiscal muscle is shrinking all the time. In fact, fiscal spending shrunk by 9.1% y/y in November. Thus, fiscal policies’ ability to act as a counterweight to monetary policy is diminishing.  

Another key flash point is inflation. Even though the economy is slowing as we expected, China’s industrial companies saw their combined profits increase by 21.9% in the year to date to November to CNY6.8trn. Without doubt, elevated commodity prices have benefit coal and other mining companies. Interestingly, SOEs were benefitting most from the profit boom, with earnings at state holding companies jumping 48.7% in the first 10 months, compared with 14.2% at private industrial companies. Essentially better profits meant that businesses feel more optimistic – and can pay down their debt bills. Lower inflation – especially at the factory gate, which slipped from 5.8% in November to 4.(% in December – may alter this status quo.

So, we have already seen that economic growth has starting to slow – dating back to October last year. Should the deceleration become more precipitous, it will test regulators’ commitment to reining in leverage. Key to the outlook is how all of these various policy priorities influence SMEs – which account for 90% of businesses, 80% of jobs, 70% of patents and 60% of GDP. Whilst the role of the Party has increased under Xi, Li Keqiang has been working hard to reduce the role of the state to make it easier for these businesses to operate. To be fair, more efficient price signals and some more creative destruction would probably help these agents identify opportunities more accurately, but that is probably a step too far in 2018.

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