Never before have China’s economic reforms been so precariously balanced between maintaining robust growth in order to maintain social stability, and reining in the excesses and imbalances from the supercharged decades-old industrial policy. Policymakers are attempting to fulfill two often diverging goals of adding stimulus with one hand and trying to force rebalancing and discipline with the other hand. Those opposing goals will continue to add policy risk and drive the two-speed economy to diverge further in 2016. We should see growth stabilized but slowing, with larger divergences between new growth sectors and traditional growth sectors within the economy. Financial system risks, overcapacity, malinvestment, and the turmoil of market liberalization will not disappear, but we should see more headway on mitigating those risks in 2016.
Growth has finally begun to pick up as the year winds down, a result of more than a year of piecemeal monetary easing, pro-housing market policies, consumption-boosting measures, and fiscal stimulus. Going into 2016, the momentum should keep the economy stable for months to come. More easing and fiscal measures should be expected, but less than in 2015 as Beijing moves the growth target one notch lower.
What Beijing Expects
China's central bank foresees the economy growing around 6.8% in 2016, above what we are assuming will be the new growth target of 6.5%. The PBOC also expects exports to grow around 3% and imports to grow just over 2%. The trend rate for those two trade numbers is in the double digits, and such low forecasts imply a continuing drag on China's suppliers as well as weak global trade in general. The new growth and inflation targets will be announced to the legislature next spring, but expect both to be lower than the current targets of 7% and 3% respectively.
What the Market Expects
Overall, most analysts and banks expect the economy to be weak but stable next year. Other expectations: Slowing growth but no hard landing, a much weaker yuan, and a few more interest rate cuts.
Market consensus is for 6.5% GDP growth in 2016. Within the consensus, some analysts are more bearish than others. According to the Wall Street Journal, both Barclays and State Street expect 2016 growth of 6%, below target and well under Xi's growth floor, as a result of excess capacity in industry and housing, persistent deflation, and other issues. HSBC in November put its forecast at a brisk 7.2%. In general most analysts see growth around 6.5%, plus or minus about a half of a percent. We are entering 2016 with a far tighter range of growth forecasts than when we entered 2015.
Two-Speed Economy Will Keep Diverging
China will slow next year, and 2016 will be another year of speculation about just how much lower the slowdown can go. I would argue that for those outside of mainland China the real question should be not "how much will GDP growth slow?" but “how far will industry slow?" The divergence between services and industry will deepen next year. Rapid growth in services and consumption are both great for domestic stability and those who sell their wares within China’s boarders. But, another year of slower factory output means another year of sluggish commodity and machinery demand. A stable China growing at 6.5% next year means a positive contribution to global growth on a mathematical basis, but means more weakness passed along to economies linked to China’s once insatiable demand for machinery and commodities.
A Soft Landing + Economic Rebalancing = Good news for consumption and service sectors, but not very good news for industry and the lion's share of import demand from the rest of the world.
Underdeveloped consumption and service sectors have a lot of room ahead to catch up to regional peers. And, most reforms favor boosting those two sectors. Less investment is being put to work in industry and construction - both plagued with overcapacity issues. In addition, most reforms seem primed to slow industrial output. Stable growth is not necessarily a good thing for key commodity and industrial machinery import demand.
For those who choose to measure China's economic activity by counting rail cars and electricity output, 2016 will look like a hard-landing year again.
3 Key Reforms to Watch For
2016 will see a constant flow of new reform and restructuring plans and policies announced. Liberalizing markets, trying to reduce financial risks, and possibly more potential changes to state-owned firms will be some of the policy themes. But, there are three very import reforms that seem to stand out as leadership priorities for 2016.
Capital account liberalization will continue to roll along next year as Beijing prepares to free the yuan by 2020. We should see higher quotas for inbound securites investment as well as more volatility in the yuan as it slowly becomes more untethered.
2016 will see meaningful changes to China's household registration system. The household registration system is a throwback to central planning days. It excludes migrants workers - roughly 20% of the population - from social services like education and medical benefits if those migrants live outside of the locality where they were registered at birth. The Mao-era policy persists because urban registered city dwellers do not want their services diluted by folks from the countryside. If Beijing can make real headway, and allow 20% of the population access to key social services, it can unlock sizable income and savings for consumption.
At a very recent meeting of China's leadership, fixing industrial overcapacity was a frequent topic for announcements. We have heard Beijing talk about fixing overcapacity issues in the past, only to ignore the problem at the first sign of economic slowdown. But, recent announcements indicate that reducing overcapacity and removing "zombie" firms through bankruptcies and mergers is a core reform for next year.
So what does this mean for growth? The household registration reforms will be good for consumption and services. Overcapacity fixes will be a negative for industry. These two reforms should drive an even bigger wedge into China's two-speed economy.
As mentioned in previous blog postings, the yuan is in a tug-of-war between market forces putting downward pressure on an overvalued yuan, and policymakers looking to keep the currency stable and strong for economic restructuring purposes and political reasons. In August, the PBOC introduced changes intended to increase market forces on yuan price setting. The PBOC still enjoys a great deal of control over the yuan via massive $3.5 trillion in exchange reserves and control over currency printing, but less control than it had before August. As a result, market pressure will weigh on yuan price moves more than in the past, and the yuan will experience greater volatility in 2016.
Beijing has indicated it wants a "strong and stable" yuan. The introduction of the CFETS RMB Index recently - a basket of currencies by which the PBOC may measure the yuan's relative value - could indicate a shift away from viewing a "strong and stable" yuan as "strong and stable" measured against a wide basket of currencies and not just measured against US dollar.
See the following blog posting for more details: 5 Important Things You Should Know About The Chinese Yuan.
All in all, downward market pressure may have a greater influence on the yuan vs. the dollar than in the past. But, a Beijing engineered policy-driven devaluation to revive growth is unlikely for reform and political reasons, especially as the PBOC is already expecting very weak exports in 2016 (see PBOC forecasts above) and China's trade surplus is already quite massive. China has plenty of tools to fight weak growth, and a large engineered devaluation would draw the ire of central bankers around the world as China prepares to host the G20 in 2016. It would also reignite imbalances by transferring wealth from households back to industry. So, we should expect to see a modestly weaker yuan vs. the US dollar in 2016, and much more volatility, but likely no major devaluation policy.
Monetary and Fiscal Policy
We should expect to see more stimulus measures in 2016, but fewer, smaller, and possibly different measures than in 2015. The economy is entering 2016 with good momentum, and a growth target lowering to 6.5% will reduce the stimulus requirements to meet that lower target.
Beijing gave indications this week that more stimulative measures could be on the way in order to create "appropriate monetary conditions for structural reforms." China's monetary policy is still more restrictive than in easing cycles in the past (see the chart on the right). Easing will probably come in the form of targeted easing over broad easing now that we have seen broad reflation finally kick in and a bottom in the recent credit slowdown. The market expects the required reserve rate (RRR) - the broadest and most effective tool - to be cut by 2% more in 2016, after being cut 2.5% this year. Given the current growth momentum and worries about excesses and overcapacity, we will probably see fewer cuts than the broad consensus; perhaps only 1% or less.
Beijing has indicated that fiscal stimulus will start to come more in the form of tax cuts, and less in the form of spending. Expect another fiscal deficit, but primarily driven by tax cuts. This will have the effect of lowering the fiscal boost impact on basic infrastructure, and therefore heavy industry investment - the traditional recipient of fiscal stimulus in past years - will probably continue to weaken. So, more fiscal stimulus does not necessarily mean more demand for key commodities and more demand for industrial machinery. A fiscal boost in 2016 could be felt more in services, green energy, or consumption, which would differentiate it from past fiscal stimulus measures.