What impact will US trade protectionism have on China's economic prospects?

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Speculation on what a Trump Presidency means for US/China trade relations is high.  Recent rhetoric from both sides suggests that at least some trade friction is on its way.  At this point, no one has solid indications of what kinds of tariffs or barriers the US might inflict on Chinese imported goods, nor do we know how Beijing might respond.  However, almost any amount of trade friction will cause pain to some unlucky firms or consumers in both countries, and risks upending an economic relationship that has been stable for nearly forty years.  This blog post will not focus on the effectiveness of imposing trade barriers and tariffs on China.  Nor will it discuss the geopolitical gains set to be made by China as the US abandons the TPP, disengages from Asian economies, alienates longstanding trade partners and allies, and opens the door for China to become the architect of an Asian economic partnership.  This analysis will focus on how US protectionist policies might affect China’s economic prospects going forward.

A quick note on the recent developments between the US and Taiwan:
In the analysis in this blog post, I am making an assumption that trade and economic disagreements between the US and China will not escalate into a wider conflict.  However, it is important to note that President-elect Trump has made it clear he intends to use US recognition of the “One China” policy as leverage in economic bargaining.  In his book, The Art of the Deal, Trump asserts that one of his key philosophies is leverage: “Leverage is having something the other guy wants. Or better yet, needs. Or best of all, simply can’t do without.”  He seems to be trying to create the maximum amount of leverage possible in order to improve the US position in trade and economic negotiations. 

There are a number of reasons why Beijing would consider the independence of Taiwan - especially if that independence is expedited by the US - as non-negotiable.  Taiwan’s official independence could embolden separatists in Tibet and Xinjiang, for example.  But, the primary reason for maintaining Taiwan’s effective, but not official, independence resides in China’s lessons from history.  After the Opium Wars in the 19th century, colonial powers carved up parts of China in a period known in China as the “Century of Humiliations.”  That period lingers in China’s collective memory, where a once proud and sophisticated civilization was broken, carved up, and humiliated by foreign powers.  The later end of that century was particularly brutal under Japanese occupation.  China took Taiwan back from the Japanese shortly after the end of World War II.  That “Century of Humiliations” has shaped social and economic policies in China for the last 70 years.  One of the mandates of the Communist Party was to make sure that China is never interfered with or humiliated ever again.  Taiwan is neither independent nor dependent.  That ambiguous state of independence limbo has allowed for Taiwan’s self-rule without violating mainland China’s historical sensitivities and provoking armed conflict.

The US “One China” policy stance on Taiwan is ambiguous on purpose.  Chinese citizens view Taiwan’s status as an official province of China as extremely important.  Ten years ago when I lived China, nearly everyone I knew viewed Taiwan’s status as important as any environmental or economic issue.  The US population, on the other hand, has never had strong feelings on Taiwan’s status either way.  And, in Taiwan, according to Forbes, over 65% of Taiwanese prefer the political status quo of effective, but not official, independence.  There has been very limited motivation on the part of the Chinese, US, and Taiwan citizens to change the status quo of independence limbo for the last forty years.  Accidentally or purposely breaking the strategic ambiguity could result in armed conflict with limited reason or gain.   If the new administration sparks a major geopolitical conflict in the South China Sea - a region where over $5 trillion in global trade cargo passes each year - by making a political miscalculation in using Taiwan’s status as leverage in trade negotiations, then the analysis below will need to be adjusted significantly.
What is in store for the Chinese economy with a Trump Presidency?
There is no way of knowing what kind of trade tariffs and barriers Trump’s administration will seek.  Trump’s recent escalation of China-bashing rhetoric, however, seems to imply that he will probably attempt to follow through on at least some of his trade protection threats from the campaign trail.  It is unclear at this point where trade measures will fall on the spectrum of seriously punitive to a flash-in-the-pan.  The range of possible effects on the Chinese economy is pretty wide.  So, to understand the many possible outcomes of a US trade barriers and tariffs on China’s economic prospects, we need to ask the following questions:  How serious could US trade protectionist policies get, how long might protectionist policies last, and what can China do to counter export losses?

Before we answer those questions, let’s take a look at the state of US/China trade.  Here are some important number to note:

The US trade deficit with China dwarfs all other countries.  In 2015, the US trade deficit with China totaled $366 billion.  The next closest deficit country was Germany, with a relatively tame $74 billion.  $366 billion amounts to roughly 2% of US GDP, and has been stable around that percent for the last five to six years.  The US/China trade deficit was 0.5% of GDP in 1996, and accelerated dramatically over the early-to-mid 2000s.  The state of US/China trade today is as much a result of US policies in the 2000s, which stoked high rates of consumption funded by unsustainably low savings rates, as it is a result of China’s own trade policies.

US trade is becoming less important to China’s economy.  According to data from the US Census Bureau and World Bank, exports to the US have gone from as high as 10.7% of GDP a decade ago to 4.4% by the end of 2015.  That has largely been driven by China’s transition to domestic consumption as the major driver of economic growth in the economy.  China is less reliant on trade in general than in the past.

Exports to China are growing more important at the margin to the US economy.  Exports to China as a percent of US GDP are roughly 0.65%.  But, that comes from a base 20 years ago of 0.10%.  US exports to China are 9.7 times higher than they were in 1996.  As a comparison, China’s exports to the US are 9.4 times higher.

China’s main product categories in the US/China trade deficit have grown more complex and advanced over time. 

China sends more advanced products to the US than the US send to China.  According to the US Dept. of Commerce, the US shipped $34 billion worth of what is described as “Advanced Technology Products” (ATPs) to China.  China shipped $155 billion of ATPs to the US.  But, nearly all of the difference comes from a single category, information and communications.  Of that category, most of the difference comes from mobile devices and cell phones. 

A large portion of the US trade deficit with China comes from other economies.  High-tech imports, defined by China’s Customs Administration, amount to 85% of China’s high-tech exports.  Much of what is considered advanced product shipments coming out of China are advanced components manufactured in places like Japan, South Korea, and Germany that have been assembled in China.  Just over 50% of China’s trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market.  The rest is processing, assembly for export, and other. 

Mobile devices and phones make up China’s largest US destined export category.  According to the US Census Bureau, mobile devices constitute 13.4% of all of China’s shipments to the US, and 17% of the trade deficit.  77% of all US cell phones come from China.  The next largest supplier of mobile phones is South Korea, with 12% of the total. 

The largest US export to China continues to be aircraft.  Shipments in 2015 amounted to over $15 billion.  China sales are roughly 13% of Boeing’s total revenues. 

A favorite talking point during the election, steel imports from China, could likely become a prime target for trade barriers or tariffs.  But, for all of the headline grabbing concerns over China steel shipments, iron and steel imports from China are only about 0.60% of US total imports from China.  Steel exports to the US account for 0.02% of China’s economic output.  The largest supplies of foreign steel are Canada, Brazil, and South Korea.
How serious could trade barriers and tariffs get?

  • What can the US president actually do?   

The Constitution gives Congress the sole authority to impose tariffs on foreign goods, with a few limited exceptions.  There are options for the President to act unilaterally.  Based on the US Trade Act of 1974, the President has the ability to impose blanket tariffs of up to 15% for no longer than 150 days.  If a foreign country is found to have unjustifiable and damaging trade policies targeted at the US, targeted quotas and tariffs may be applied.  The Trump administration would likely find targeted trade restrictions on Chinese products easier to implement.  A large blanket tariff on all Chinese goods would require congress, and would be politically challenging.

The WTO would present an obstacle to US protectionist plans.  Under WTO rules, any member must treat all imports from member countries equally.  Additionally, a WTO member can’t impose tariffs beyond the bound rate in its tariff schedule.  Hefty tariffs on Chinese goods would likely violate WTO rules.  Unless the new administration decides to withdraw from the WTO, trade protection overreach could be limited.

Labeling China a currency manipulator as proof of unjustifiable and damaging trade policies in order to clear the way for targeted quotas and tariffs seems likely given the rhetoric on the campaign trail.  But, that would require evidence that Chinese authorities are intervening to devalue the currency, when in fact China has spent $700 billion in foreign reserves in order to keep the yuan from a freefall in the face of capital outflows.  Most market indicators, including long-term real effective exchange rates, reveal the Chinese yuan as one of the world’s most overvalued major currencies.  But, proving the value of a currency is a murky exercise, and there is plenty of room for imaginative interpretation. 

  • How far is the US willing to take things?

This is probably the most important consideration in the calculus of trade import restrictions.  Trade restrictions or taxes on Chinese imports, with or without Chinese retaliation, will cause at least some short-term pain in the US. 

Pain felt by Trump’s core supporters could limit the willingness to take punitive trade measures too far.  A blanket tariff on all China shipments will certainly be felt in the form of price increases for everyday products.  According to the Economic Policy Institute, a liberal think-tank, 11% of Chinese imports are sold through Walmart. That would constitute nearly 40% of non-grocery US domestic sales at the retailer.  Blanket tariffs and the inevitable decline in the Chinese yuan in the face of reduced China economic sentiment would be punitive for the Trump administration’s core supporters.  Sizeable imported inflation numbers would also likely expedite Fed rate hikes, cooling the recent employment growth.  The administration may not be willing to take things too far if his core supporters feel too much pain at the checkout line.

Without Chinese trade retaliation, tariffs and trade barriers on specific Chinese imports would concentrate the pain on specific sectors and firms.  It would be difficult to make a sizeable dent in the China trade deficit without putting up barriers to tech products.  The US trade deficit with China is dominated by tech.  44% of the trade deficit falls in the category of tech, telecom, tech components, or electrical machinery.  Anyone looking to purchase a mobile device, computer, or nearly any product that has incorporated some tech components would see prices rise. Window dressing by raising tariffs and barriers on products that grab headlines but have limited effect on trade numbers, like Chinese steel, would be an option for an administration less willing to inflict economic pain on voters.

Chinese retaliation would increase the pain of a protectionist trade policy.  China’s trade retaliation is expected to be levied against the major US export products, like soybeans and aircraft.  According to the USDA, over two-thirds of US soybean exports go to China.  But, soybeans are a globally traded commodity.  China would need to get soybeans from other producers, like Brazil.  US farmers would need to supply markets that once bought soybeans from Brazil.  Agricultural product retaliation probably won’t be too painful.  However, China accounts for 13% of Boeing’s sales, so the aircraft manufacturer has the most to lose from trade policy retaliation.  Additionally, Beijing officials have a great deal of control over domestic markets, and can apply punitive policies to US firms operating in China.  US carmakers are highly vulnerable to Chinese retaliation.  GM revenues from China this year are higher than those generated in the US and represent 38% of the firm’s total sales.  Tech firms have a particularly high level of interest in China.  According to Bloomberg, 43% of Micron Tech sales, 23% of Apple sales, and 57% of Qualcomm sales come from China.  Over 30% of Texas Instruments sales come from China.   China can make things very difficult for firms operating on the mainland, and many of those firms have deep pockets for lobbying the US congress to stop the pain.

Pain felt by US allies could limit the willingness to take punitive trade measures too far.  China is not only a manufacturer of export products, but the world’s largest assembler of component parts manufactured elsewhere.  Just over 50% of China trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market.  The rest is processing, assembly, and the like.  Nowhere is that fact more evident than in China’s $65 billion mobile phone and device shipments sent to the US market in 2015.  The iPhone is a good example of the extent to which China is simply the last stop for many goods on an extensive global supply chain.  Apple has component suppliers in 31 countries.  Big-ticket components, like displays and processors are made in Japan, South Korea, and Taiwan.  The cameras are made in Japan and the US.  The gyroscopes are made in Europe.  According to Credit Suisse, Taiwan suppliers are projected to earn up to $26.9 billion from the iPhone 6 alone.  A trade war with China would effectively be a trade war with staunch US allies, namely Japan, Germany, South Korea, and Taiwan.  An escalating trade war would also be felt globally by friend and foe alike.  In October, the IMF warned that a rise in global protectionism could shave 1.5% off of global growth for the next several years.


How long could trade tariffs and barriers last?

How new tariffs and import barriers impact China’s economy not only depends on the severity of those measures, but the length of time they are in place.  Chinese leaders can patch the hole from short-lived tariffs by extending cheap financing to exporters in order to help bridge the production gap, and running some short-term stimulus.  A one-time devaluation of the yuan would help, as well.  However, a long, protracted trade war would require more intensive actions to fill the hole in China’s economy, and result in stoking inflation, delaying economic rebalancing, and increasing China’s large debt burden.

Unfortunately, examples of historic trade measures have varied significantly.  In 2009, the Obama administration set punitive import taxes of 25 – 35% on Chinese tires for three years.  In 1964, President Johnson put a 25% import tax on potato starch, dextrin, brandy, and light trucks entering the US.  That import tax still exists today, 53 years later.  So, based on historical presidential action, punitive tariffs might last three years, or they might linger for over 50 years.

Two factors probably point to import penalties landing on the short end of the time spectrum.  First, Chinese retaliation against deep-pocketed US firms like GM, Apple, and Boeing will probably result in increased lobbying efforts for a speedy end.  Congress is ultimately responsible for imposing tariffs, and Congress is also susceptible to lobbying.  The second factor comes from Trump himself.  What we know about the President-elect more than anything else is that he considers himself a master dealmaker and negotiator.  It stands to reason that the administration will be looking to use trade protection measures to produce a deal that, at least in appearance, can be held up as an example of stellar negotiating and successful policymaking.  While the timing of US trade protectionist measures against China is an unknown, it is likely that such measures will be short-term.

What does it all mean?
So, what does all of this mean for China’s economic prospects?  The outcome for China lies somewhere between the unlikely worst case and the best case scenario. 

The worst case scenario for China economic prospects – assuming no major geopolitical escalations beyond trade policies – would be a blanket tariff on all Chinese goods of 45%, a number Trump frequently cited in campaign speeches.  If we make a very simple assumption that a 45% tax on all China imports results in a 45% drop in US imported goods from China, and China’s domestic production falls by the same amount, then the economic output shortfall will amount to roughly $216 billion.  But, since half of China's trade is assembly and processing of components manufactured elsewhere, not all of China’s export revenues are captured by domestic producers.  So, if we conservatively assume that domestic producers only feel 60% of the production drop, the production shortfall would be $130 billion, or 1.20% of GDP.  Using simple math and not accounting for multiplier effects or tariff evasion and other secondary effects, GDP growth could drop from 6.7% to around 5.5%.  Production declines would primarily be focused on light manufacturing and tech assembly, industries concentrated in the wealthy southern coastal provinces.  It will be difficult for the government to use fiscal stimulus to help those industries without buying excess products and dumping them on another country.  Unless Beijing can somehow extend support to export firms directly affected by the tariffs, the result could be tens of millions of job losses, and that would be a serious problem for China’s leaders.
The best case scenario would be "window dressing" policies that both Presidents can point to in order to prove their nationalist bonafides.  The Trump administration could apply more trade barriers to Chinese steel imports with close to zero economic implications for China.  China could respond in kind with some headline grabbing, but fairly benign trade restrictions of its own.  That would limit the economic impact on China to virtually zero.
But, the likely scenario will be somewhere in the middle.  Specific Chinese products will probably be targeted by US tariffs rather than a blanket tariff on all goods.  A realistic assumption is that some of the largest product categories face 25% to 35% import tariffs for a limited number of years.  In that scenario, China could see 0.30% to 0.50% shaved off of annual growth, and 3 to 4 million jobs at risk, concentrated in the wealthy coastal regions.  That outcome would be painful, but manageable.

What can China do to limit the impacts of trade friction?
China has tools to dampen the impact of increased US trade protectionism.  But, plugging holes in economic output and escalating retaliation to force an end to trade barriers would risk stoking inflation, damaging China’s restructuring efforts, and boosting the debt burden.  Here are some measures China can take in the face of increased US trade protectionism.

  • Evading trade tariffs and barriers.

Chinese firms will likely try to evade trade restrictions.  Tariff evasion has been used for years by clever importers.  Ford Motor came up with a clever method to skirt the steep 25% tax on its foreign-manufactured imported light trucks.  The firm simply adds windows and seats, imports the light trucks in disguise for the much lower 2.5% passenger car import tax, and then removes the windows and seats back in the US.  In the 1980s, in order to give extend a lifeline to Harley-Davidson Motorcycles, the US put in place 45% import taxes on 700 cc Japanese motorcycles.  Yamaha and Suzuki evaded the tax by producing a 699 cc engine for export to the US.  Evasion can relieve some of the pain of protectionism, but will not work on all tariffs and barriers.

  • Retaliation or threaten to retaliate.

It would be hard to imagine that Beijing would not respond to import taxes or quotas with retaliatory trade protectionist measures of its own.  If we use the same worst-case scenario from a previous example and assume China responds by stopping 45% of all imports from the US, US GDP growth could potentially be impacted to the tune of 0.30%.  But, almost a third of all US shipments to China are commodities and agricultural products traded in global markets.  So, the full impact of a 45% drop in US exports to China would be less than 0.20%, without adjusting for secondary effects. 
If China wants to expedite the end of US protectionist policies, the most likely retaliation target will be US firms with deep enough pockets to hire armies of lobbyists.  Large US firms with a significant presence in China, like GM and Ford, could start to be subject to sizeable punitive retaliation.  Apple and other tech firms might also be subject to Beijing interference in their Chinese operations.  Pain from China’s trade retaliation will be concentrated more in specific firms than in overall US economic growth prospects.  US firms facing potential losses in the tens of billions have great motivation to step up lobbying efforts.
China’s retaliation would not come without costs to its own economic health.  Restricting agricultural imports or US aircraft purchases, for example, would drive up both food inflation and service sector inflation.  Chinese citizens are particularly sensitive to food inflation.  Food constitutes over a quarter of household expenses for the average Chinese family.  Retaliation by China may also run afoul of WTO rules.

  • Domestic stimulus to counter the impact of export losses.

The most likely measure to counter an export driven slowdown will be fiscal and monetary stimulus.  Traditionally, officials have countered unexpectedly slow growth and economic shocks with infrastructure spending and rapid credit expansion.  Beijing deployed $157 billion of infrastructure spending in 2012 to counter a couple of years of pretty steep economic deceleration.  That stimulus stabilized growth for some time.  To counter the global financial crisis in 2008, the central government massively boosted credit expansion to reflate growth.  Outstanding annual credit growth peaked in November 2009 at 40%.  In absolute terms, outstanding debt increased by an eye-popping $2 trillion in 2009.  Countering the worst-case scenario $130 billion drop in exports and production discussed earlier with massive stimulus measures is well within the realm of extraordinary actions taken in the past to stabilize growth.  But, domestic stimulus has its own downsides. Monetary easing to boost credit growth and fiscal stimulus are both inflationary.  More credit will exacerbate China’s already risky debt burden.  Stoking inflation at the expense of consumers and spending massively on infrastructure would go against China’s urgent efforts to rebalance the economy.

  • Devalue the currency.

Once the US labels China a currency manipulator, the threat of using that label as a negotiating tool will disappear.  China could let the yuan go into a freefall without worrying about a US retaliatory policy response because that policy response will have already been used.  Given the long-term valuations of the yuan and the capital outflow pressures faced by the central bank, it would not be outside the realm of possibility for the yuan to drop over 20% in response to harsh US blanket tariffs.  The cheaper yuan would provide a sizeable lifeline to exporters in the face of rising US tariffs.  But, a yuan devaluation would not be without costs.  Inflation, already accelerating, would certainly rise, and complicate the job of the central bank.  A falling yuan would effectively be a tax on consumers in order to support exporters.  Such a tax would be in direct conflict with economic restructuring towards a consumer and service based economy, a transition seen pivotal to China’s long-term economic sustainability.

All in all, there is a great deal of uncertainty about China’s growth prospects as the Trump administration prepares to take the reins of government.  At this point, there are some likely events and outcomes.  US import taxes and barriers on Chinese goods will probably be targeted and short-term.  China’s retaliation will probably hurt influential US corporations with large stakes in China’s markets.  Beijing’s measures to counterbalance export declines will exacerbate inflation and the country's debt burden. And, the risk of political miscalculation rapidly escalating into major conflict is rising.  Listening to the rhetoric in the lead up to January 20th, I can’t help but imagine that China’s leadership is in for a bumpy ride for the next four years as it copes with an administration unlike any it has contended with in the last forty years.

Key Points from China's National People's Congress

China kicked off its 3,000 delegate National People's Congress (NPC) meeting on Saturday.  Under China's 1982 Constitution, The NPC, China's parliament, is meant to be the most important body of state rule.  But, China's Communist Party controls the state.  So in practice, the NPC is effectively a rubber stamp parliament for the Communist Party decisions and plans.  More importantly, for outsiders, the NPC meeting is also the venue for the Premier, China's number two leader, to lay out goals and targets for the year as well as its five-year plan.  This blog posting will cover plans for the next year, and I will leave an analysis of Beijing's new five-year plan for a later posting.  

As is the custom, the NPC began with a speech by Primeir Li Keqiang, where he laid out policy goals and economic targets, warning of a "difficult battle" ahead for painful rebalancing.  It should not be forgotten that policymaking by the Party in China is meant primarily for maintaining control.  Reforms and goals set out at the NPC are effectively a road map for the Party to maintain stability and control in a post-rapid-growth China.  I dissected Premier Li's 37-page speech and have put together a number of key points.  I will concentrate on economic policies and targets that might impact us here on the other side of the world. 

Premier Li started his speech listing some economic results over 2015.  Here are some of the key points.

  • 13 million new jobs were created in 2015, exceeding the 10 million goal.
  • Contribution of consumption to GDP reached 66.4%.
  • 12,000 new business startups occurred per day on average.
  • Per capita disposable income rose 7.4%.
  • Savings deposits rose 8.5%.
  • Energy consumption per unit of output fell 5.6%.
  • 64 million people gained access to safe drinking water.
  • 14 million were lifted from poverty.
  • 3.2 trillion RMB in local government bonds replaced shadowy local debt through Beijing's swap program.  That has reduced overall financial system risks.
  • Red tape for business and industry was cut. The number of items required for new business approval were cut by 85%.
  • Services now account for over half of the economy at 50.5% of GDP.

Some of the most important information given during the meeting are plans and targets for the economy.  Here are the key 2016 targets.

  • Target GDP: between 6.5% and 7.0%, vs. 7% in 2015. For the first time in decades, Beijing announced a GDP target range instead of a specific number.  The change is a signal that President Xi's regime is putting increasingly less emphasis on overall generic output goals.  Last year Li's NPC speech qualified the growth target, defining it as "about" 7%, not the hard target seen in years prior.  Within the next few years, the target might be scrapped altogether.  Beijing's true goal is not general economic output, but instead is focused on employment stability and robust job creation that can only come from new economy sectors.  The new target range also implies that the potential range of stimulus measures will vary.  We may see a little, or we may see a lot;  forecasting possible stimulus measures will be difficult in 2016.  But, since China's underlying GDP (adjusting for a temporary surge in the financial sector) is already growing close to 6.5% already, some amount of stimulus is required to keep the economy within the range.  Lowering the growth target while needing rapid growth in the service sector, consumption, and new economy sectors to support job creation means one thing: industry - heavy industry like cement and steel making in particular - will continue to grow weaker.  The two-speed economy will grow more divergent.  Overall import demand from the rest of the world will remain weak, even if the economy remains stable.  Rapid growth in China's new economy sectors cannot replace the hole in global demand left by declines in the old economy sectors.  For more details, see my blog post: Rebalancing to consumption is grinding forward, but don't expect Chinese consumers to revive global growth.
  • Job creation target: 10 million new jobs, unchanged from 2015.  Urban unemployment target: 4.5%.  This year may begin the largest purge of old economy jobs since 40 million workers were laid off in the late '90s during SOE privatizations and subsequently absorbed by faster-growing sectors.  Officials last week said 1.8 million people this year will be laid off from old economy sectors, like steelmaking and coalmining.  Also announced last week were plans for 100 billion RMB in funds to help find new employment for those losing jobs to economic restructuring, in a sign that Beijing anticipates more cuts to come in traditional industries.  Reuters, citing anonymous sources, put the number of planned firings at 5-6 million over the next two years.  Forced mergers, deleveraging, and planned reductions of "zombie" firms will result in a continuous flow of jobs out of old economy sectors.  Therefore, 2016 will require much more aggressive job creation than we've seen in the last two decades, and new economy sectors seem to be the only source for absorbing the job losses.  The fast-paced service sector has been able to absorb job losses from economic restructuring for years (see chart on the right), but those losses will accelerate.  Rapid job creation in China's new economy sectors is the most important factor for maintaining economic and social stability in 2016.  
  • Inflation target: 3.0%, unchanged from 2015.  M2 growth target of 13%, unchanged from 2015.  Inflation running around 1.6% to 1.8% recently means plenty of room - in theory - for monetary easing to help the ambitious job creation. But in practice, the real ceiling to monetary easing efforts is not inflation, but instead is the debt burden. Total credit growth is running around 12%, well above GDP growth and pushing higher China's 220%-plus debt to GDP burden. The corporate debt-load in China is over 130% of GDP, a major risk and headwind to growth.  The PBOC can print a lot more money to boost job creation before bumping against the inflation target, but that would exacerbate the debt burden situation.  2016 monetary easing will not be constrained by inflation, but instead will be mitigated by corporate debt-load worries.
  • Ficscal deficit target: 3% of GDP, compared to 2.7% target in 2015.  China's fiscal deficit will increase by 560 billion RMB.  But, it is important to note, 500 billion of that will be from tax reductions, not additional spending.  Traditionally, fiscal stimulus has been done through infrastructure spending, like rail and road projects, benefitting the industrial sector.  Tax cuts may have less benefit to traditional industries.  Fiscal boosts via tax cuts also mean that stimulus will bypass local leaders frightened to deploy fiscal capital over worries of Xi's anti-corruption.  
  • Explicitly stated non-numeric goals: "Maintain a balance between ensuring steady growth and making structural adjustments", "Cut overcapacity and excess inventories".  Those two goals mean Beijing is probably going to start getting serious about reforming inefficient "zombie" firms, but will probably step in and roll back restructuring if growth begins to veer off track.
  • There were some more plans to boost consumption and services: promoting more online retailers, setting up consumer finance companies to grow consumer credit, ensuring people take allowed vacations to boost mass tourism, and cutting import tariffs to name a few.  Consumption and services seem to be the recipients of growth-boosting reforms, and industrial sector reforms are set to focus on cuts to capacity and waste.

Each year since ascending to power, Xi's regime has surprised nearly everyone with a number of policy shifts; from corruption crackdowns that stunted local infrastructure investment and changed consumption spending, to the yuan policy shifts that spawned global market turmoil.  Within Premier Li's speech, here are the key plans that may result in more policy shocks. 

  • Li stated that Beijing will "push hard" to successfully upgrade and reform state-owned enterprises.  After years with meaningless and disappointing state firm restructuring, 2016 might be the year we finally see some big changes, including mergers, shutting down firms, bankruptcies, and privatizations.  That would be disruptive to industrial sector growth and imports, stunting commodity usage, but would eventually lead to higher quality growth.
  • Innovation-driven development is a key goal in Li's speech.  China was the first country to have over a million patent registrations in one year.  Venture capital and local government support of the tech sector has surged.  Beijing plans to train 21 million migrant workers in order to improve skills for the new economy.  2016 could see another jump in start-ups, patents, and many more purchases of global firms by local corporate champions to acquire technology and innovation.  With the new "Made in China 2025" announced, we could see Beijing trying to stifle foreign new economy firms operating in China as part of a drive to boost local tech and service competitiveness.  
  • Pollution fighting is another key area of reform mentioned.  Plans to expand natural gas and renewables remains ambitious.  See my blog posting: China's ambitious renewable energy investments.  But, plans like cutting back on coal burning and reducing vehicle emissions could add both opportunities and risks.  Shutting down inefficient plants could exacerbate downside risks to SOE reforms.  3.8 million old high-emission vehicles will be taken off the roads, and will need to be replaced.  This is another reform that will be bad for the old economy sectors and good for the new.

The announcements and plans were plentiful this NPC.  But all in all, if I had to break Li's NPC speech down into one sentence for those of us outside of China interested in its economic prospects, it would be the following:  Beijing will try to push growth-boosting policies in new economy sectors - services, consumption, renewable energy, tech firms, start-ups - and hope those sectors will compensate from reforms designed to contract the old economy sectors.  Perhaps the new growth range will allow them more flexibility to ease the pain of restructuring than in past years when policymakers were beholden to a hard growth target.


China 2015 in review: Lots of turmoil, lots of rebalancing progress.

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


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.







Reforms: Slow Progress but Enough Progress

Confidence in China policymakers' ability to manage robust growth during significant economic reforms has never been lower.  Some of the views from China watchers and economic pundits have moved to a narrative where growth is collapsing, and China’s leaders have lost control, rolling back reforms in a panic, and fabricating economic numbers to contain the story.  Many headlines and news stories recently contain parts or all of those elements.  In a country where meaningful change moves at a snail's pace, recent reforms are brisk relative to the last 40 years of very gradual transition.  The notions that Xi and his regime are losing control of the economy and rolling back important reforms in a panic to counter a hard landing are premature.   

This blog posting will cover the question of reforms.  For my view on GDP data reliability see my blog posting Should We Believe China's GDP Data?.   We are seeing evidence of restructuring taking place in recent years (see my posting Rebalancing To Consumption Is Grinding Forward, But Don't Expect Chinese Consumers To Revive Global Growth.)

Reforms Are About Control

It is important here to point out the rationale for China leadership's recent acceleration of economic reforms.  China's economic reform plans are primarily about ensuring the Communist Party of China (CPC) stays in power for the foreseeable future.  A great deal of the leadership's legitimacy is based on consistent improvements in living standards and rapid economic development leading to a strong China in control of its own destiny.  After years of accumulating imbalances from a hard-driving industry and investment-centric economic policy, risks to longer-term economic stability put CPC future legitimacy at risk.  

Restructuring too soon may derail economic stability in the short term; not fast enough, and risks will derail stability in the long term. Reforms need to balance control and stability now with control and stability later.  The CPC knows very well the existential threats of economic turmoil in the short term as well as economic turmoil sometime in the future.  Collapsing wealth and the end of economic prosperity brought about by inept handling of the economy would not end well for leaders already under the gun for deadly pollution and massive corruption.  Many reforms, like capital market and financial market liberalization, are grinding along.  But, reforms that expose the soft underbelly of control, like reforming employment-supportive SOEs or judicial independence, have been hollow announcements without real action.

Backtracking on reforms is nearly as dangerous as squashing short-term growth.  Every currency devalue is a tax on consumers to support the export industry.  Every boost in credit will need to be paid in defaults and potential financial sector turmoil in the future.  Every leadership override of a judicial case leads to less innovation and lowers the chances of moving manufacturing beyond assembling cheap goods that don't match rising wages.  And, every push-back of SOE reform to protect short-term employment creates another zombie firm to eventually face collapse at an undetermined time in the future.  Economic reform decisions are a choice of how much stability and control now vs. how much stability and control later.  To that end, China's leaders don't need to match economic reform feats akin to Lee Kuan Yew or Park Chung Hee.  They just need to manage reforms enough to maintain control and stability.

With that in mind, how are reforms in some key areas progressing?

Capital Controls

Though the commentary on China's yuan policy has become negative lately, capital control reforms are grinding along.  The Chinese yuan is stronger than most major currencies and slightly more market-based than two years ago.  In July last year, the trading band was increased to 2% on either side of the fixing vs. 0.5% in 2012.  The August devalue was accompanied by adding more market information into the yuan fixing.  The CNY is on track to become a reserve currency and earlier this month the yuan became the world’s 4th largest payment currency after the USD 45%, EUR 27%, and GBP 8.5%, at 2.8%.  Programs for letting investment capital in and out of the mainland (QDII, QFII, etc...) are grinding higher.  This month policymakers announced that they are poised to remove all capital controls by 2020, integrating the third largest bond market and second largest stock market with the rest of the world.

Financial System

A financial reform milestone came last week with the announcement that the PBOC would end mandated deposit rates, the final and riskiest piece of interest rate market liberalization.  China began interest rate liberalization in 2013 by removing mandated lending rate ranges.  With the removal of the mandated deposit rate based on the PBOC's benchmark rate, policymakers have effectively allowed for markets to set interest rates.  However, not all control has been given up with the liberalization moves.  The PBOC still has significant control over banks and has indicated that it will "discipline" banks that use unusually high interest rates and disrupt the market, and reward those with low deposit rates.  Rates have been officially freed-up, but the PBOC will probably exercise influence in other ways.  

Liberalizing rates is a milestone for reforms intended to roll-back decades of financial repression, whereby households subsidized rapid growth in industry and investment via cheap loans funded by artificially low bank deposit rates.

Financial system risk has been moderated by restructuring efforts in the last couple of years.  Beijing has not curbed the debt burden expansion, but continues to make efforts to move debt from non-transparent shadow banking and opaque local government borrowing schemes to transparent forms of debt. That can be seen in the credit growth numbers and the local government bond swap program, which is now up to 3 trillion RMB.  Bond markets and equity financing have picked up some of the slack left by slowing shadow banking activities.  The debt burden growth has also slowed from a rapid pace this decade as credit growth has moved closer to nominal GDP growth.

But, China's main source of debt risk is the 125% of GDP in debt on the books of Chinese companies.  Household debt and government debt are mild compared to the burden carried by companies.  There has been no real progress with company debt burdens yet, other than rolling a very small portion into equity and allowing some small firms to default.

Beijing’s explicit plan to increase private banks seems to be gaining ground.  As of mid-year about 40 firms have applied to open their own banks following the success of Alibaba and Tencent entries into the sector.  Five new private banks were given the green light this year.  Bank depositor insurance covering 99% of depositors launched in May this year will continue to drive the move to get more private lenders involved in the financial system that historically has been dominated by state-owned firms.

State-Owned Enterprises

Lack of real tangible restructuring of China’s state-owned enterprises (SOEs) has been one of the main disappointments of Xi’s reforms.  State firms have half of the return on assets of private peers, and many are saddled with debt while private firms have been deleveraging.  In September, Beijing announced more plans to reform SOEs, but like plans in the past, details and a timeframe were lacking.  Following the announcement, an official stated the need to “make more efforts in reforming ‘zombie enterprises’, long-time loss-making enterprises and in disposing those low-efficient and non-performing assets.”  Announcements are in essence saying, “there is something wrong, and this is on our to-do list”, but there have been no significant actions.  Addressing “zombie enterprises” would be a significant step forward, but there are many vested interests who want to keep SOEs unchanged.  And, SOEs allow the party to influence key industries and ward off employment instability.  Those factors inhibit meaningful SOE changes.

In the 1990s, Premier Zhu liquidated and privatized thousands of SOEs, dramatically shrinking the states sector and resulting tens of millions of layoffs.  Current reform plans are much less bold, looking to mostly improve the SOE sector and force SOEs to pay more dividends back to the state.

Private Entrepreneurship and Innovation

One of the key areas of promoting innovation is moving closer to an independent judiciary in a country where the Party has had traditionally been the last word in legal rulings.  Judicial reform is second to SOE reform in delayed progress. The October 2014 plenary session included some strong language for improving the legal system.  China’s supreme court this year launched a set of reforms to prevent official interference in court decisions.  More judges and legal professionals have been hired.  China is approaching 200,000 judges (more per person than in the US), and boasts over 400 law schools.  However, the crackdown on "Rights Defence" lawyers and muted progress reported by legal experts run counter to reform announcements.  In spite of weak judicial reforms, innovation seems to be accelerating.  R&D spending nearly doubled between 2010 and 2014.  Patent applications have also doubled in that time, from 1.2 million to 2.4 million.  Long-term sustainable innovation from the private sector will require independent judges to protect patents and copyrighted assets.

China needs to allow more firms to default on bad debt.  Defaults are needed to let zombie firms fail and champions grow, one of the key hallmarks of Korea's execution of the Asian industrial policy that China has adopted.  Allowing defaults has begun with small insignificant firms, a coal firm and real estate developer for example, but a meaningful amount of firm failures is slow in coming.  A start, but a long way to go.

Xi's administration has been successful in pushing China's service exports overseas.  Recent deals to build a nuclear plant in the UK and ultra high voltage transmission capacity in Brazil highlight the success of China in development beyond manufacturing.  Nearly all peers with similar per capita GDP would need to bring German or French firms in to build advanced infrastructure.  Shifting to the export of "know-how" is a significant move to get away from simply being the world's factory floor. 

Tax cuts for small businesses, allowing private firms more access to state projects, a pivot towards letting markets play a more decisive role in the economy, and a push to get more lending to small firms all seem to be gradually improving private entrepreneurship.  According to the Economic Times, China has seen over 10,000 new start-ups a day this year, many of which are tech startups promoted by China's relaxing of ChiNext listing rules and allowing sabbaticals for University students pursuing the next app or social media project.  Successes of the likes of Alibaba and Tencent in creating new billionaires has lead to a rise in animal spirits, and reforms appear to be fostering those animal spirits for now.  

Slow Progress, But Enough Progress

Progress is being made and reforms have not been rolled back.  The reform pace is most likely enough to keep the wheels on the rails, but nothing to earn high grades.  Until we see Beijing allow more defaults to rid the country of zombie firms, progress on corporate debt reduction, and finally start implementing SOE changes, it is hard to give Xi a great review.  On a scale with Lee Kwan Yu as an A+ and Hugo Chavez as an F, I would give Xi's regime a C/C- so far; not stellar reform progress, but enough to keep the wheels on the rails and start putting long-term prospects on a stable footing for now.


China commodities: Falling demand in a sea of expanding global supply.

China's voracious appetite for raw materials from the rest of the world is in flux.  The economy’s inevitable slowdown to a more sustainable rate of growth has been one of the most widely anticipated global economic events in recent times; the quandary has been just how slow and how extreme the drop will be.  Gauging China’s demand for commodities will depend not only on figuring out how slow China's economy will eventually grow, but what sectors are slowing.  

There are three important things to note about China’s commodity demand.  First, industry and construction, the main sources of raw material usage, have declined much faster than the overall economy.  This trend will continue in 2016 as Beijing lowers its growth target again, keeping downward pressure on major commodity demand.  Second, price declines have exaggerated China’s commodity import drop.   Recently, most major commodities have seen weaker imports, but not the collapse suggested by headline numbers.  Import volumes have held up much better than in the last economic downturn (see the charts below).  And third, demand for various commodities will be highly divergent going forward, with coal demand for example, dropping for the foreseeable future, and agricultural imports rising.

China's slowdown is disproportionately hurting commodity demand, and supply growth globally has overwhelmed weaker demand.

For years Beijing has told us two things: They are going to restructure to quality growth (services and consumption playing a bigger role), and policymakers want to move growth to a lower sustainable trend rate.  The only way to achieve those two goals is by letting industry and fixed investment drop (which is what we have seen in recent years) while maintaining rapid growth in services and consumption.  Heavy industry has dropped like a bag of hammers, and services and consumption have remained strong.  That has made growth highly uneven on its way down to a lower more sustainable long-term rate.  A commodity exporter gets little benefit from a soft landing in overall GDP in such a bifurcated growth scenario.  Online retail sales are growing at almost 50% a year, while steel production is down almost 5% from last year.  Compounding the uneven slowdown effects, much of the world's commodity capacity was built for China's "miracle growth" of the 2000s.  Supply, especially from mainland China producers, will take some time to adjust to a weaker China.  For many commodity exporters in markets where supply has charged forward unabated, China's uneven slowdown has felt like a hard landing.

Expect weak demand for many commodities to continue into 2016 as Beijing will probably reduce the growth target another 0.50%.  

A reduced growth target will lead to reduced fiscal and monetary stimulus, which will disproportionately weigh on investment and heavy industry, the main sources of demand for raw materials.  We may see a short-term boost in demand from the property market rebound this year and late '15 fiscal spending, but demand may slow further in 2016 for most major commodities.

Demand has weakened for most commodities, but we are not witnessing a complete collapse of all commodity demand.  

In fact, as seen from the charts below, the volume of imports is weak, but not falling dramatically.  It is the combination of both weak demand and commodity producers increasing output that has lead to the massive price drops, and the dramatic drop in the value of China's imports.  Iron ore, copper, oil, and aluminum suppliers in particular have pushed greater output despite weaker demand in recent years.  The result has been a tidal wave of supply overwhelming demand and crushing prices.  China's suppliers in particular have kept production robust in the face of weaker demand.

Domestic suppliers are still pushing down prices.

China mining firms are not subject to the same profit maximizer behavior as more market-oriented firms globally.  Local mines will keep pumping out production regardless of the price as local leaders are incentivized to keep mines and smelters open in order to maintain stable employment.  China produces 47% of the world's aluminum and over 40% of its iron ore, and miners seem to be keeping the foot on the production “gas pedal" regardless of prices. Therefore, excess supply in local commodities - aluminum and iron ore in particular - may persist for some time, even as prices drop.  China only produces 9% of global copper output, meaning supply is primarily based outside of China and will come offline much quicker than other base metals as prices fall.  

Here are some details on selected commodities in China:


China accounts for 13% of global economic growth, but 47% of the world’s coal consumption.  almost 70% of China’s electricity production comes from coal burning, causing the deadliest pollution in the world.  A recent study by Berkeley Earth concluded that 1.6 million deaths in China each year can be attributed to air pollution.  Coal has powered China’s economic "miracle growth", and now is the source of much pain.

After the 2013 “airpocalypse” events in China, pollution became the main source of civil unrest.  Beijing countered by announcing the “war on pollution”.  Since then, coal demand has plummeted.  Coal mining investment to August 2015 is down 14% from last year.  Beijing is trying to rapidly reduce coal burning as it adds massive amounts of renewable energy capacity.

The bottom line is, coal demand will face the double whammy of slowing industry and the “war on pollution”.  Coal demand of all types will continue a rapid decline for the foreseeable future; bad news for Mongolian and Australian exporters.


Copper demand has remained very weak, which for many analysts seems to be a surprise given the potential state-directed boost expected this year.  China is working to upgrade its cross-country electricity transmission in order to send electricity instead of coal from resource rich regions to wealthy coastal cities beset with deadly air pollution.  Grid upgrades, renewable energy investments, and vast long distance ultra-high voltage power line investment was supposed to boost copper demand this year.  Grid investment alone was supposed to increase 24% in 2015, as announced early in the year.  As recent as September 1, officials announced new spending of $315 billion from 2015 to 2020 for grid infrastructure improvements.  

However, improved demand for copper has yet to materialize.  Recent estimates for 2015 demand by Antiake are for a 6% consumption growth in 2015, down from a 9% increase forecasted at the beginning of the year.  China copper imports by volume are down 8% so far this year vs. 2014. 

Most research firms have grown more negative on copper over the last few months as uncertainty over Beijing’s ability to keep the economy on track grows.  Goldman Sachs sees copper demand continuing to decline on property weakness, arguing that potential improvements in grid-related demand are overstated.  Societe Generale recently cut its forecast for 2015 global copper demand nearly in half, to 2.5%, primarily driven by uncertainty in China.  Supply on the other hand is expected to increase 3% for the year.

Demand improvement depends on whether or not you think China’s infrastructure and grid spending surge will ever materialize.  I expect it will, and imports will have to increase as inventories have dwindled.


There are two offsetting factors in China’s oil demand prospects.  First, demand from the real economy has weakened.  Car sales have slowed to around 2.5% so far this year from a 10 year average annual growth rate of 21%.  Freight traffic will moderate with the industry slowdown.  Pollution controls will force changes to automobile efficiency.  Crude oil imports on a volume basis have grown 10.5% on average for the last ten years.  But going forward, the demand from the real economy will certainly be weaker than the last ten years.  As of August, the IEA’s latest forecast for Chinese demand growth is 3.2% for 2015.  China imports almost two-thirds of its oil consumed, and production is up only 3% this year.  So, import growth from underlying demand will be weaker than in the past, running at a third of the trend growth rate potentially.

On the other hand, China is building massive strategic petroleum reserves, and is not finished yet.  According to the International Energy Agency China has accumulated about 200 million barrels of crude in its reserve so far and aims to have 500 million by 2020.  300 million barrels represents about 13% of China’s total 2014 crude imports.  When and if all this storage is added is in the hands of policymakers.

The end result of these two opposing factors is a robust 10% growth in imports for the year so far.  But going forward, the problem with oil demand is similar to other commodities; structural underlying demand growth is certainly growing weaker relative to previous years, but the prospects for a boost in demand are in the hands of policymakers building reserves, and therefore remains an uncertainty.


Argicultural commodity demand in China is widely expected to fare much better than metals and energy.  Rising incomes, changing preferences, a structural rebalance to consumption, and recent price declines have pushed commodity imports higher this year.  By volume, some commodity shipments have surged dramatically (see chart below).

The USDA expects continued growth for years to come, with soybeans dominating imports.  The US supplies half of China’s soybean and cotton imports, so the trend is a positive for US exporters.

Year to Date Imports % Change from Last Year to Aug '15

Source: National Bureau of Statistics of China

Iron Ore

With the expectation of another target growth reduction next year, infrastructure growth is likely to continue its deceleration.  Iron ore demand will suffer from lower infrastructure investment than most other commodities.  About a third of iron ore goes to infrastructure building, with another third to property, and the last third to “other”.  Beijing’s infrastructure investment in the pipeline this year will probably add to demand a bit, but with the lower growth target comes less infrastructure spending.  So, on the demand side, the property market rebound will improve demand, but a lower growth target in 2016 will potentially negate the property market rebound.  Demand will weaken further, but not collapse.

On the supply side, many expect China ore producers to drop out when prices fall below $45/t, but iron ore production is a political issue.  Local policy bias to keep folks employed often outweighs profitability.  Supporting mines could get quite costly eventually.  China’s mines are high cost, with estimated break-even prices as high as $80.  That compares to BHP at $28/t, Rio around $30/t, Vale at $39, and Fortescue roughly $42/t.  If China were to support all of its iron ore producers down to $50/t, it would cost the government potentially 0.40% of GDP at a time when more pressing fiscal needs are abundant.

Credit Suisse expects iron ore prices to stay flat for the rest of the year, declining to $50/t in early 2016.

China's housing market rebound: A tale of two (types of) cities

China's housing market rebound is highly mixed. The more developed coastal regions and tier 1 & 2 cities are in the midst of a rebounding property market.  Regions in the hinterlands and the lower tier cities are still in the negative.  Much of this has to do with the amount of pent-up inventory across the different regions.  

China's hinterlands have seen the bulk of the country's housing overcapacity and "ghost town" construction as local leaders and developers unleashed massive projects in anticipation of never-ending boom times.  As boom times have ended for many hinterland economies - mining regions in particular - less developed cities and provinces have been left with a mountain of unused housing property.  According to the most recent IMF Article IV report this year (see the chart to the right), China's residential real estate inventory surplus is primarily a problem of overbuilding in the lower tier and less developed regions of the country.  Inventory in the more developed cities and regions - those with the largest contribution to growth - is much tighter.

The bifurcated housing market rebound has two potential implications going forward: First, the tight supply and price increases in the big provincial economies on the coast and top tier cities (see the chart on the top right) will be a boost to short-term growth. A construction and real estate rebound in those large drivers of growth (see provincial map below right) will result in a positive contribution to overall economic activity in the short-term.

Second, property development has been a major driver of economic activity and income growth in the hinterlands.  The lower tier cities and less developed regions have already taken a hit from the slowing of mining and industrial activity. If heavy industry, mining, investment, and lastly the real estate market are faltering, what are the prospects for hinterland and low tier city economic restructuring?  Less developed regions with plenty of heavy industry and mining activity, Shanxi and Heilongjiang in the North for example (2.7% and 5.1% GDP growth on the year respectively), have seen faltering growth this year.  More developed regions like Tianjin and Chongqing are still experiencing relatively rapid growth.

Without the same rapid income growth - partly funded by rapid real estate development - that helped service and consumption develop in the wealthy regions, will less developed China have the same capacity for economic restructuring?  If developers and governments in the hinterlands are unwilling and unable to fund more housing overbuilding, then real estate - an important growth engine - will be flat.

Property prices in the more developed cities are rebounding dramatically


Overbuilding of unused property is a well-documented problem in China.  The problem is difficult to measure due to China's opaque housing figures.  Potentially countrywide 1 out of 5 housing units remains empty.  

How the problem will be resolved is difficult to forecast as well.  China's household registration reform and rapid urbanization will eventually fill the demand.  Beijing wants to urbanize 100 million rural Chinese by 2020 alone.  That will require the equivalent of at least 24 Bostons or 37 Chicagos.  The inventory surplus and "ghost town" phenomenon has been exacerbated by the location of development megaprojects.  Massive residential districts have been built in the undeveloped and low tier regions, without enough infrastructure or industries to support them.  Perhaps the urbanization infrastructure push will help fill them some day. But for now, the overbuilding has left the lower tier regions out of the housing market rebound and will certainly have implications for income growth and restructuring prospects.

For the short-term, the tighter inventory and price increases in the more developed regions - the largest engines of growth - should help modestly boost broad activity.  But the massive inventory and declining prices in the hinterlands will have consequences for income growth and therefore restructuring to consumption and services.  The hinterlands may be much slower following their wealthy counterparts into service and consumption rebalancing.




3 reasons why China could lower the 2016 growth target to 6.5% and what it means going forward

Fall is on its way, and with it comes preparations for China's Party Congress.  Leaders in Beijing will begin making and setting plans for economic goals and targets for 2016, which they will announce next Spring.  With the planning comes leaks, forecasts, and speculation by China watchers around the world.  This Fall's big worry will be the potential for another target growth drop to 6.5% from 7% this year.  2016 targets will not be announced until next Spring, but as enough consensus builds in the market for a growth target drop, risk assets and commodities will see more upheaval.  

Here are 3 reasons why a China target growth rate cut to 6.5% is highly probable:

1. Maintaining a higher rate of growth than necessary to maintain stability gets more costly each year.

Reflation per increased unit of GDP growth is growing more costly over time, both in terms of actual costs (budget deficit, bank costs from NPLs) and indirect costs (higher debt burden from monetary stimulus, financial repression from a weaker currency and lower deposit rates).  The fact that Beijing has done the bare minimum stimulus needed this year to stoke growth towards the 2015 target shows that policymakers are very aware of the costs and declining benefits of stimulus.

Each easing cycle meant to push growth to a politically mandated growth target brings a surge in the debt burden, NPLs, overcapacity, and pollution.  When China's non-sovereign debt-to-GDP was around 100% or so, easing was not a problem.  Now, with debt still growing faster than GDP, each increase in credit to spur growth pushes debt deeper into the 200% plus territory.  The incremental improvements in overall growth may not be worth the increased debt burden and the risks that burden creates.  In addition to the overall debt burden, NLPs are rising - up 11% in the second quarter - increasing with each round of easy credit.  

Fiscal stimulus is usually directed to sectors that boost polluting and overcapacity - heavy industries like steelmaking and construction materials for example.  Public money flowing to those industries adds to China's existing problems and pushes against structural reforms and pollution fighting measures.

A cut to 6.5% will reduce costs involved with fiscal and monetary measures, and will allow policymakers to save some dry powder for future potential economic risks.

2. A lower growth rate will help with the "war on pollution".

After years of China's rapid growth at the expense of air and water quality, by 2013 a series of events commonly referred to as "airpocolpyse" moved pollution to the top of the list of reasons for protests, beating out land expropriations.  Political degradation and the unrest it caused led to 2014's "war on pollution".  But, this year a Berkely Earth study estimated air pollution accounts for 1.6 million deaths a year.  On top of that, a recent NASA study named the Northern China Plain, one of China's most densely populated and economically important regions which includes Beijing, as one of the world's fastest deteriorating aquifers.  China's air is poisonous, its water polluted and scarce, and the result is 30,000 to 50,000 "mass incidents" of protest every year.  

Lowering the growth rate to 6.5% will help with the pollution fight and therefore take some pressure off of social dissent.  More dissent has been caused by pollution than growth already slowing below 7% this year.

3. Service sector employment growth is keeping employment stable at lower overall growth rates.

If you strip out the transient surge in financial services from stock market activity, China has been growing at about 6.5% so far this year already, and we have not seen the widespread employment problems that Beijing's leaders worry over.  One possible explanation is the continuing fast growth of service sector employment as services grow well above 8%.  

For China's policymakers, employment stability is of paramount importance.  The legitimacy of the country's political system depends on the Party's ability to maintain stability and prosperity.  Massive and sudden joblessness would put that legitimacy in jeopardy.  The underdeveloped service sector has been a source of fast employment growth for years.  The net workforce increase in the service sector for the five years to 2013 (the latest data) averaged 9 million jobs a year. That compares to 5 million jobs a year in industry, and a decline of 11 million jobs a year in agriculture.  The recent renewed shift of investment into services will keep that trend on track (see the chart to the right).

This year has illustrated that China's growth can run below 7% without triggering the widespread employment instability that frightens Beijing's policymakers.  As long as services and consumption rapidly grow from an underdeveloped state, growth around 6.5% can be tolerated.

What will another growth target rate cut mean for China's economy?

China doesn't need a hard landing for industrial machinery and commodity exporters to suffer.  It only needs a significant slowdown in industry after years of double digit growth, which is what we have seen so far in 2015.  

China's policy directed slowdown is highly uneven.  Services and consumption continue to grow at a fast clip.  Industry and construction have decelerated sharply.  The reason for this is the dual task of slowing trend growth to facilitate a soft landing while at the same time rebalancing the economy to grow the underdeveloped the consumption and service sectors.  China's service sector accounts for 48-49% of GDP.  EM peers, including Korea, Brazil, and Turkey all have service sectors above 60% of GDP.  Faster services and slower industry will help make headway on the "war on pollution" as well as slowly remove overcapacity in a number of heavy industries.

China Import Categories as an % of Total

Going forward this trend will continue.  A lower target rate of 6.5% GDP growth will result in a disporoprtunate deceleration in industry as services only modestly slow.  China is the workshop for the world's consumer goods, and faster consumption has few beneficiaries outside of China (see pie chart).  Services also have few beneficiaries outside of China.  But, commodity and industrial machinery exporters will feel more pain as the industrial sector moves from just below 6% this year to around 5% next year.  

The map below illustrates countries reliant on China demand that will be subject to further slowing in China's industrial sector.



Don't mistake China's uneven slowdown for a hard landing.

Growth in China's secondary sector, its biggest driver of the economy's boom over the last two decades, is falling like a bag of hammers.  China's service sector, now the largest portion of its economy, is growing strong.  The rapidly declining growth in the secondary sector - the making and building of tangible things - has caused many China watchers to argue that the hard landing has arrived, and Beijing is hiding the true growth rate.  The truth is much simpler:  China's policy directed slowdown is highly uneven due to parallel efforts to rebalance the economy away from industry and investment.  Therefore, measuring China's overall output by counting rail cars and electricity usage has become insufficient for getting a picture of the entire economy. 

The transition to a more balanced economy that everyone has been advocating and policymakers were avoiding for years is taking place in China. The change is not moving in a straight line or as smooth as many would like it to go, but the transition is happening according to 2015 data.  As a result, the targeted slowdown to a lower growth rate is highly uneven.  The making and building of tangible things - the secondary sector - is slowing much faster than the overall economy.  Services and consumption, on the other hand, continue to show strong growth, both nominally running around double-digit growth rates.  Within China's 7% real GDP growth number, secondary growth has fallen significantly to 5.8%.  Services are growing at a robust 8.9% (see the chart on the right).

More evidence of an uneven slowdown can be seen in the recent PMIs.  The services PMI rose to 53.9, one of the highest numbers of the year.  Manufacturing PMI modestly declined to 50 from an already weak number.  

Category as a % of China's Total Imports

The uneven nature of China's slowdown presents a problem for the rest of the world's economies and exporters.  China import demand is dominated by commodities and industrial machinery (see chart below).  China is already the factory floor for the world's consumer goods, and consumer goods import demand is very limited for now (see my trade maps for more info).  So, more consumption in the short-term and a strong service sector have far fewer beneficiaries outside of China relative to the pain felt from the falling industrial and construction sectors that make up secondary growth.  For the majority of countries and firms dependent on China's once insatiable demand for commodities and machinery, growth has fallen effectively to 5.8% already.  That is a very low growth rate considering much of the world's structural export capacity was built over the last decade to accommodate secondary growth in the double-digits.  The latest results on import demand can be seen here:  http://laohueconomics.com/trade/ 


Service growth

The service sector's importance to China's economy is moving higher.  So far this year services represent 49.5% of GDP.  That is up almost a full percent from last year, but still a low number relative to peers.  Services constitute more than 60% of GDP in South Korea, Brazil, Turkey, Poland, and a number of other developing countries.  In Singapore, the number is above 70%.  So, the rebalancing has a long way to go, but the pace has accelerated.  As a result, many light industries with linkages to services are doing quite well (see charts on the right).

China's primary economic goal is to maintain employment stability.  The numbers indicate that China can withstand a slowdown in its traditional engines of growth, industry and investment, as long as the fast-growing service sector picks up the job creation slack.  

Employment in the service sector rose nearly 10 million jobs per year for the 5 years to 2013 (the latest data).  The creation of 10 million net new jobs is Beijing's target for 2015.  According to the New York Times, around 300 million people now work in services, accounting for 40% of China's workforce.  Job creation in the service sector has been absorbing much of the rural labor migration as the agriculture sector workforce continues to rapidly shrink. 

Job creation and its ability to lift living standards and increase wages is a key variable in the legitimacy of the country's political model.  So, as long as the service sector continues to expand quickly, supporting employment stability, China can withstand a weakening secondary industry for some time.  

The secondary sector and the slowdown

A slowdown in the secondary sector has been in the pipeline for years.  Investment in China's industry and construction sectors have decelerated significantly over the last few years (see the chart on the right).  Heavy industry, mining, and industries with overcapacity (steelmaking for example) have seen the quickest slowdowns. State-owned investment continues to lag private investment.  Much of the slowdown in investment, which in turn lead to slowing output, has been directed by Beijing in the form of years of restrictive monetary conditions and a clampdown on local financing vehicles.  The vacuum caused by an investment slowdown by local governments, China's primary driver of infrastructure investment, has not yet been filled by Beijing.  The slower local investment, whether intentional or not, has the benefits of reducing local debt, reining in overcapacity, and curbing pollution.  All of these changes come at the expense of reduced import demand from a slowing secondary sector.

With Beijing keeping service and consumption growth robust in order to facilitate a rebalance, the secondary sector will be used as the main lever to allow overall growth to moderate.  China could possibly lower its GDP growth target to 6.5% within the next couple of years.  If so, the secondary sector could slow to below 5%.

There are a number of structural reforms China needs to do in order to keep the economy on track in the long-term.  Whether Beijing will be successful at all or most is up for debate.  But, for now the data shows that the long-awaited transition to a more balanced economy is unfolding, and a number of China-dependant firms and countries are feeling the effects.  For many, an uneven soft landing feels like a hard landing.  This trend will continue in the long-term.

The good news is that in the short-term, H2 2015 growth will benefit from a cyclical pickup as housing improves and fiscal stimulus finally gets deployed (see my posting Quick Update: Anticipated Fiscal Boost On Its Way? for details).  The bad news is that secondary industry will probably never see growth above 6% after this year, even as GDP goes through a stable slowdown.



Despite stock market volatility, growth prospects look better for the second half of 2015.

There are encouraging signs that overall growth has improved very recently.  Retail sales, manufacturing, trade (see my post Quick Data Update: Trade Data Improves In June. The Improvement Is Much Better Than The Headline Numbers Imply. ), and investment all saw modest improvements in June.  The property market improvement has accelerated.  Housing prices in the top-tier cities are on fire, and sales are growing in the double digits.  Prospects look good for the second half of 2015, but we are coming from a much lower growth rate than the first half headline GDP growth number implies.

It is not all good news however.  Growth in the first half was worse than the headlines suggest owing to a big distortion that may not carry over into the rest of 2015.  And, growth in the industrial sector portion of GDP dipped below 6% already this year (the secondary sector of GDP grew at 5.8% in Q2).  For those worried about commodities and China's making and selling of tangible stuff (and not services), growth is effectively 5.8%, well below the 7% figure overall.  Imports of many key commodities have fallen in the double digits as policy reflation has yet to produce the expected growth boost.

So, expect improvements for the second half of the year, especially in construction and property linked sectors.  However, the poor showing in H1 will increase the risk of Beijing failing to hit the 7% target by the end of the year.

Here are some key factors for growth prospects for the rest of the year:

Growth overall seems to have improved in June.  

A number of indicators improved modestly in June.   The rebounding numbers were not massive, but the upticks were broad.  The data suggests at least a stabilization if not the front end of a cyclical rebound.  Industrial production, retail sales, fixed investment, services & manufacturing PMI, both imports & exports, and housing data all saw an improvement in June.  

April/May looks to be the low point of growth this year so far.  If we see fiscal measures deployed in the second half of the year, PBOC reflation measures spreading into the broad economy, and the property market acceleration all take place, then the rebound will most likely gain momentum.  If the policy reflation effort fizzles, then the rebound may be muted.

Policy reflation expectations.

While certain parts of the economy, property in particular, are showing tangible signs of meaningful improvement, the effects of PBOC easing and a planned government fiscal expansion are much more muted.  Total outstanding credit is still slowing (See chart), and fiscal stimulus has yet to be fully deployed.  Expectations of policy reflation are still mostly based on anticipation and not tangible evidence that reflation is taking place.

As far as the expected fiscal boost goes, fiscal spending usually accelerates in the second half of the year.  Although a budget deficit was targeted this year, China has netted a surplus in the first six months of the year.  If the budget deficit target holds up this year, the second half of the year should see more than 2 trillion RMB in spending unfold.  If spending plans play out for the rest of the year (I think they will), the stimulus will be a much-needed boost to the industrial and the construction sectors.

But, again, reflation expectations for the rest of the year are mostly driven by the anticipation of policy measures boosting growth.  That is a risk to growth prospects.  There is little evidence of stimulus deployment in the numbers so far.  Beijing is still running a fiscal surplus, total outstanding credit is still slowing, and without the extra boost from a transient surge in financial services GDP growth would be well below 7% so far this year.  For more on the risks to policy reflation see my post Reflation Troubles.

The housing market is on the mend.

China's housing market continues to improve.  Prices are rebounding, especially in the larger coastal economies.  Inventory continues to be drawn-down; housing sales are up 18%, and finished construction is down 17%.  There are a number of catalysts for the rebound: price declines, inventory drawdowns, policy easing, favorable mortgage rule changes, and homeowner upgrades.  Given China's demographic changes and existing inventory excesses in the hinterlands, the long-term prospects are murky.  But, for now we are at the front-end of a cyclical housing rebound.  That is good for the industrial and construction sectors.

 For more details see my post China's Property Market Continues To Improve.

GDP growth is lower than 7% if we remove a temporary distortion.

For the first half of the year, the GDP number was distorted on the upside.  The distortion was not due to manipulation by Beijing, but was instead a product of an unsustainable boom in the financial sector, at the very least encouraged by Beijing.  

GDP Growth Rates in H1 2015 by Sector

The financial intermediation portion of the H1 GDP number grew 17.4%, driven by the surging stock markets and record IPOs.  Without the additional one-off boost, growth would have certainly been below 7%, perhaps 6.5% for the year so far.  So, unless financial services can surge another 17%, which is highly unlikely, the second half of the year will need to see a meaningful boost from reflation and the rebounding housing market to make up for it.

See my posting 7% GDP growth? Probably not. for more details.

The secondary sector of GDP growth (industry and construction) is falling like a bag of hammers.  Services continue to fly.  

China's growth in Q2 was dominated by a fast-growing service sector, while the secondary sector (the building, making of tangible things) continues to decelerate.  Even after removing the unsustainable surge in the financial sector, the service sector grew over 8% in Q2, while the secondary sector struggled to a disappointing 5.8%.  The vast overwhelming majority of China's imports are meant for industry. So for those concerned with China's making and building of things, or China's commodity demand, Q2 effectively grew at 5.8%.  We see the results of sluggish H1 industry and construction in China's weak commodity demand this year (See the chart below).


Year to Date Commodity Imports (Volume) vs. Last Year to June 2015 (Percent Change)

China Outlook in a Nutshell: Growth, Housing, and Trade

Here is a brief summary of views on China's growth outlook for the remainder of 2015.  I am restricted by my employer from giving investment advise, so I will stick to broad fundamental views.  For views on PBOC activity, reforms, and policy, see other blog entries.

Growth outlook:

My economic growth outlook is based on three main factors:

  1. Economic activity, especially industrial activity, will continue to soften for some months before Beijing's stimulus measures kick in (see my blog positing "Things will get worse before they get better.")
  2. RRR cuts and fiscal measures will probably begin to boost activity - mostly in the industrial sector - sometime in the summer (see my blog positing "Beijing's stimulus steps so far: what do they mean for growth prospects?")
  3. Construction activity will finally begin to rebound and contribute to growth in the early fall (see my blog positing "Some housing data the only good data in April's ugly economic release.").  This will compound the effects of the fiscal and RRR cut measures in boosting Q4 growth.

Q1 grew at 7.0%, right on Beijing's 2015 target.  Assuming things get softer in Q2 before stimulus kicks in, I am forecasting growth moderating to the high 6%s.  Activity will be boosted in Q3 by the PBOC and fiscal stimulus, along with a consumption boost due to the wealth effect from house prices and equity market gains.  By Q4 property construction will begin to contribute and be additive to growth.  Most of the fiscal and PBOC stimulus will provide support to industry, so most of the pickup will take place in the industrial sector portion of GDP.

Here are my quarterly forecasts:

2015 GDP Forecasts by Quarter, Full Year GDP of Forecast 7.1% in 2015

Q1 is Actual GDP

Housing and construction outlook:

It will be extremely difficult for the Chinese economy to maintain robust growth rates without a positive contribution from the property market.  25 - 30% of the economy is tied to real estate directly and indirectly (urbanization infrastructure, steel, glass, cement, furniture & appliances, and the wealth effect.)  According to the IMF, real estate creates at least 14% of China's urban jobs.  The sector is stuck with oversupply, but with ten million new urban residents each year looking for housing, and significantly low-quality old housing being demolished, inventory can be used quickly when construction declines.  Construction has tanked over the last year. 

We have seen some positive signs from China's housing market (see my blog positing "Some housing data the only good data in April's ugly economic release.").  Sales and prices have turned positive in April after steep declines in the last year, which where in turn followed by declines in construction.  A drop in new units and the roll-back of mortgage restrictions in March has improved prices on an month-on-month basis.  Whether the renewed housing market driven partly by Beijing's efforts to ease mortgage lending will help the market in the short term at the expense of more long-term structural problems is up for debate.  In the short term however, the housing market is looking modestly better, and construction and resource demand will eventually look better this year.

Much of the housing weakness this last year came after a surge in supply in early 2014 (see chart below), exacerbating oversupply built up over years (perhaps 500,000 to a million units of excess supply annually beyond demand and a 20% vacancy rate).  New starts and construction have tanked over the last year.

Improved housing will have two main effects:

Home Ownership Rate

  1. The wealth effect from increasing prices will stimulate consumption.  Over 60% (according to Goldman Sachs) of household assets are held in property and homeownership rates are high (see chart on the right).  Historically, housing is one of the few investment options available in China, so ownership rates are high and investment properties are plentiful.  The improvement in prices should lead to a boost in consumption in Q2.
  2. Sales and price increases will eventually lead new starts, which will be a boost for construction.  This will in turn be a boost to commodity imports, iron ore in particular.  Heavy industries like cement and steel will improve.  Sales lead new starts by 6 months, so expect a construction pickup in the Fall.  Nearly half of all steel consumption goes to construction.  Construction is about a quarter of copper consumption.  

Trade and external position:

Going forward, the CNY will be flat and stable vs. the dollar, requiring continued liquidation of USD foreign exchange reserve assets.  Beijing will try to keep the CNY stable vs. the dollar for various reasons including lobbying the IMF to include the yuan in the special drawing rights (SDR) and maintaining economic restructuring plans.  Considering the PBOC is still easing while the Fed is ending its easing, growth is weak, and investment cash is flowing out of China, significant amounts of reserves will need to be sold to keep the CNY stable.

Exports have declined, as the CNY has appreciated nearly 20% vs. the EUR and 15% vs. the JPY over the year, dramatically reducing export competitiveness.  Exports will continue to stay weak for much of the year due to the currency policy coupled with subdued global growth.

Imports will continue to decline on a value basis, but expect the stimulus-boosting measures to improve import volumes. Copper, oil, heavy machinery, and consumption goods imports will get a boost in the summer from improved investment and the wealth effect.  Iron ore will see a pick-up once construction rebounds.

Year to Date % Change for Selected Commodities vs. Last Year

Crude oil: Crude import demand is expected to increase in H2 2015 for three reasons. First, cheaper oil and the wealth effect from better housing and share prices will improve consumption on a volume basis. Second, domestic production is expected to decline about 120,000 bpd as firms cut capital spending. Third, vast storage containment will come online in H2 2015 to fill China's strategic petroleum reserves. New strategic storage facilities with 50 billion barrels of capacity will be completed in H2.  Refiners are also expected to restock inventories in the tens of millions of barrels over the second half of the year.

Iron ore: Nearly half of China's steel production goes into construction.  A pick-up in the housing market will push iron ore demand higher by Q4.  On top of that, inventories have fallen significantly over 2015, and mining firms have cut investment and production.  Beijing's stimulus will help import demand for iron, but a construction rebound later in the year will bring about a significant pick-up considering the inventory drawdowns so far this year.  

China Copper Consumption % Breakdown

Copper: Copper import demand is expected to grow.  Demand this year is expected by Platts to run around 4-5%.  A pickup in construction will improve demand by the fall.  Beijing's expanded fiscal budget and the "war on pollution" will contribute further to a pick-up in demand.  

Copper stock levels are low, according to Platts, and an 11% decline in imports by volume YTD so far would imply that an import surge is inevitable sometime this year.






Things will get worse before they get better.

Expect China's economy to get worse before it gets a boost from the PBOC's recent easing and the expanded fiscal budget.  China's fixed investment has slowed dramatically, to 9.6% YoY in April.  Credit growth is running at the slowest pace in decades.  The slowdown in credit and investment, as well as the negative import data (see previous trade data post) point to weaker economic activity for some time before the RRR cuts begin to boost growth



It takes roughly 4 months or so before RRR cuts boost activity via credit growth and investment.  This means that we probably have a couple of months of ugly economic data before things start to turn around.

The first RRR cut was in February. Assuming we see more fiscal spending to help with the monetary policy boosts, then it will be Summer before growth picks-up.

Here are what my forecasts show for import demand from select countries for the next three months.  Commodity exporting countries will see terms of trade deteriorate.

Beijing's stimulus steps so far: what do they mean for growth prospects?

There are two major economic factors to keep your eye on this year: Beijing's monetary and fiscal stimulative policies, and the property market.  I will make a few comments on Beijing's policies here, and discuss property later.

There has been a constant flow of news about the PBOC trying to stimulate growth, and the central government's plans to step up fiscal spending.  As I wrote in a prior blog entry, lending facilities are intended to minimize rate volatility and liquidity disruptions, so I will not estimate their effect on stimulating growth.  Lowering benchmark rates are much less effective than they once were, because technically they have not been mandated lower and more rate liberalization steps this year will make the effects uncertain.  Benchmark rate cuts will probably have some effect on growth, but I will not try to estimate that effect, because I think it will be very modest.  Mortgage down payments have been lowered, but until the demand for housing improves, I will not estimate the effects of mortgages.

The two most important interventions out of Beijing are the RRR cuts (See PBOC tools infographic for details) which should free-up money for lending, and the increase in fiscal spending which should increase underlying demand.

The PBOC has cut the RRR twice this year.  We are assuming that the PBOC does one more reserve cut this year, probably in the Fall.  

How much will Beijing’s measures boost growth?

PBOC’s broad easing measures so far this year (not including activity meant to stabilize interest rates and benchmark rate cuts) amounts to a 1.3% expansion of credit if fully utilized, not accounting for a multiplier effect.  I estimate that this credit expansion would result in a contribution of 0.3% to real GDP growth, if historic relationships hold.

Beijing announced an expansion of the budget deficit to 2.3% from 1.8% in 2014. The central government's budget expansion would mathematically amount to another 0.5% if fully utilized, not accounting for multiplier effects.

What pace would we estimate ex-intervention growth?

Assuming underlying growth maintains its deceleration trend (I estimate ex-intervention slowing of .25% per quarter) and without intervention slows to 6.25% by Q4, that would point to 6.6% growth in 2015.

A very simple rough estimate of stimulus boosting by Beijing:

6.6 + 0.5 + 0.3 = 7.4%

This is not to say that 2015 will see growth of 7.4%.  Last year the central government underspent its budget target, so we may not see the full fiscal expansion.  And, over time the effectiveness of credit growth on broad activity has declined, so historic relationships may not hold.  But, my point here is that growth can run over 7% this year, even if the existing stimulus is half as effective as in the past.  Given that consensus is 7% for 2015, I think that there is a good chance that forecasters are underestimating the stimulus measures, and the balance of risk falls on an upside surprise by year’s end.  Also, as growth gets worse into the summer, we may see more downward revisions to growth forecasts, and consensus will fall further.  

Beijing's measures to boost growth will take time, and things will get worse before they get better.

When will we see things turn?

I have calculated that it takes roughly 4 months for PBOC boosted credit growth to translate into economic activity.  3 months after a credit increase you may see some signs, but 4 months seems to be when the bulk of credit growth spreads to the overall economy. That would imply a pickup from the first reserve cut starts stimulating growth this summer, with the second larger reserve cut boosting activity by the fall.  A third RRR cut, assuming it falls later in the year, will boost 2016 activity.

PBOC continues to roll-back restrictive policies of the last few years.

China's PBOC has been very active over the last six months, using every tool in the toolbox (See infographic page for information on PBOC tools).  The recent stepped-up PBOC activity and easing is not a shift back to the easy money policies of the late 2000s, but instead is a normalization from very restrictive policies starting in the early 2010s to rein-in the excesses of the post-crisis surge in debt and overcapacity.  As the chart below shows (as well as a dramatic slowdown in outstanding credit growth, seen on my debt chart and table page), rates are relatively high vs. inflation.

The most important tool to watch is the reserve requirement ratio (RRR), and here is why:

  • Many PBOC activities are being employed to minimize rate volatility and reduce liquidity distortions.  China does not have an overnight target rate, like the Fed and ECB, resulting in short-term rates driven mostly by market forces and seasonal disruptions (for example, during Chinese New Year huge numbers of depositors take money out of the banks for gifting, and that cash then returns to the banking system sometime after.  This causes seasonal volatility in rate markets). China's short-term interest rate volatility has been nearly 50 times the rate volatility in the US and 10 times South Korea over the last 5 years.  Direct lending through the SLF and MLF (again, see infofraphics for details) are tools created to limit volatility and disruptions, in a restrictive monetary environment in particular.  These tools are not intended to stimulate broad growth prospects, as their tenors are relatively short-term and therefore meant to manage temporary disruptions in liquidity and before the cash is given back to the PBOC.
  • Lowering the deposit and lending rates are much less effective than they once were.  The mandated lower limit lending rate was already removed for all but property loans. Lending rates are technically set by the markets.  And as deposit rates are lowered, the ceiling for the deposit rate has remained the same because the allowable range above the mandated benchmark rate was increased.  Deposit rates haven't technically been mandated lower.  Private banks can keep deposit rates unchanged, as state-owned banks probably feel obliged to lower them.  Changes to the benchmark lending rates are more about laying the groundwork for rate liberalization & making private banks more competitive than stimulating broad growth.  We are 5 months removed from the first benchmark rate cut, and economic activity has been unfazed.  Lowering benchmark rates will have some stimulative effect, but as rate liberalization takes place the effect is uncertain.
  • Lowering the RRR releases funds for lending potentially for many years to come.  Coupled with expansion of the budget announced in March, we should see a meaningful stimulus to broad growth from RRR cuts.  As far as the PBOC toolbox goes, the direct lending facilities are like a chisel, meant to smooth.  Benchmark rate cuts are like a mallet, meant for specific tasks, but nowadays less useful for big jobs.  The RRR (as long as there is stimulus on the demand side) is like a sledgehammer, heavy enough to get the job done.