2015 was a tumultuous year for China sentiment and markets. A massive stock market roller coaster ride, the most currency volatility in decades, turmoil caused by Beijing's poorly articulated policy moves, and widespread disbelief of official economic numbers led to a low-point in sentiment in the last two decades. Google searches for the words "Chinese Economy" this year much more often than last year were accompanied by the words "collapse" and "crisis."
But, under the hood this was a big year for reforms and restructuring. We saw significant progress in rebalancing from a super-charged industrial policy towards an economy increasingly driven by services and household consumption; all the while employment stability was maintained. The economy saw the slowest debt accumulation in twenty years. The last of China's benchmark interest rates - the bank deposit rate - was finally freed up. The yuan moved more towards market-driven price moves than any time in the last few decades. Local government debt and shadow banking risks were reduced significantly. 2015 may be the first year in many that housing sales outstrip completed homes. Residential inventory has actually declined.
But not all was good. Zombie firms were kept on enough life support by Beijing only to end up flooding the rest of the world with cheap materials, like steel and aluminum. Bankruptcies and failed firms are still a rarity, even as a number of industries - mining and smelting in particular - see financial losses mount. No progress was made on fixing industrial overcapacity and corporate debt load. Pollution levels hit new highs in some major cities. Xi stepped up the Party's power consolidation, rounding up more lawyers and journalists, along with business tycoons and powerful Party members. Market freedoms are increasing, civil freedoms have been reduced.
Here is a list of what I view as the seven most important issues that took place this year.
1) 2015 was a momentous year for the yuan.
Beijing broke from its previous currency regime, allowing markets more influence in currency moves and modestly devaluing the currency in August. Poor communication of intentions led to turmoil in global markets worried over a new currency war or China's potential to export deflation if Beijing devalued further.
The IMF decided to include the yuan in its Special Drawing Rights (SDR). The SDR's yuan addition will take place in October of 2016. This is the first change in the SDR currency makeup since 1999, and the first time an EM country was added to the basket. The yuan weight will be nearly 11%, compared to roughly 8% for the JPY and GBP each. The USD and EUR will be roughly 42% and 31% respectively. Beijing's end goal is not to become a small slice of the $280 billion SDRs. The end goal is to become a large slice of the $11 trillion reserve asset market for both political and economic reasons. The IMF's stamp of approval will facilitate inflows from central bank reserves, sovereign wealth funds, and other institutional money managers.
Beijing this year made a promise to make the yuan fully convertible by 2020. Such a move would have significant implications for global asset markets. China has the second largest stock market and third largest local currency bond market in the world. By 2020, many emerging market investment indices will be dominated by Chinese stocks and bonds. And, Chinese mainland savings deposits total $21 trillion. Outbound investment by Chinese mainland investors will have a huge impact on global markets and global asset management firms.
For more info on what to expect in 2016, see my blog posting:
China 2016: A brief overview of expectations
and:
5 Important Things You Should Know About the Chinese Yuan
2) China's two-speed economy diverged considerably in 2015.
In 2015, China saw its economy running at two speeds. Underdeveloped services and consumption grew at a relatively fast clip while industry and construction - China's traditional drivers of rapid growth - have slowed to new lows for those sectors. Don't count on Chinese consumers to replace the hole in global demand left by declining demand from China's once rapidly growing industrial and construction sectors. China's industry and construction sectors drive demand for commodities and industrial machinery - the economy's primary imports. For many global suppliers to China's once insatiable industrial juggernaut, 2015 felt like a hard landing year.
3) 2015 saw widespread skepticism over China's official GDP numbers.
Doubt over the veracity of China's official economic numbers has been around for some time, but 2015 seemed to be a peak year for skepticism. There are two reasons for this in my view: 1) The two-speed economy has caused many to mistakenly conclude broad growth is in hard landing territory. As consumption and services drive growth, conventional measures like electricity and rail freight are increasingly less relevant as a total GDP measure. Using traditional measures of heavy industry production and traditional bank lending will result in an indication of narrow sectors, and not broad growth. The service sector, over 20% larger than the industrial sector, has been largely ignored by many analysts and pundits. 2) Much of the skepticism of official data comes from some of the most pessimistic forecasters. Skepticism of official numbers combined with custom indicators that use industrial-only indicators only allow the most pessimistic forecasters to say that their forecasts have been right on the money.
The balance of statistical evidence from research done by the San Francisco Fed, my own research, and domestic evidence - like employment stability - points to official numbers in the ballpark of underlying broad GDP growth. Below are links to blog entries with more details on the subject.
Should We Believe China's GDP Data?
The "Li Keqiang" Index: Why is that still a thing?
4) New revelations about China's deadly pollution came to light.
Some major cities in China have been recently besieged by thick clouds of air pollution. China has set massive outlays for green energy investment, but there are two studies out this year that remind us how bad things are.
This year a study by Berkeley Earth monitoring 1,500 measurement stations over four months concluded that 17% of Chinese deaths each year can be attributed to air pollution. That is 1.6 million citizens a year. That is 180 deaths each hour from air pollution alone. That number was more than double the estimated 650,000 deaths attributed to air pollution by the WHO in 2007. Berkeley Earth researchers estimate nearly 40 percent of Chinese residents were regularly exposed to air that was unhealthy to breathe. And, the effect of Beijing's air quality is the equivalent of smoking 40 cigarettes a day.
Also this year, NASA's GRACE satellite data showed that the majority of the world's largest groundwater basins - major sources of the planet's drinking water - were being rapidly depleted and on the verge of disappearing. The North China Plains aquifer, which provides water for 11% of China's population and 14% of its arable land, was one of the critical basins cited. The NASA revelations are a reminder that China has serious problems with its water resources.
Recent Study: 1.6 million deaths each year across China can be attributed to air pollution.
Structural Growth Headwind: Water Problems
China's ambitious renewable energy investments.
5) The housing market rebounded, mostly in the wealthier and tier 1 & 2 cities, but construction remains in the dumps.
China's residential housing market rebounded in 2015, with prices and sales rising higher after Beijing introduced policies to support the market - including lowering the required mortgage down payment. But, higher prices and improved sales have yet to convince developers to increase construction activity. Construction has yet to rebound, keeping the impact on overall growth subdued. Investment in residential real estate is still declining.
Most of the rebound has taken place in the top-tier, wealthier cities, especially on the coast. The hinterlands (where most overcapacity and ghost cities have been built) are still negative. A housing rebound in the larger more economically vibrant provinces will add to broad growth prospects.
New housing inventory has contracted this year - more than any time in the last few decades. I calculate that this amounts to about 1.5 million fewer housing units on tap to be finished this year compared with last year. After a surge in sales, at the current pace demand is probably outstripping supply this year.
6) China's debt burden is still growing, but much was done in 2015 to mitigate some key risks.
China's debt burden grew in 2015, as broad debt expansion outpaced economic growth. But, transparency into opaque areas of China's debt burden has been improved significantly through Beijing's local debt swap and the declining use of shadow banking. Two favorite topics of China hard-landing doomsayers - opaque local government debt schemes and the rapid growth of murky shadow banking - are successfully being diffused.
Local government debt swaps - intended for "closing the back door, and opening the front door" for local government lenders - allow local leaders to swap ousdtandig debt in the form of opaque financing vehicles for more transparent municipal bonds. The creation of a municipal bond market will make debt more transparent and allow financial risks to be diversified away from banks. Launched in March this year, the swap program plans to swap out roughly 15 trillion in murky local debt with municipal bonds over then next three years.
Trust loans, entrusted loans, and other shadow banking vehicles that over the years have worried analysts and economists slowed in 2015, as more transparent credit growth - non-financial bond issuance for example - thrived.
China's Debt Burden: Some Key Developments in 2015.
7) 2015 highlighted the risks and limitations of Beijing's control over market forces.
Within economic transitions, liberalizing markets is messy business. If it were not, then every developing market would already be like Hong Kong. China's stock market rose spectacularly, and crashed in a dramatic and short-lived one-year roller coaster ride. Chinese leaders willfully failed to stop the bubble from inflating and struggled to fix it when the crash came. China is still in transition, and we should expect to see more difficulty in managing market turmoil in the future.