Debt, Oversupply and Globalization (DOG) will be the three big ticket items for China

Build your well before you are thirsty

The Chinese economy performed relatively well in 2017 (real GDP up +6.9%) with (i) domestic demand and exports rising in sync, (ii) a rise in producer prices, (iii) less external pressures (more stable RMB and capital flows). 

Moreover, short term indicators are still relatively favorable. External demand is well oriented with a growth acceleration expected in the US and emerging markets, solid growth in both Eurozone and Japan.

Domestically, consumption growth should remain growth supportive thanks to a strong labor market, favorable rise of income and solid consumer confidence. Against this background, we believe that authorities are in a good position to address structural challenges.

We see three D.O.G. themes as areas of focus: Debt, Oversupply and Globalization.

Addressing these issues will likely cost some GDP points of percentage in the short-run. In fact, we pencil in slower growth for this year (+6.4% after +6.9% in 2017) and 2019 (+6.2%). Yet, in the longer term, growth would be based on healthier foundations with less financial risks, less deflationary pressures and stronger growth drivers (both domestic and external).

Debt: tighter regulation will help deleverage

Based on Bank for International Settlements data, we estimate that aggregate non-financial debt reached 256% GDP mid-2017 (from 141% GDP in 2008).

Out of this figure, corporate debt accounted for 163.4% GDP (from 96.3% GDP in 2008). Household debt is contained (45.7% GDP) but has almost doubled since 2008 (27% GDP in 2018).

Against this background, financial authorities have started to tighten credit conditions. 

Supervision has been reinforced with the introduction of new macro-prudential measures and the creation of a supervisory body, the Financial Stability and Development Board, whose objective is to curb financial risks.  

Lending rules have been tightened (purchase restrictions, higher down payment requirement for property market related transactions; credit constraints on SOEs and specific sectors such as metal).

Last, a series of deleveraging policies have been enacted including guidelines to tighten rules for asset management products and internet micro-lending.

We expect credit growth to slow in 2018 close to nominal GDP growth as a result of tightening measures.

We forecast a non-financial corporates debt around 160% GDP in 2018.

Yet dynamic might be different across sectors with credit growth provided to the co-called old sectors (basic industrial material, machinery and equipment, e.g.) below nominal growth (10% in 2018) and slightly above for future leading sectors (high value added and high technology intensive).

For households, we see household’s debt rising to 53% GDP in 2018, yet policies might focus on reducing exposition to the real estate market. 

Oversupply: it is not just about the steel sector

Continuing the reduction of oversupply for basic industrial materials (coal and steel, e.g.) and certain segments of the property markets (third and fourth tier cities, e.g.) will be the second item of the agenda.

Strong growth in China has usually been associated with some demand-supply imbalances. These became more acute after the global financial crisis.

While global demand was low and insufficient to absorb Chinese excess, China’s massive stimulus package exacerbated the problem, channeling credit to sectors for which there was no additional demand. Manufacturing deflation started in 2012 and lasted until 2016. 

Last year marked a turnaround as the strengthening of both external and domestic demand and some quality oriented reforms (cuts in overcapacity for steel and coal, e.g.) helped reduce imbalances. Producer prices rose by +6.3% y/y in 2017 after -2.3% y/y p.a. on average in 2012-2016.

Yet, it is probably too early to declare victory. First, while external demand may remain firm, a rise in protectionism measures from China’s main partners – the US added 17 protectionist measures against China in 2017 after 8 in 2016 - poses a risk. Secondly, domestic demand may decelerate somewhat in 2018 as a result of deleveraging policies and negative impact of capacity cuts on employment. 

Looking ahead, we expect authorities to pursue their current plan (10-15 % of 2015 production for coal and steel sectors by 2018-2020)  and implement measures to avert potential oversupply risks (low end electronic, e.g.). In that context, we expect producer prices to remain in check (+2.7% on average in 2018). 

Globalization: Belt and Road and China’s financial openness

The leadership has been clear in its willingness to promote globalization.  We see two drivers.

First, the Belt and Road initiative is a key item of the strategy. It involves 65 countries, one third of the global economy and nearly two thirds of the global population.

The latter is expected to:

(i) boost financing flows (from China and investing partners) to Belt and Road countries;

 (ii) raise infrastructure investment and hence improve connectivity;

(iii) and increase trade flows between Belt and Road markets. We expect the plan to get traction this year with additional partners brought on board (Latin America, e.g.), and clearer regulatory framework (arbitration rules, e.g.).

The second driver relates to China’s financial openness. Capital flows have seen some limitations in 2015-17 in the context of strong capital outflows and RMB volatility.

As growth started to show some strength, risks on external accounts have reduced (capital outflow are below USD200bn compared to 600+ in 2016), we believe that China could adopt a more constructive approach going forward with stronger incentives on inflows and a gradual removal of restrictions on outflows.

While external demand may remain firm, a rise in protectionism measures from China’s main partners such as the US poses a risk. Secondly, domestic demand may decelerate somewhat in 2018.