Strategy & economics
A 3D view of china
In a widely expected move, the Chinese government signalled its tolerance of slower growth by lowering its 2015 growth target from 7.5% to 7.0%. Economic obstacles include a continued slowdown in fixed investment, little thrust from consumption, overcapacity in some industries and relatively subdued external demand. Indeed, we think there is a high chance that growth will undershoot the 7.0% target. 2015 will be an even more challenging year compared to 2014. We have identified three key issues (3Ds) that will become more important as we move further into 2015: disinflation, devaluation and de-synchronisation.
Disinflation is becoming more prevalent in China due to weak domestic demand, overcapacity, subdued credit growth and the slump in oil prices.
Inflation used to be a key concern for the Chinese authorities as it raised the risk of social unrest, and hence monetary policy has been kept tight. Nowadays the authorities are no longer talking about the risks of inflation. The 2015 Consumer Price Index (CPI) target has been lowered from 3.5% to 3.0%, which looks too ambitious: CPI inflation averaged only 2.0% in 2014 and it will likely moderate further in 2015. Slowing growth in China will continue to exert downward pressure on industrial commodity prices, putting further negative pressure on factory output prices. This will maintain the downwards trend in producer prices that has been seen over the past two years. While lower inflation will allow more headroom for policy easing, it is negative for investment sentiment and corporate profitability.
As momentum in the domestic economy diminishes, there is growing pressure to devalue the renminbi (RMB) as a result of the need to boost growth in export volumes. The shift from investment- and export-led growth to a consumption-based economic model is proving to be difficult. The need to deleverage from the excessive build-up of debt since 2009 will continue to be a drag on economic growth. It is difficult for consumption to provide the impetus as the savings ratio is unlikely to come down meaningfully and the property sector is in a secular bear market. In particular, anecdotal evidence suggests the anti-corruption campaign has not only depressed high-end consumption, but has also affected lower-end products, given the increasing disincentive to make gifts within the business community. Perhaps less-widely discussed, the anti-corruption campaign has significantly discouraged large capital movements (and the velocity of money) within the domestic economy, as executives are wary of any potential investigation by the state. Meanwhile, local government finances are under pressure due to the fall in land revenues, while central government is unlikely to embark on massive fiscal stimulus due to debt aversion.
As fixed investment, consumption and government expenditure are unlikely to provide much uplift, action to boost exports appears an increasingly attractive option. After all, China remains one of the “world’s factories”. In recent years, China has been under constant pressure from the US about the undervaluation of the RMB. As a result, the RMB has been appreciating for the past two decades, eroding China’s export competitiveness. Now that the US dollar has started to appreciate, China has been presented with an ideal opportunity to allow a devaluation of the RMB.
Hence, against the backdrop in which China has struggled to stimulate growth through monetary easing, a managed devaluation of the RMB in 2015 is looking increasingly plausible. Unless a hard-landing scenario materialises (which is not our central case), devaluation is likely to happen at a gradual pace. This is because of policymakers’ preference for stability (crucial for a government which is still in the process of power consolidation), their plan to internationalise the RMB and the potential for a counter-productive impact on international sentiment.
Given the long list of worries and consensual bearishness on China, it might be considered surprising that the Chinese stock market has risen over 50% during the past six months. This reflects a clear de-synchronisation between stock prices and economic reality. We are concerned that this de-synchronisation will persist in 2015, as the rally in equity prices has been driven largely by retail investors’ speculation about more policy easing. In reality, the recent rate cuts have not lowered financing costs for private companies, but have induced excessive liquidity flow into the equity markets. It is becoming evident that private investors are not selective in their investments and this is likely to result in inefficient use of capital and speculative bubbles.
Given a difficult outlook for the property sector, restricted access to wealth management products and lower deposit rates are expected to channel higher household savings into the equity market. The consequence seems likely to be continued de-synchronisation between the equity market and the economy, and also higher volatility in equity prices.
A more challenging 2015
Compared to 2014, the “3Ds” we described above make 2015 more challenging for China, disinflation poses downside risk to corporate margins, devaluation risk may prompt considerable capital outflow, and the de-synchronisation of the stock market and fundamentals may create further unwanted asset bubbles.
On the positive side, the lack of strong stimulus in 2014 actually leaves more room for easing in 2015. The authorities have been signalling that more macroeconomic tools will be used to underpin growth. However, easing measures may not be sufficient to fully offset the negative influences on growth. Accordingly, our central view is that China’s growth will continue to disappoint despite more accommodative policies, but also that a hard-landing will be avoided.
This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission.
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