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.

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• 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.

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• 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.

Credit numbers remain modestly positive for growth prospects, but not as much as implied by the headline numbers.

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• Do not put too much weight on the seemingly eye-popping lending numbers.  Seasonal factors heavily distort numbers this time of year. Lending always jumps at the beginning of the year when banks are far away from year-end lending quotas.  Credit growth numbers were modestly higher, but not out of line with recent months on a 1 year outstanding growth basis.
• There is no evidence of domestic PBOC monetary conditions tightening as a result of the fx interventions.  The PBOC has been able to offset the fx interventions with broad domestic monetary policy tools.
• The numbers were consistent with the results over the last few months.  Bank lending grew faster than overall credit as trust lending and local government lending has decreased.  Transparent credit markets like bonds have outpaced shadowy trust and local government lending.  These rates of credit growth may add some boost to short-term investment with a small increase to the total debt burden vs. GDP but not by any dramatic amounts.
• Credit growth is still outpacing economic growth.  China's debt burden is a risk, and certainly a headwind to growth as resources are used to prop up indebted firms instead of improving economic prospects.  But, crisis is not imminent, and in fact risks have receded a bit over the year with the shifting of debt from the shadows to transparent credit markets.
• All in all, credit numbers remain modestly positive for growth prospects, but not as much as implied by the headline numbers.
• The rising debt load has recently brought renewed worries over China's debt problem, and its potential for crisis.  For more details on China's debt problem see: 

Be vigilant over indebted Chinese firms, but don't freak out about China's debt load.

and

Charts with labels.

Outflows, Outflows, Outflows. January Forex Reserve Data Shows That PBOC is Still In a Tough Spot.

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China had another month of declining foreign exchange reserves in January.  Reserves fell $99.5 billion USD to $3.23 trillion in the first month of 2016.  The numbers show that China’s outflow problem persists, and while the yuan has stabilized, downward pressures continue to require the PBOC to burn through its reserve hoard.  Mathematically, if outflows continue at the rate seen over the last two months, Beijing has reserves to last until early 2019.  But, it is unlikely that the PBOC will simply let the money run dry.  Continued outflows and expectations by the markets of a lower yuan put the PBOC in a tough position.  The PBOC needs to either use reserves to hold its ground and wait for sentiment and expectations to change, or they may find themselves in a vicious circle of outflows and expectations that will make the situation far worse.    

How much capital has left the economy?

There have been a number of estimates for 2015 capital outflows recently, some over $1 billion USD.  Estimating capital outflows flows is complicated, but if we use the balance of payments as a guide, we can use the following equation to get a rough estimate:

Capital flows = current account surplus + decline in foreign exchange reserves

Estimated Capital Outflows ($ billion USD)

Source: IMF, PBOC

Using this method, we get a rough estimate of: $293 + $513 = $806 billion USD (see the chart on the right for past outflow numbers).  Even if we make adjustments to the number, the point is that outflows in 2015 reached a staggering sum.  

$216 billion in 2015 capital outflows was recorded in the official numbers under “errors and omissions”, and widely considered as capital flight that has made it through China’s strict capital controls.  But, “errors and omissions” is a “plug” number used to bring the overall number into balance.  It is an oversimplification to view all of that as capital flight that has circumvented Beijing’s capital controls.  Price declines in forex reserve assets and Chinese firms delaying conversion back to RMB require a significant “plug” figure to get the official numbers balanced.  Many wealthy Chinese looking to send money overseas beyond current quotas, or officials looking to hide ill-gotten gains certainly are getting capital out of the country through unofficial channels, but the number is probably much lower than the $216 billion often cited.

Where are the outflows coming from?

The vast majority of capital flight is coming through official channels from a few main sources.

• FDI inflows have slowed, declining 4.7% on the year in Q3 ’15, after averaging 18% annual gains since 2007.
• Fears and expectations of a lower currency by investors has created a self-fulfilling scenario, accelerating investor-driven outflows and leading to a weaker yuan.  Portfolio and "other" investments have seen meaningful outflows.  Portfolio investment and “other” investment outflows totaled $370 billion USD for the year by Q3 2015.  Investors, foreign and domestic, have moved massive sums out of the country.  Stock market turmoil, weaker growth than many have expected, and the monetary policy mismatch between the PBOC and the Fed have sent sentiment to an all-time low.  Chinese outbound investors have been felt around the world and have re-shaped a number of global markets.  Chinese investors are now the largest foreign buyers of property in the US, Canada, and Australia.  
• Chinese firms have recently become significant FDI investors.  Outlbound FDI rose 53% on the year as of Q3 2015.  That trend has accelerated in 2016, with Chinese companies announcing plans in January alone to purchase 66 foreign firms worth roughly $68 billion, according to CNN/Money.  
• Chinese firms with USD debt have been paying down obligations for a number of reasons, effectively deleveraging China's external debt.  This is not an insignificant development.  The Institute of International Finance (IIF) estimates that half of the recent outflows have been repayments of dollar liabilities by Chinese companies, estimating that towards the end of 2014 total dollar debt was around $1.5 trillion. According to the World Bank, private external debt by the end of 2014 was only $800 billion.  Firms are paying down USD bonds and loans as worries over currency volatility, expectations of rising US rates, and low Chinese domestic interest rates make holding USD debt look much less attractive.  That would paint a less pessimistic picture of outflows, as sentiment-driven investor outflows are less than the headline numbers imply.  There is a finite limit to these deleveraging outflows, and we will most likely hit the limit in 2016 if the current pace is maintained.
• Lastly, some amount of money has fled the economy through unofficial channels.

The PBOC has some difficult decisions.

China's Annual Trade Balance $ billion USD

Source: China Customs Administration

China's Exports as a Percent of Total Global Exports

Source: World Bank

The outflows leave the PBOC with a difficult problem.  First, aside from sentiment and outflows, there are few reasons for downward pressure on the yuan.  A lower yuan will not make exports more competitive.  China already has the most competitive exports in the world.  The trade balance last year was $600 billion USD, larger that the Swedish economy.  And China is now 13% of all global exports, larger than its share of global GDP.  China does not need to make its exports more competitive via the currency.  Beijing policymakers do not want a falling currency for both reform and political reasons.  Engineering a currency devalue would force consumers to subsidize industrial exporters, exactly what current reform efforts are trying to reverse.  Beijing does not want to be seen as starting a currency war with the G20 set to meet in China later this year.  

If Beijing does not want or need a weak currency, the PBOC has been left with a difficult decision: burn through reserves in a game of chicken waiting for outflows to slow or end, or let some pressure out by allowing for some controlled currency devaluation.  The first choice threatens to empty China’s foreign reserve hoard, removing Beijing’s safety net for global financial turmoil.  The second choice creates the risk of a vicious circle.  When the PBOC is seen giving the green light to currency weakness, the market panics, and outflows accelerate.  Just about any size move lower in the yuan seems to generate fears of a loss of Beijing's control.  Accelerating outflows require more currency declines to relieve pressure, causing more panic and worry.  The PBOC can either wait out currency market sentiment as long as it has ample reserves, or potentially ignite worse sentiment and make matters worse.

Going forward, 

It is uncertain where outflows go from here.  Looking at the outflow sources described above can give us a little bit of insight.  

• Given China's slowing growth, inbound FDI will probably not see a significant rebound anytime soon.  Outbound FDI will continue to grow, as Chinese mainland firms see less rapid growth at home, and firms looking to acquire technology and know-how to compete globally.  The FDI situation will not be supportive of stopping outflows.  
• USD liability pay downs by Chinese firms will eventuality slow, certainly before the PBOC runs out of reserves.  If the IIF is correct, at the current pace, companies will have reduced external liabilities to half of the 2014 peak by mid-year this year.  Outflows due to liability pay downs, possibly half of all outflows, will subside this year.  
• The real wildcard in the outflow problem is investor-driven flows.  It is impossible to know just how long it will take for investment outflows to slow.  Missteps and poor communication from Beijing have exacerbated negative sentiment and pushed it to new highs.  Beijing has recently signaled willingness to avert more yuan weakness, which could be a possible step in shoring up confidence in the PBOC's ability to get ahold of the capital outflows and yuan declines.  After declining 1.5% in the first week of the year, Beijing has chosen to hold the yuan steady for the last month, and has been willing to burn through reserves to do it.  Beijing seems to be signaling the willingness to stem a downward vicious cycle of expectations and more outflows.  

So what amount of reserves might Beijing target, and how many months of $100 billion outflows until they reach that amount?  There are a few commonly used rules of thumb for reserve adequacy: 3 months of imports, short-term external debt, and 20% of broad money supply.

• If we take IIF's estimate of all external liabilities, not just short-term, then conservatively the PBOC can get by with at least $1.5 trillion to cover external obligations.  It would take 17 months of outflows at the current rate to get there with $100 billion USD a month in outflows.  
• If we assume the PBOC wants enough reserves to cover a full year of imports, not just three months given the heavy reliance on imports of raw materials, then it will take potentially 15 months to get there with $100 billion USD a month in outflows.
• 20% of M2 money supply means reserves of $4.2 trillion USD is need, and reserves are $1 trillion USD too low.  Given China's closed/controlled capital account, they probably don't need to cover so much of the broad money supply.

If investor sentiment and yuan expectations can ease within those time frames, then the PBOC has time to wait out the market.  If not, the PBOC will enter into extremely uncertain times.  Perhaps the Spring Festival holiday this month will give markets time to calm their worries a bit.

On the Subject of China's Ability to Innovate and Compete in Global Markets

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For the 6th year in a row, China remained in the top fifth of economies in the World Economic Forum Global Competitiveness Index, ranking a respectable 28th out of 144 countries in 2015-16.  That put China 47 places above Brazil and 17 places above Russia, its two BRIC peers.  But, China’s current rank in the index does not tell the whole story.  China’s economy moved up in the rankings quickly early last decade, leapfrogging a slew of other developing economies to become one of only two middle-income developing nations to crack the index's top 30, along with Malaysia.  The economy has moved up considerably from its 55th place showing in 2005.  But, since 2012, its move up the ranks has stalled.  Add to that the fact that China has accumulated more debt to achieve its level of competitiveness than many other economies.  China has burned through more capital to improve its competitiveness than most peers (see the chart on the left).

As questions mount over the sustainability of robust growth in China, the issue of competitiveness is highly important.  According to the Asia Development Bank, China exports over 55% of Asia’s low tech goods, a massive amount that has partly funded rapid growth. But, as wages rise, the workforce shrinks as a result of the one-child policy, and consumers become more demanding, Chinese firms need to push their way up the value chain into high-tech and high-value innovative product exports to sustain robust growth.  If they cannot move up the value spectrum and create globally competitive products, the economy will be squeezed between rising labor costs and low-cost, low-tech assembly.

So, is China still growing more competitive, or has the economy hit a ceiling? Can Chinese firms create innovative, globally competitive products to keep moving up the manufacturing value spectrum and outpace growing labor costs?  Measuring China’s ability to innovate and produce globally competitive products presents a mixed picture.  While China’s economy seems to be in the midst of growing its innovation potential, it is unclear that the country has moved far beyond the days of cloning foreign ideas and low-cost assembly.

Chinese Firms’ Share of Global Revenues
Chinese companies do have some successes in competing on the global stage.  According to McKinsey & Company, Chinese appliance firms account for 36% of global revenues, telecom companies about 18%, high speed trains account for roughly 41% of the global market, and Chinese solar panel firms account for over half of all global solar panel revenues.  A single Chinese firm, DJI, accounts for 70% of the global consumer drone market.  But in R&D heavy science-based industries, like branded pharma and semiconductors, Chinese firms account for less than 12% of global revenues, below China’s share of global GDP.  China’s auto firms only account for 8% of total global revenues.

Patent Filings
Many discussions on China’s capacity to make innovative, globally competitive products turn to the recent massive surge in patent filings.  According to the World Intellectual Property Organization, in 2014 China patent filings numbered roughly 928,000, compared to 579,000 in the US, 326,000 in Japan, and 210,000 in South Korea.  That number amounts to one-third of all global patent filings, a huge number for a country still in the middle of an economic transition.  And, 2015 filings in China rose another 18.7% to 1.1 million, making China the first country to file over a million patents in one year.  Sinopec led Chinese patent filings in 2015 with a total of 2,844, followed by telecom equipment national champions ZTE and Huawei.  China’s successful rise in patent dominance has been cited as evidence of its success as an innovation economy.

By the numbers, China has churned out some impressive patent filing statistics over the last few years, but a great deal of China’s patent surge is proving hollow.  Some years ago, Beijing instituted a number of incentives for patent filings, including tax breaks, remuneration, and other benefits.  Those incentives have resulted in an emphasis on quantity rather than quality.  Evidence of that can be found in two numbers described below.  

Only a third of China’s patent filings are for invention patents, the rest are for design and utility model patents whereby a patent can be filed for making minor design adjustments to existing inventions.  The high ratio of non-invention patents highlights the low quality of China’s total patent filings.  Large numbers of patents for minor modifications should not be seen as rapid innovation.

Chinese firms tend to file the vast majority of patents domestically, and not in foreign markets where incentives are not offered and costs are higher.  Fewer patents were filed in the US in comparison to China, but US firms account for 26% of European patent filings and China only 9%.  Only about 6% of China’s innovations are protected and commercialized outside of China.  That all implies that the lion’s share of China’s growing war chest of patents are meant for collecting Beijing’s incentives, and not for the purpose of competing in the global marketplace.

More evidence of China’s lack of patent quality can be found in the Thompson Reuters 2015 Top 100 Global Innovators list published in November last year.  The list looks at the volume of unique inventions owned by firms globally, as well as the quality and usage of inventions by those firms.  Not a single Chinese firm made the 2015 list.  Huawei made the list in 2014, but was dropped last year.  The reason for China’s absence in the top 100 is its lack of innovation outside of its borders, according to Thompson Reuters.

So, while China’s surge in patent filings is impressive, the underlying level of innovation is much lower than the headline numbers imply.

High Tech Exports as a % of China's Total Exports

Source:World Bank

High Tech Exports
Another often cited demonstration of China’s growing innovation and rising competitiveness in high-value products is the country’s exports of high-tech goods.  The Asia Development Bank recently reported that China’s share of Asia’s exports of high-tech goods, like aircraft and telecommunications equipment, rose to 43.7%, overtaking Japan’s dominance in the region.  According to the World Bank, China has increased its export share of high-tech goods significantly over the last decade.

But, again, here is another instance where the headline numbers do not tell the full story.  Asian export statistics do not clearly specify exact component destinations along the global supply chain and mistakenly credit the full values of assembled high-tech goods to China.  MIT’s Yuqing Xing in his paper “China’s High-Tech Exports: The Myth and Reality” published in 2014 contends that China’s real contribution to such a high share of high-tech trade is simply labor and assembly, not technology innovation.  On top of that, 82% of China’s high-tech exports were produced by foreign-owned firms, like Taiwan’s Foxconn.  China’s real value-added technology exports are not only much lower than the stated numbers, but perhaps impossible to estimate precisely.  It is hard to differentiate between assembly of parts and production of competitive, innovative indigenous products.

A Boost to Potential Innovation
While attempting to measure China’s current level of innovation and global competitiveness yields mixed results, there are a number of factors in the works to boost China’s potential for competitive and technological strides.  The first is education.  Back in 1999 fewer than one million students acquired a college degree.  By 2004, China college graduates surpassed the US, and by 2014, college graduates numbered roughly 7 million.  Adding to the rise in secondary education, Chinese universities award nearly a third of their degrees to engineering students, while in the US that number is only 5%.  China’s pool of potential innovators is growing rapidly.

R&D spending is another factor driving China’s innovation potential.  China is the second largest R&D spender in the world, after the US.  In 2014, R&D spending grew almost 10% to over $200 billion USD, more than spending by innovation giants Germany and Japan, but well under half of the $475 billion in the US.  

Over the last few years, Beijing tax breaks and the success of tech firms like Alibaba and Tencent have spawned a wave of new tech start-ups.  Last year China cut nearly $46 billion in taxes associated with entrepreneurs and start-ups.  The numbers are quite staggering.  According to the Wall Street Journal, by the end of 2014 there were 1,600 tech incubators in China with start-up projects employing roughly 1.75 million people.  China Daily reported that last year 10,000 start-up firms were being set up every day.  Venture capitalists poured a record $37 billion USD into start-up firms in 2015, over double the tally in 2014.  That total was 27% of all global venture capital investment in 2015, but trails the US with $68 billion.  Those numbers indicate China’s entrepreneurs have possibly embraced the kind of investment and potential for failure required to build globally competitive innovation.  Although it is important to note that China’s investors have a well-documented history of throwing massive sums of capital into numerous boondoggles.

But, China’s biggest secret weapon in its strive to improve technological competitiveness is its manufacturing ecosystem.  As mentioned above, China assembles much of the rest of the world’s innovative products, and that assembly capacity can be put to work for use by indigenous starts ups.  According to McKinsey & Company, China has five times the Japanese supplier base, 150 million experienced factory workers, massive ports, and the world’s largest hoard of contract manufacturers.  Not only has China developed an unparalleled manufacturing ecosystem, the countries in close proximity to growing and often untapped Asian markets allow for rapid deployment of new products.

So, measuring China’s current ability to create globally competitive products in order to move up the value spectrum presents a mixed picture.  Recent developments indicate that China’s potential for more innovation is on the rise.  But, only time will tell if massive R&D capital investments, more university graduates, a patent hoard, and a surge in start-ups will drive competitiveness, or whether China’s attempts to push for innovation will be as empty as its massive ghost towns.

December economic data chartbook.

December economic data in a nutshell: December data was a bit softer than the previous month, but Q4 points to a modestly weaker but broadly stable economy.  Concerns over hard-landing economic prospects are overdone.  Consumption remains strong.  Service growth is robust.  Heavy industries, like steel and cement, are still falling like a bag of hammers as overcapacity weighs on traditional growth driver sectors.  Fiscal expenditures picked up.  Credit growth has stabilized at a weak 11-12%.  The housing market is improving, and constriction is less negative. 

Here is my Chartbook for more info:

Data Update: Trade Data Improves, Shows Limited Upside for Yuan Devaluation Policy

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Trade data came in better than expectations, and is further evidence that growth momentum picked up into the end of 2015.  A weaker yuan might have helped contribute to the better numbers after declining around 4% vs. both the USD and JPY.  But, the yuan is still almost 8% higher against the EUR, China’s largest trading partner currency, so a weaker yuan has probably only contributed a modest improvement to the trade data.

China's share of total global exports is still rising, and the trade surplus continues to hit new record highs.  Those two factors leave little reason for an engineered fx devaluation from Beijing meant to make exports more competitive.  Exports are already competitive, and growth stimulus needs to come from domestic tools.  

China's Trade Surplus ($ billion USD)

China Exports as % of Global Exports

All in all, the data supports my view that it is very probable Q4 headline GDP numbers will be better than current expectations when announced next week.

Some key takeaways from China’s December trade data:

• Trade for processing and exports was much weaker than trade for domestic use.  Exports for processing declined 10% from last year.  That points to weak global trade in general.
• Key commodity imports by volume increased from last year.  On the year, crude oil imports rose 9%, with copper and iron ore -0.3% and 2% due to declines early in the year.  Commodity demand has increased going into 2016.
• If we adjust imports for commodity prices moves, we get an adjusted import number of around 2%, weak but positive.
• Exports to EM economies declined overall, indicating weak demand from those economies, as well as weak growth in the global supply chain. 
• For more data see: http://laohueconomics.com/trade/

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On the subject of stock market turmoil

China’s new stock market circuit breakers forced the market to find the bottom in 7% chunks at a time this week. But, in less than 5 days, Beijing has already discarded the short-lived circuit breakers scheme, requiring Beijing to directly purchase shares and rewrite large shareholder selling restrictions to stop the panic selling.

Overnight on Thursday, markets shut within 30 minutes after a 7% drop triggered the newly created circuit breakers again for the second time this week.  The circuit breaker is a mechanism created in 2015 in order to stop panic selling. A 5% loss or gain in the CSI300 Index triggers a 30 minute trade suspension.  A 7% gain or loss in a day triggers a market closure for the day.  On Thursday the market burned through the 5% trigger, right to the 7% threshold within a half an hour, and trading was halted for the day.  

Early into Friday's trading session without circuit breaker protection, the market declined to 2%.  State funds purchased shares with large weights in the index to push the market up 2% by the close.

Some things to note about the market turmoil this week:

• The links between China's stock market and the real economy are minimal. 90% of the market participants are retail investors, as opposed to institutional. And a major chunk of investors are new to stock investing, having opened the first accounts last year.  Institutional investors put money to work in China’s stable bond market - the third largest in the world -  leaving stocks as a venue for irrational stock gamblers. The local bond market has been both stable and strong during stock turmoil.  Only 8% of the adult population owns shares, and liquidity is massive - bank deposits in the country are 200% of GDP.  Statistical analysis shows no direct relationship between share prices and economic activity over the last few years.  A share sell-off should not be confused with a hard-landing in the economy.  The Shanghai stock exchange is the world’s largest gambling den, and should not be confused with the real economy.  Whatever your China economic growth outlook was last week, the events of this week should not change that outlook.
• Most of the turmoil in the stock markets this week are probably a product of 3 main factors: The expiration of large shareholder sale restrictions set for this week, the uncertainty over weakening of the yuan, and the ever-present worries over growth - perhaps exacerbated by the very modest downward revision of GDP overnight or weak PMIs.
• In order to stop the market panic in 2015, on July 8th Beijing instituted a six-month ban on share sales by investors with holdings over 5 percent in a single company, along with corporate executives and directors.  That was slated to end this week, causing most of the market carnage.  Goldman Sachs estimates that the share ban kept 1.1 trillion RMB in shares off the market.  The value of the Shanghai Composite has fallen about 6-7 times that amount this week.
• On Thursday, after the market halt, new rules for large shareholder sales were published.  Now, large shareholders can only sell a max of 1% of their holdings every three months.  And, they must apply for share sales 15 days in advance.  The new rules might delay the panic selling from continuing in the short-term, but share sales from large shareholders will happen eventually.  Other trading restrictions still on the books: Individual shares halt trading after a 10% drop in one day, and investors are not allowed to buy and sell the same shares in a single day.
• After spending almost $240 billion last July, August, and September - mostly through a group of a group of state-backed investors, brokerages and funds referred to as the “National team” -  to support the market, the “National team” has entered the market again.  Tuesday and Friday trading sessions saw Beijing directed share purchases to support the market.
• Market pressures and outflows have led to a drop in the yuan this week, leaving the PBOC liquidate reserves to slow the declines.  The yuan drop has contributed to the uncertainty, but Beijing has much more control over its currency than its equity markets, with its daily trading range, closely controlled capital account, and massive reserves.

Beijing is pretty lousy at managing free market liberalization. Their policy responses seem ad hoc, frequently add to uncertainty, and often exacerbate the turmoil.  But, stock market turmoil and policy blunders should not negatively impact already weakening - but stable - economic growth and employment stability.  The real economy - already expected to slow by another 0.50% in 2016 - momentum is positive in the short-term on the back of consumption and service growth.  Beijing reflation efforts have finally started improving activity.  Don't mistake stock market turmoil with economic growth prospects.  My calculations indicate that it is highly probable that Q4 GDP will be better than expectations when announced on Jan 19th, which may be met with some disbelief.

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

and:

5 Important Things You Should Know About the Chinese Yuan

2) China's two-speed economy diverged considerably in 2015.

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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.

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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.

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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.

China 2016: A brief overview of expectations

Never before have China’s economic reforms been so precariously balanced between maintaining robust growth in order to maintain social stability, and reining in the excesses and imbalances from the supercharged decades-old industrial policy.  Policymakers are attempting to fulfill two often diverging goals of adding stimulus with one hand and trying to force rebalancing and discipline with the other hand.  Those opposing goals will continue to add policy risk and drive the two-speed economy to diverge further in 2016.  We should see growth stabilized but slowing, with larger divergences between new growth sectors and traditional growth sectors within the economy.  Financial system risks, overcapacity, malinvestment, and the turmoil of market liberalization will not disappear, but we should see more headway on mitigating those risks in 2016.

Growth has finally begun to pick up as the year winds down, a result of more than a year of piecemeal monetary easing, pro-housing market policies, consumption-boosting measures, and fiscal stimulus.  Going into 2016, the momentum should keep the economy stable for months to come.  More easing and fiscal measures should be expected, but less than in 2015 as Beijing moves the growth target one notch lower.

What Beijing Expects

China's central bank foresees the economy growing around 6.8% in 2016, above what we are assuming will be the new growth target of 6.5%.  The PBOC also expects exports to grow around 3% and imports to grow just over 2%.  The trend rate for those two trade numbers is in the double digits, and such low forecasts imply a continuing drag on China's suppliers as well as weak global trade in general.  The new growth and inflation targets will be announced to the legislature next spring, but expect both to be lower than the current targets of 7% and 3% respectively. 

What the Market Expects

Overall, most analysts and banks expect the economy to be weak but stable next year.  Other expectations: Slowing growth but no hard landing, a much weaker yuan, and a few more interest rate cuts.  

Market consensus is for 6.5% GDP growth in 2016.  Within the consensus, some analysts are more bearish than others.  According to the Wall Street Journal, both Barclays and State Street expect 2016 growth of 6%, below target and well under Xi's growth floor, as a result of excess capacity in industry and housing, persistent deflation, and other issues.  HSBC in November put its forecast at a brisk 7.2%.  In general most analysts see growth around 6.5%, plus or minus about a half of a percent.  We are entering 2016 with a far tighter range of growth forecasts than when we entered 2015.

Two-Speed Economy Will Keep Diverging

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China will slow next year, and 2016 will be another year of speculation about just how much lower the slowdown can go.  I would argue that for those outside of mainland China the real question should be not "how much will GDP growth slow?" but “how far will industry slow?"  The divergence between services and industry will deepen next year.  Rapid growth in services and consumption are both great for domestic stability and those who sell their wares within China’s boarders.  But, another year of slower factory output means another year of sluggish commodity and machinery demand.  A stable China growing at 6.5% next year means a positive contribution to global growth on a mathematical basis, but means more weakness passed along to economies linked to China’s once insatiable demand for machinery and commodities.

A Soft Landing + Economic Rebalancing = Good news for consumption and service sectors, but not very good news for industry and the lion's share of import demand from the rest of the world.

Underdeveloped consumption and service sectors have a lot of room ahead to catch up to regional peers.  And, most reforms favor boosting those two sectors.  Less investment is being put to work in industry and construction - both plagued with overcapacity issues.  In addition, most reforms seem primed to slow industrial output.  Stable growth is not necessarily a good thing for key commodity and industrial machinery import demand.  

For those who choose to measure China's economic activity by counting rail cars and electricity output, 2016 will look like a hard-landing year again.

3 Key Reforms to Watch For

2016 will see a constant flow of new reform and restructuring plans and policies announced.  Liberalizing markets, trying to reduce financial risks, and possibly more potential changes to state-owned firms will be some of the policy themes.  But, there are three very import reforms that seem to stand out as leadership priorities for 2016.  

Capital account liberalization will continue to roll along next year as Beijing prepares to free the yuan by 2020.  We should see higher quotas for inbound securites investment as well as more volatility in the yuan as it slowly becomes more untethered.

2016 will see meaningful changes to China's household registration system.  The household registration system is a throwback to central planning days. It excludes migrants workers - roughly 20% of the population - from social services like education and medical benefits if those migrants live outside of the locality where they were registered at birth.  The Mao-era policy persists because urban registered city dwellers do not want their services diluted by folks from the countryside.  If Beijing can make real headway, and allow 20% of the population access to key social services, it can unlock sizable income and savings for consumption.  

At a very recent meeting of China's leadership, fixing industrial overcapacity was a frequent topic for announcements. We have heard Beijing talk about fixing overcapacity issues in the past, only to ignore the problem at the first sign of economic slowdown.  But, recent announcements indicate that reducing overcapacity and removing "zombie" firms through bankruptcies and mergers is a core reform for next year.

So what does this mean for growth?  The household registration reforms will be good for consumption and services.  Overcapacity fixes will be a negative for industry.  These two reforms should drive an even bigger wedge into China's two-speed economy.

The Yuan

As mentioned in previous blog postings, the yuan is in a tug-of-war between market forces putting downward pressure on an overvalued yuan, and policymakers looking to keep the currency stable and strong for economic restructuring purposes and political reasons.  In August, the PBOC introduced changes intended to increase market forces on yuan price setting.   The PBOC still enjoys a great deal of control over the yuan via massive $3.5 trillion in exchange reserves and control over currency printing, but less control than it had before August. As a result, market pressure will weigh on yuan price moves more than in the past, and the yuan will experience greater volatility in 2016.  

Beijing has indicated it wants a "strong and stable" yuan.  The introduction of the CFETS RMB Index recently - a basket of currencies by which the PBOC may measure the yuan's relative value - could indicate a shift away from viewing a "strong and stable" yuan as "strong and stable" measured against a wide basket of currencies and not just measured against US dollar.

See the following blog posting for more details: 5 Important Things You Should Know About The Chinese Yuan.

All in all, downward market pressure may have a greater influence on the yuan vs. the dollar than in the past.  But, a Beijing engineered policy-driven devaluation to revive growth is unlikely for reform and political reasons, especially as the PBOC is already expecting very weak exports in 2016 (see PBOC forecasts above) and China's trade surplus is already quite massive.  China has plenty of tools to fight weak growth, and a large engineered devaluation would draw the ire of central bankers around the world as China prepares to host the G20 in 2016.  It would also reignite imbalances by transferring wealth from households back to industry.  So, we should expect to see a modestly weaker yuan vs. the US dollar in 2016, and much more volatility, but likely no major devaluation policy.

Monetary and Fiscal Policy

We should expect to see more stimulus measures in 2016, but fewer, smaller, and possibly different measures than in 2015.  The economy is entering 2016 with good momentum, and a growth target lowering to 6.5% will reduce the stimulus requirements to meet that lower target.  

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Beijing gave indications this week that more stimulative measures could be on the way in order to create "appropriate monetary conditions for structural reforms."  China's monetary policy is still more restrictive than in easing cycles in the past (see the chart on the right).  Easing will probably come in the form of targeted easing over broad easing now that we have seen broad reflation finally kick in and a bottom in the recent credit slowdown.  The market expects the required reserve rate (RRR) - the broadest and most effective tool - to be cut by 2% more in 2016, after being cut 2.5% this year.  Given the current growth momentum and worries about excesses and overcapacity, we will probably see fewer cuts than the broad consensus; perhaps only 1% or less.

Beijing has indicated that fiscal stimulus will start to come more in the form of tax cuts, and less in the form of spending.  Expect another fiscal deficit, but primarily driven by tax cuts.  This will have the effect of lowering the fiscal boost impact on basic infrastructure, and therefore heavy industry investment - the traditional recipient of fiscal stimulus in past years - will probably continue to weaken.  So, more fiscal stimulus does not necessarily mean more demand for key commodities and more demand for industrial machinery.  A fiscal boost in 2016 could be felt more in services, green energy, or consumption, which would differentiate it from past fiscal stimulus measures.

Overall growth picked up in November

Overall growth picked up in November, due primarily to the strong service sector and revved up consumption.  After seemingly waiting in vain for a meaningful boost from government fiscal and monetary stimulative measures, we are finally seeing those measures bear fruit. 

Never before have China’s economic reforms been so precariously balanced between keeping prosperity robust for the masses and reining in excesses and imbalances from a supercharged decades-old industrial policy.  Policymakers are attempting to fulfill two often diverging goals.  Beijing is trying to stimulate growth just enough to hit around the target and keep employment stable without going too far and adding to the debt pile. And, at the same time Beijing is going through the often messy job of pushing reform and rebalancing policies that sink traditional growth drivers and risk crushing the economy. November data shows that these two goals are sufficiently being met for now.

That being said, while restructuring and stable growth is good for China, consumption and service booms cannot fill the void in global demand left by China's faltering industrial behemoth. China's contribution to global GDP at a robust 7% growth is a positive one mathematically, but the country's transition will continue to be a drag on growth for many economies worldwide.

Click here for my chartbook with more details:

Quick Data Update: November Trade Data Declines, but Improves Overall

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China's November trade data pointed to more weakness, but on balance improved from last month.  There were three important factors at work in the numbers: Slow global growth has pushed down trade for processing and re-export, manufacturing imports overall declined as a result of slowing investment, and commodity import volumes surged for some key commodities.  

Manufacturing trade weakness and commodity price drops were the main culprits for the declining trade numbers, not commodity demand.

The export headwinds from early 2015 yuan strength have diminished with recent currency moves.  China's currency vs. most peers has been strong over the last year (up 8% on the EUR and double digits vs. most BRICS), but the yuan is now modestly lower vs. both the USD and JPY.

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Both imports and exports were highly divergent, with some sectors rising into double digit growth and other sectors dropping significantly.  As an example, palm oil imports rose 47%, and auto imports dropped 27%.  Trade data was more mixed than any other month this year. 

The trade balance moderated from last month, but still remains relatively high at $54 billion as import prices and import demand have dropped more than demand for China's goods.  Given the large trade surplus, the mixed nature of trade numbers (some exporters are doing very well recently), and the weaker currency headwinds, there is not much here that would point to Beijing moving to devalue the yuan dramatically as an explicit stimulus policy to revive growth.  Beijing still has domestic tools to stimulate growth before it needs to devalue and stoke tensions that will come with a devalue and the massive trade surpluses that would follow.  But, as mentioned in past blog postings, market pressures are on a weaker yuan (see my posting 5 Important Things You Should Know About the Chinese Yuan).

The weak trade data points to another month of weak manufacturing.  There is not much in the numbers that would hint at improved growth prospects.  But, nothing in these numbers points at growth getting any slower.  

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Some other important points:

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• Trade for processing was down much more than trade for domestic use.  Imports for processing dropped 16% from last year in a bearish sign for the global trade supply chain.  
• Exports to the larger EM countries dropped 30 - 40% in a bearish sign for growth in those economies.
• Imports from Brazil surged 35% from last year as soybean and iron ore imports rose significantly.
• Iron ore, crude oil, copper, natural gas, palm oil, and soybean imports by volume are all up meaningfully from last year.

On the subject of China exporting deflation

Over the last decade, China's effect on US domestic prices has been a frequent topic of debate.  The "China price" contributing to cheaper goods coming into the US has been cited as both a positive and a negative over the years.  This summer, a devalue of the Chinese yuan brought panic over China's potential to export deflation to the US.  With highly active central bankers around the world and uncertainty over global rates, China's effect on global and US inflation is a concern.  Here are my views on how China may impact US inflation going into 2016.

It is important here to first explain how China can affect prices in the US.  Here are what I consider the main mechanisms whereby China impacts US inflation/deflation: 1) The impact of China's demand for goods and commodities on overall global growth, 2) The impact of currency moves on US import prices, 3) The impact of China's domestic prices, wages, and activity on export prices, and 4) The impact of China's commodity demand on the price of global commodities.

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Lets start with the most impactful mechanism.  China is 13% of global GDP.  At a 7% growth rate, it will contribute 27% of the IMF’s expected 3.3% 2015 global growth.  China is the largest trading economy in the world, accounting for 12% of global trade.  It is the single largest importer of heavy machinery and capital goods, and the most important trade partner for the 3rd and 4th largest economies in the world.  China’s economic activity has a meaningful impact on most of the world’s major economies.  As China slows, the world economy slows, and global inflation slows.  The world's factories and mines were built for a China growing 10-plus percent, pushing global growth above 5 percent.  Those high growth days are over, and now there is plenty of slack in the system to last a while.  Most signs point to that slack growing.  From a purely numerical perspective, regressing China GDP and US inflation shows a statistically significant relationship, with an R-squared of .35.  That would indicate China growth explains 35% of US inflation, mostly via China’s impact on global growth and global demand.  China export prices alone only explain 15% of US inflation based on a ten-year monthly regression, so the China economic growth impact is about more than China export prices.  With Beijing lowering the growth target and headwinds slowing broad activity, expect growth to slow further, putting downward pressure on global growth and leading to a potentially deflationary impact on the US for some time.

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The second most important mechanism for China’s impact on US inflation is the direction of the yuan.  The yuan has contributed to upward US price pressures for the decade leading up to 2015.  The yuan appreciating against the dollar more than 30% over the last decade has effectively raised the prices of China’s exports by the same amount.  Up to 2015, the yuan was a one-way bet, pushing consistently higher.  2015 has changed that trend.  Directly, China accounts for 16-17% of US imports.  But, indirectly the impact goes beyond that 17%, because China is a highly important stop on the global supply chain.  Moves in the yuan can have an impact in the short term as US import prices would be affected quickly by currency moves.  Numerically, China export prices adjusted for the currency changes over the last ten years explain 32% of moves in US inflation.  Most market pressures are for a depreciating yuan, which would have a deflationary impact on the US.  For my views on the yuan, see my blog post here 5 Important Things You Should Know About the Chinese Yuan.

China is a massive importer of commodities.  But, the economy’s impact on global commodity prices is not a clear-cut story.  China’s commodity consumption is concentrated on industrial and base metals, as well as other infrastructure building materials.  See China’s commodity consumption here: http://laohueconomics.com/china-commodity-consumption/.  Energy commodity demand, for example, is not as meaningful as with other major economies.  China's crude oil consumption constitutes 12% of the world’s total, and natural gas only 5%, compared to 55% of the world’s total iron ore consumption.  China’s weaker commodity imports have recently had a direct impact on growth in commodity exporting countries, like Australia and Mongolia.  But the economy’s weaker commodity demand has less of an impact on the prices of US imported commodities.  The commodity import make-up between the two countries is different.  US crude oil consumption is nearly double that of China, and China's iron ore consumption is over five times that of the US. Again, it is China’s impact on growth in commodity exporters and the resulting weaker global growth that has an impact on US inflation, not necessarily a direct impact on US imported commodity prices themselves.  Add to that the fact that China’s imports by volume have not collapsed as much as prices have dropped (see trade data here http://laohueconomics.com/test/).  Global commodity prices have dropped due to global supplier production increases more than China’s lower demand.  The prospects for global commodity prices and their effects on US prices are in the hands of global commodity producers, and not merely a product of lower China demand.

China's domestic prices may have some impact on US prices, but the connection is a weak one.  China's export price growth has averaged slightly below zero for the ten years to 2015, and modestly above zero in 2015.  Efficiency gains, logistics improvements, and low wages kept export prices low on average even as commodity demand drove up materials costs.  But, surplus labor from the countryside is drying up, and wages are rising as the labor force has peaked.  The "China price" will see upward pressure even as material prices decline.  The offsetting effects will mean a muted direct impact from China's domestic prices on US inflation.  Numerically, as mentioned above, China export prices alone have a very weak link to US inflation, with an R-squared of just .15.  And, it is uncertain how the offsetting wage increases and materials costs decreases will play out going forward.

In a nutshell, up to 2015 China's decade-long currency appreciation had been inflationary, and its insatiable demand for goods and commodities from abroad fueling global growth was also inflationary.  But, those same two factors have probably reached a turning point, reversing course and reversing the impact on prices globally and within the US.  Downward pressure on the currency means a meaningful probability for lower prices exported to the US.  Lower growth targets and mounting headwinds mean slower demand for materials and goods, leading to a high probability of lower global growth, more slack, and lower prices globally and in the US.  On balance, most signs point to China contributing to deflationary pressures in the US for some time.

5 Important Things You Should Know About the Chinese Yuan

1) By many measures the Chinese yuan is overvalued, or at a bare minimum fair-valued.  Real effective exchange rates (REER) - inflation adjusted exchange rates against a basket of trade partner currencies - indicate that the yuan is possibly the most overvalued major currency in the world.  As seen in the chart below, on a five-year basis, the yuan is 40% overvalued.  

REER Percent Difference from 5 Years Prior

A high number can be read as overvalued, a low number undervalued

Other market forces point to an overvalued yuan.  Chinese mainland and foreign investors have been moving capital out of the yuan at a rapid pace, indicating there is greater value to be had in other currencies.  The economy has been in a state of outflows since spring this year, forcing the PBOC to liquidate foreign currency reserve assets to compensate.

A number of organizations that once put a spotlight on Beijing’s use of a cheap yuan to boost trade have argued recently that the yuan is undervalued no more.  In May, the IMF declared that the yuan is no longer undervalued after years of criticism.  The Peterson Institute as well has argued against the notion of an undervalued yuan recently, after charging that the currency had been undervalued as few as 3 years ago.

So, how has the yuan - a heavily managed currency used in the past to support Chinese exports and industry - turned into an overvalued currency?  Beijing changed the currency policy in 2005, allowing the yuan to slowly appreciate.  For the last decade, the yuan has been a one-way bet, appreciating over 30% vs. the US dollar.  Policymakers have been biased towards a strong yuan for years to facilitate rebalancing.  An undervalued currency once helped Chinese industry immensely, but at the expense of adding to financial repression - whereby households subsidized industrial growth through low savings rates and imported inflation from a cheap currency.  A stronger yuan has been a tool to roll back decades of imbalances, and to that end we should not expect Beijing to reverse course without a major and unexpected drop in output.  A stable, strong yuan is an important tool for rebalancing and reversing financial repression and we should not expect Beijing to suddenly shift gears to a meaningful devalue.

2) The yuan will likely become fully convertible within the next five years.  Chinese leaders recently have promised full yuan convertibility by 2020.  Historically, capital market liberalization and free-floating a currency are often risky and messy reform moves for developing countries, which eventually pay off for an economy in the long-run.  Giving up control of the currency is particularly difficult for policymakers that have used the significant control over the yuan as a policy tool to steer the economy, first driving down the value as a catalyst for industrial growth, and then letting the currency rise to facilitate rebalancing.  

So, I would expect the next five years of opening the capital account and floating the yuan will be characterized by bouts of turmoil, some significant currency interventions, and occasional temporary roll-backs of market freedoms.  But, Beijing will push forward; open capital markets and a free-floating yuan are a necessity for long-term global ambitions and domestic economic health.

Because China has the third largest bond market and second largest equity market in the world, expect China to be a major weight in just about every major global investment index within the next five years as the yuan is liberalized - EM bond and stock indices in particular.

3) The yuan’s importance is growing fast.  The yuan’s use in global transactions is rising rapidly, and that pace will accelerate with capital market liberalization. 

In 2013 China overtook the US as the largest trading nation in the world, accounting for 11% of global trade in 2014.  Beijing is making efforts to expand yuan settlement of that trade.  In October, the yuan overtook the Japanese yen as the fourth most used currency for global payments with 2.8% of the total, up 9% from last year.  The yuan has a 9% share of global letters of credit.  The number of financial institutions using yuan for global payments rose 14% in 2015.

As China further opens up its capital markets to outward and inward investment money flows, transactions will accelerate.  The country has the second largest stock market and third largest local bond market in the world, potential targets for inflows.  Chinese savings deposits are over $20 trillion, roughly 200% of GDP.  Those savings are primed to seek out investments around the world as outflow restrictions diminish with reforms.  

4) The Chinese yuan will be a major reserve currency in the long-term.  Beijing has tandem plans in place to realize ambitions for making the yuan a major reserve currency - for both economic reasons and geopolitical ambitions.  Policymakers have lobbied the IMF for inclusion in the Special Drawing Rights (SDRs) - a basket of four currencies used as an international reserve asset - as well as slowly set about liberalizing capital flows.  

Recent comments by IMF chief Christine Lagarde indicates that China has succeeded in SDR lobbying efforts, and will be voted in at the end of the month.  However, Beijing’s end goal is not to become a small slice of the $280 billion SDR basket.  The end goal is to be a large slice of the $11 trillion reserve currency asset market.  The IMF endorsement will be seen as an official nod for central bankers to increase yuan assets in foreign currency reserves.  As yuan-denominated trade and financial transactions around the world increase, central bankers will increase yuan holdings in reserves.

However, China will need a much deeper and larger government bond market to unseat the USD as the world's preeminent currency (see below).  China's entire bond market is roughly $5 trillion, compared to the $36 trillion US market.

Currency as a Percent of Global Fx Reserve Assets

5) Beijing will try to maintain meaningful control over the yuan for its reform agenda.  Regardless of how free the yuan is allowed to float, Beijing will attempt to maintain heavy control over the yuan as both a tool for restructuring the economy and protecting against the risks of opening up capital markets.  The yuan is a policy tool that Beijing will be unlikely give up completely.  For the last decade, Beijing policy has pushed for a strong and stable yuan vs. the USD.  This year we have seen rapid appreciation vs. major trading partners.  Only in an unusual circumstance will Beijing let the yuan decline meaningfully.

Beijing can manage the currency much better than the recent mishandling of equity markets for two reasons.  First, over three trillion USD worth of currency reserves will allow China to intervene on the side of a strong yuan, regardless of the duration and extremity of outflows.  The reserve currency war chest is unprecedented, even after this year's liquidations.  Second, Beijing policymakers have control over central bank activity and can print money and intervene to push the yuan down at will - but they risk stoking inflation and rolling back reforms as a result.  China can do what it wants with the yuan, regardless of market pressures.

I cannot give investment advice nor market advice due to restrictions set by my current employer.  But, I will say that we can expect to see a tug-of-war play out in the short and near-term between market forces putting downward pressure on an overvalued yuan, and policymakers looking to keep the currency stable and strong for economic restructuring purposes.  As a result, we will continue to see the occasional PBOC intervention, more volatile foreign fx reserve activity, but probably only modest ups and downs.

Data Update: Solid Retail Numbers

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China's retail sales continued to improve in October, with both real and nominal retail sales growing at a rapid 11% from last year.  

There are two big takeaways from October retail sales numbers.  First, consumption continued to strengthen while investment stabilized at a very weak 9.3% from October last year and production growth slowed well under half of its long-term trend to 5.6% on the back of declining heavy industries.  Rebalancing has not only continued but has accelerated.  

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Second, retail sales have been improving post-stock market turmoil.  That would support the view that stock market turmoil had limited negative pass through to the real economy.  It would also indicate that potential spenders who delayed purchases on order to pile cash into the hot stock market earlier this year have reversed their behavior and are now deploying money into consumer goods having seen the ugly side of a stock market bubble.

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The solid retail numbers were released just as more positive news for the consumer market rolled-in.  Record-breaking online sales on "singles day" - a once obscure anti-Valentines day style holiday that Alibaba over the last six years has promoted to the largest online retail shopping day on the planet - bodes well for continued retail growth.  Alibaba alone had $14.36 billion in sales for the day, up 60% from last year, compared to less than $3 billion spent with all online retailers on Cyber Monday in the US last year.  According to Wired, the company plans on deploying 1.7 million delivery personnel to handle the business.

Beijing also announced today a number of policy plans intended to boost consumption.  These include encouraging imports of consumer goods through tax policies,  accelerating household registration reforms, and encouraging businesses to improve product quality.

It is important to reiterate that while improved consumption and accelerated rebalancing are good for economic stability and benefit specific sectors directly, the benefits of improved consumption cannot fill the hole in global demand left by China's slowing industry.  Industry import demand dwarfs consumer goods imports by a wide margin.  See my posting Rebalancing To Consumption Is Grinding Forward, But Don't Expect Chinese Consumers To Revive Global Growth.

Data Update: Trade data points to weak domestic manufacturing and weak global growth

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China's October trade data was full of mostly bad news, but not all was negative.  Trade numbers pointed to weakening global demand, slower domestic manufacturing activity, but improving demand for some key commodities.  Exports declined and Imports on a value basis meaningfully dropped from October last year.  

A number of imports of manufactured goods and imports from manufacturing countries declined in the double digits; a break from months past.  Weak commodity demand was not the biggest driver of the bad trade numbers, weak manufacturing-oriented trade, a strong currency vs. trade partners and lower commodity prices where the big drivers.

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There are a number of takeaways from the data:

• Headline imports exaggerated commodity demand weakness.  In fact, many key commodities on a volume basis continue to increase.  Much of the drop in imports can be attributed to the extremely sharp commodity price drops over the last year as suppliers continue to drive forward production.  Volumes are increasing for key energy, agricultural, and some metal imports.  
• By volume, crude oil imports were up 9% from last year.  Soybeans imports by volume were up 35%, copper increased 7%, while iron ore was down 5% from last year.
• A $61 billion trade surplus means Beijing is less likely to let the CNY decline.  A strong currency is important for restructuring the economy and reserve currency ambitions.  There is nothing in these numbers that would convince China to devalue.  The mini-devalue that shook global markets in August was most likely a one-off. 
• China's currency has been relatively strong vs. most trading partners over the last year, decreasing trade competitiveness. Much of this has resulted in declining trade numbers.  The CNY is up over 9% on the EUR this year, and up about 4% on the JPY. 
• Manufacturing imports from the EU and ASEAN declined significantly, a negative for growth prospects in those countries.
• Exports for processing declined 12%, pointing to weaker global demand. 
• Manufacturing imports have declined significantly, and trade with key partners in the global manufacturing supply chain has dropped by double digits.  That would indicate weaker global demand.

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Beijing's Latest Plenum: What's In It?

The plenary session of the Chinese People's Congress (the Communist Party congress) took place last week.  The Congress put the final touches on the next five-year plan - a Soviet-style planning holdover of the command economy - as well as 2016 policy goals.  China's five-year plan and the 2016 targets will officially be instituted and announced at the People's Congress (the government legislature) next spring in March or April, but announcements and a communique have laid out some broad themes.

Over the years, Beijing has found it easy to successfully meet goals laid out in past five-year plans.  Most of those goals have been output-related and in modern times coincided with tremendous economic tailwinds.  Implementing the next five-year plan will be far more complicated with difficult and risky reforms announced in tandem with a robust 6.5% growth line drawn in the sand.

The plenum themes are not very new, and most reflect an extension of reform goals already laid out by Xi's government.  In a nutshell, the overall goals of this plenum seem to be: moving growth to a more sustainable and inclusive balanced growth rate, promoting high-tech innovation, improving quality of life issues for rural and middle class citizens, and pushing for further integration with the world - using policies like the "One Belt, One Road" initiative.  

But not all plans seem to be moving the country forward.  On the social front, the plenum plans include tightening controls over culture and art, "purifying" the internet, and strengthening socialist core values.  Xi wants to liberalize the economy, but is keen to tighten control broadly.

So far, here are some of the most important issues addressed:

Full yuan convertibility by 2020

Chinese leaders have promised full yuan convertibility by 2020.  Historically, capital market liberalization and free-floating a currency are often risky and messy reform moves, which eventually pay off for an economy.  Giving up control of the currency is particularly difficult for policymakers that have used the significant control over the yuan as a policy tool to steer the economy.  So, I would expect the next five years of opening the capital account will be characterized by bouts of turmoil, some significant currency interventions, and occasional temporary roll-backs of market freedoms.  But, Beijing will push forward; open capital markets and a freer-floating yuan are a necessity for long-term global ambitions and domestic economic health.

Plans to free up the yuan are in tandem with explicit goals to get the yuan into the IMF special Drawing Rights (SDRs), a basket of four currencies used as an international reserve asset.  The SDR inclusion is not in itself a meaningful event.  Inclusion in the SDRs will be a stamp of approval for the yuan's use as a global reserve currency.  The end goal is not to become a small slice of the $280 billion SDR basket.  The end goal is to be a large slice of the $11 trillion reserve currency asset market.  

Even without the IMF's endorsement the yuan has become the fourth largest global payment currency, and central banks and sovereign wealth funds have been buying RMB-denominated assets.  That trend will accelerate with an IMF SDR endorsement, capital account liberalization, and improved convertibility of the yuan over the next five years.

China's leaders want the yuan to eventually be a major reserve currency for both political and economic reasons.  That is a goal that is possible in the long-term, but in the near-term the use of the yuan as a reserve will be limited by the size and depth of China's onshore bond market; roughly $5 trillion compared with $36 trillion in the US.  China will need a larger and deeper sovereign bond market to challenge the USD as the world's dominant reserve currency at 63% of all global reserve assets.

Robust 6.5% growth to 2020

The Party has pledged to double the real GDP between 2010 and 2020.  That will require 6.5% growth for the next five years.  Xi has effectively identified a lower bound for GDP growth over the next five years of 6.5%.  That will be a challenge for an economy already struggling to stay above 6.5% as headwinds - like corporate debt of 125% of GDP, a shrinking labor force, and weak global demand -  drag down prospects.  We will likely see next year's target reduced, meaning less reflation and weaker industry over the next year.  But, to reach long-term goals, expect Beijing to make serious attempts to hold the line at 6.5% at least until 2020.

Whether China puts Xi's growth pledge above other reform pledges is a big question mark.  When push comes to shove, will Beijing let messy and risky capital market and asset market liberalizations push forward if robust growth is jeopardized?  Will Beijing allow large debt-burdened industrial corporations and state-owned firms to fail in order to ensure investment capital flows to the fast-growing service and consumption sectors?  Given the buildup of economic headwinds over the years, it is possible that policymakers will need to choose between letting growth goals or restructuring goals go unmet over the next five years.

Addressing inequality and social welfare

A slew of social improvement intentions were announced: Plans to pull 70 million people out of poverty, increase the minimum wage, improve the medical system, make changes to the household registration system, further regulate the price of medications, allocate state-owned assets to the social security system, expand pensions, phase out fees for vocational education, and more.  

Social welfare reforms will probably have a positive effect on consumption by improving social safety nets and government services, allowing households to put more savings to work.  If these initiatives are funded by borrowing or an improved market or regulatory environment, then they will be stimulative to overall growth.  If they are funded by public funds or SOE proceeds, then they will constitute a shift to improved household and government consumption without a meaningful lift to broad growth.  

Social initiatives should also improve social stability.  However, small improvements to social and welfare issues will be a moot point if economic growth collapses, unemployment rises significantly, or deadly pollution is not improved. 

Addressing environmental concerns

Beijing has committed to raising non-fossil fuel share of energy production from just over 11% this year to 15% by 2020.  Increasing green energy is an area where policymakers have really pushed forward, expanding investment dramatically after pollution became the largest source of protests in 2013 (see my blog postings Recent Study: 1.6 million deaths each year across China can be attributed to air pollution. and also Structural Growth Headwind: Water Problems).  After Li Keqiang announced his "war on pollution" two years ago China has attacked the issue of deadly pollution with massive investment outlays, building renewables faster than anyplace on earth.  According to Bloomberg, China led the world in renewable investment last year with $89.5 billion deployed, almost one out of every three dollars spent on green energy in the world.  For more details about renewable energy investment see my blog posting China's ambitious renewable energy investments. 

Other environmental plans worth a mention: A real-time pollution monitoring system for citizens, expanding alternative energy vehicles, the broad goal of reduced carbon emissions, and the establishment of a Green Development Fund to expedite environmental efforts.

These plans are good for alternative energy tech industries of all kinds, but continue to be a sizable negative for the world's coal exporters.  China has driven its rapid growth by burning more coal than nearly the rest of the world combined.  But environmental plans are slowly making coal enemy number one.

Changing the one-child policy to a two-child policy

China's leaders announced they would allow married couples to have two children, rolling back the decades-old one-child policy.  In a country where nearly ever aspect of life was once controlled by the Communist Party, the change reduces the Party's control and intrusion into an important and intimate household decision.  The effect on the economy in the short-term will be muted, but the change has the potential to accelerate rebalancing to consumption in the near-term and mitigate demographic problems in the long-term.  

When Mao's Communists took over in 1949, he encouraged families to have as many children as possible in order to boost the ranks of farmers, factory workers, and soldiers.  As a result, China added 260 million to its population by 1970.  To contend with fears of overpopulation, the Party instituted the one-child policy in the 1970s.  

The one-child policy has left China with an aging population to support and a workforce already shrinking from its peak in 2010.  China's aging population is on track to become a significant burden over the next few decades.  Before this week's policy change the population of 60-year-olds and over was expected to rise from 36 million to 245 million by 2020; from 3% of the population to roughly one-fifth.  Not only will the retired population eventually be a significant burden, but older workers require more money and benefits and will add pressure to China's low-cost manufacturers.  The policy change should mitigate some of those demographic headwinds.

See my blog posting here for details: Decades-Old One-Child Policy Ended

Decades-Old One-Child Policy Ended

China's leaders announced Thursday they would allow married couples to have two children, rolling back the decades-old one-child policy.  In a country where nearly ever aspect of life was once controlled by the Communist Party, the change reduces the Party's control and intrusion into an important and intimate household decision.  The effect on the economy in the short-term will be muted, but the change has the potential to accelerate rebalancing to consumption in the near-term and mitigate demographic problems in the long-term.

Leaders are fixing a bad population policy put in place to fix a bad population policy.

When Mao's Communists took over in 1949, he encouraged families to have as many children as possible in order to boost the ranks of farmers, factory workers, and soldiers.  As a result, China added 260 million to its population by 1970.  To contend with fears of overpopulation, the Party instituted the one-child policy in the 1970s.  

The one-child policy has left China with an aging population to support and a workforce already shrinking from its peak in 2010.  As you can see from the chart below, China's aging population is on track to become a significant burden over the next few decades.  Before this week's policy change the population of 60-year-olds and over was expected to rise from 36 million to 245 million by 2020; from 3% of the population to roughly one-fifth.  Not only will the retired population eventually be a significant burden, but older workers require more money and benefits and will add pressure to China's low-cost manufacturers.  The policy change should mitigate some of those demographic headwinds.

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Source: Population Division, DESA, United Nations

The change will be muted in the short-term.

There are a couple of reasons why a GDP boost in the short-term should not be expected from this change.  First, it will take time for the change to kick in, and obviously even longer for the workforce increases.  But, there may be some sectors that benefit rather soon.  Households with more than one child are more likely to buy a car.  House purchasers may plan on upsizing when they buy a home.  Healthcare and some consumer goods will benefit early.  But, most of the boost to consumption will come years from now, and the boost to the workforce will take a couple of decades.

Second, many have argued that urban Chinese families are less likely to want or have two children because of the huge costs involved with raising children.  China began to relax the one-child rules in 2013, and according to the NYT, as of May this year a disappointing 12% of eligible couples applied to have a second child.  It is uncertain how effective the policy change will be on boosting the birth rate.  If the policy shift does little to meaningfully increase the birth rate, then both long-term and short-term effects will be limited.

The change will help expedite consumption rebalancing.

The one-child policy change could be coming at a good time for rebalancing to consumption if the change can increase the birth rate.  Over the near-term, new parents will need to increase spending out of necessity just as millions of newly retired diligent savers begin to finally unleash hoarded cash into services and healthcare spending.

As China's population ages, millions of prospective pensioners will be getting ready to finally spend decades of hoarded savings.  According to Bloomberg, China's most recent bank deposits amounted to roughly $21 trillion, about 200% of GDP.  Millions of diligent savers are about to accelerate spending and divert savings to travel, healthcare, and a number of other services.  Additional consumption from new parents and pensioners should help boost consumption spending over the next decade as overall growth slows.

The change might mitigate future problems caused by the male/female population disparity.

Allowing for two children could change the male/female population disparity over the next few decades.  Removal of the one-child policy will potentially limit the various measures taken by families with cultural preferences for sons over daughters.  According to the UN, China has 106.3 males for every 100 females.  As a result, there are nearly 52 million more males than females in China, a larger number of people than the population of Spain and Norway combined.  That leaves a massive number of potential "broken branches", men with no prospects of having a partner or family, leaving the door open to social issues and diminished quality of life.  The NIH in the US has argued that high ratios of males vs. females in countries are a cause of increased aggression and violence of all types.  In China, large male/female disparities have not ended well in the past.  In 1850, "broken branch" militias in China lead to 18 years of violent uprisings, devastating the Qing dynasty.

Important reforms accompany PBOC easing

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China's easing measures on Friday were accompanied by the removal of the mandated deposit rate ceiling, the final and riskiest piece of financial rate market liberalization.  The required reserve ratio (RRR) was lowered 0.50% to 17.5%, potentially unleashing $80 billion USD of funds into the lending market.  Benchmark rates were also cut, bringing the 1 year deposit benchmark to 1.50%, below the latest inflation reading of 1.60% in an effort to boost consumption.  HSBC expects all easing measures last week to release roughly $110 billion of liquidity into credit markets.  The potential boost to overall economic activity will come in 2016, as easing measures take months to spread.

But, it is important to note that easing measures over the last year have done little to boost overall credit growth as policy measures to rein in shadow banking and clean up local government debt have amounted to credit tightening.

Interest rate market liberalization moves accompanied the easing measures.  According to the PBOC, evidence shows that financial liberalization in the midst of low inflation while lowering rates reduces the riskiness of financial reforms.  ICBC, China's biggest lender, had a deposit rate below the mandated ceiling, in an indication that banks are not fully utilizing deposit rate flexibility yet.

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.  The rate cuts last week followed a similar pattern to the currency devalue in August: Lower the rate, but allow markets more control.  The moves were a trade-off between short-term stimulus and reform advancement.

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.

Data Update: Trade data points to weak China manufacturing and potentially weaker global growth. But commodity demand improved.

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China's September trade data was full of mostly bad news, but not all was negative.  Trade numbers pointed to weakening global demand, slower domestic manufacturing activity, but improving demand for many key commodities.  Exports declined, but less than last month. Imports on a value basis meaningfully dropped from September last year.  A number of imports of manufactured goods and imports from manufacturing countries declined in the double digits; a break from months past.  Weak commodity demand was not the biggest driver of these bad trade numbers.

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There are a number of takeaways from the data:

• Headline imports exaggerated commodity demand weakness.  In fact, many key commodities on a volume basis continue to increase.  Much of the drop in imports can be attributed to the extremely sharp commodity price drops over the last year as suppliers continue to drive forward production.  Volumes are increasing.
• Improved exports and a $60 billion trade surplus mean Beijing is less likely to let the CNY decline.  A strong currency is important for restructuring the economy and reserve currency ambitions.  There is nothing in these numbers that would convince China to devalue.  The mini-devalue that shook global markets in August was most likely a one-off. 
• China's currency has been relatively strong vs. most trading partners over the last year, decreasing trade competitiveness. Much of this has resulted in declining trade numbers.  The CNY is up over 7.5% on the EUR this year, and up about 8% on the JPY. 
• Imports for processing declined 37%, pointing to weaker global demand. 
• Manufacturing imports have declined significantly, and trade with key partners in the global manufacturing supply chain has dropped by double digits.  That would indicate weaker global demand.

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