Q3/2017: Growth takes priority over debt reduction

Focus topic:

China's plans for 2020: ambitious targets constrain economic policies

The Chinese Communist Party (CCP) wants China to reach ambitious economic goals before its 100th anniversary in 2021: both the economy and per capita income are to be doubled compared to 2010 levels by 2020.

Reaching these targets would symbolize China’s rise to prosperity and enhance the legitimacy of the Party. These targets have their roots in Deng Xiaoping’s vision of a “moderately prosperous society” and were officially adopted in Party documents under Xi Jinping, including the 13th five-year plan. The ambitious targets carry major political weight within the Communist Party. Their importance for a legacy-minded leader such as Xi should not be underestimated.

We expect that these economic targets will take priority over solving many other urgent issues such as China’s growing debt problem, industrial overcapacities, asset bubbles and environmental pollution. Seriously addressing these issues would negatively affect economic growth, which we believe is not acceptable to the CCP under Xi.

The political significance of the targets will place constraints on what will be an acceptable bottom line for economic growth over the next three years. For this reason, we believe that the Chinese leadership will not tolerate a drop of GDP growth between 2018 and 2020 below an average of 6.4 percent. Maintaining average GDP growth at this level will ensure a smooth shift to lower levels of economic growth. This allows for some leeway in structural reforms, but the advances are likely to be timid.

To assess whether the 2020 targets are achievable we did a series of calculations. With the economy expanding by 6.4 percent on average our analysis indicates that the targets can only be partially met. Out of the two economic targets – the GDP target and the income target – only the doubling of real GDP is a hard target. It is precisely defined in official documents and is of utmost political importance to the CCP. In the 13th five-year plan, a GDP growth target of no less than 6.5 percent was set to ensure that the 2020 GDP target would be met. But because recent growth has beat expectations, growth of 6.4 percent annually over next three years will be sufficient to reach the target. This appears within reach.

At that level of GDP growth, however, reaching the income targets will be more difficult if not impossible. Compared to the GDP target, official documents define income more vaguely. Income could either refer to GDP per capita or to disposable household income. Adding to the uncertainty, the documents do not clarify whether the indicators should be adjusted for inflation. This leaves ample room for interpretation – and it gives the government some flexibility when they to no one’s surprise announce the goals have been met.

But, for income to double in anything but name, the real indicators, i.e. adjusted for inflation, would have to double. Official party documents refer to the doubling of both rural and urban income. But official GDP per capita statistics make no distinction between the two.  Therefore, we assume disposable income is a more realistic benchmark than GDP per capita. But, to be thorough, we have calculated the economic growth required to double both GDP per capita and disposable income.

Adjusted for inflation, only the doubling of rural disposable income is achievable. Our calculations indicate 4.4 percent annual growth would be sufficient to reach the target. Considering that average rural income growth in the past five years reached 8.6 percent, this seems like a given. Achieving the target in cities will be more difficult: urban disposable income growth would have to accelerate to 7 percent annually in real terms. Based on our calculations, this would require the overall economy to grow at 8.4 percent annually.

The doubling of GDP per capita is equally challenging. To reach this goal, the GDP per capita would need to grow by 7.4 percent annually over the coming years. Assuming that the population grows at roughly the same pace as in the past five years and that economic growth reaches 6.8 percent in 2017, GDP would have to grow at 8.2 percent annually between 2018 and 2020. A return to such high growth rates is unlikely.

The doubling of GDP will be met, but the doubling of real income is likely impossible. The vague definition of the income target provides an escape for the leadership to proclaim success, for example by focusing on nominal targets. The income target is also more likely to be forgone as long as citizens remain confident in the economy. This leads us to believe that the doubling of income is a soft target which will not be pursued it at all costs. 

Despite this flexibility the commitment to doubling GDP lodges the Chinese leadership between a rock and a hard place. Maintaining average GDP growth of 6.4 percent until 2020 leaves little room to address long-term problems such as environmental destruction, asset bubbles and credit growth. Defending the politically motivated targets will require keeping stimulus measures in place while slowing reforms. Postponing structural reforms for the sake of creating a seemingly pleasant economic environment for the CCP’s upcoming 100-year anniversary may end up in a big hangover following 2021.



Growth begins to slow gradually: GDP expands by 6.8 percent in third quarter

Growth of China’s GDP is only gradually shifting to lower levels. It recorded a slight drop to 6.8 percent in the third quarter, but remained at 6.9 percent year on year for the first nine months. This puts economic growth within the upper range of the government’s growth target of between 6.5 and 7 percent for the year. In the build-up to the 19th Party Congress, much focus was put on maintaining a stable economic environment and on ensuring that the CCP is in full control. This has been matched by increasing efforts to increase control over parts of the economy, including the financial system and the private sector economy, through regulatory tightening.

Real progress in reigning in excessive credit growth and tackling speculative investments in real estate however have only been limited. The government continues to walk a fine line between maintaining stable economic growth and cautious advances in the area of structural reform and deleveraging. Growth has most likely peaked in 2017, and a gradual shift to lower GDP growth can be anticipated over the coming quarters. 

Over the third quarter China’s economy benefited from a broad range of factors. The manufacturing component of GDP showed robust growth, expanding steadily by 7.1 percent in the third quarter. Targeted productions cuts in heavy industries aimed at dealing with overcapacities and environmental concerns did not pull-down growth. The industrial sector also benefited from strong demand in global export markets. Meanwhile construction slumped to 4 percent, the lowest level since 2000, pulling down growth in the secondary sector, which combines industry and construction, down to 6 percent.

The service sector again remained the fastest expanding part of the economy. Growth in the tertiary sector accelerated from 7.7 percent in the first six month to 8 percent in the third quarter. The dynamics of the tech sector are reflected in the newly established category by NBS: IT and software expanded by 29 percent, accelerating growth over the year. Despite the hype about the positive effects on growth, the sector only accounts for 3.5 percent of GDP.

The financial services sector showed signs of having bottomed out following a steady decline in growth since the stock market crash in 2015. Growth expanded by 5.6 percent in the third quarter. Recent regulatory tightening in the financial sector may however constrain growth again. Regional efforts to curb runaway housing prices took a toll on real estate related services. Growth crumbled to just 3.8 percent in the third quarter, down from 6.9 percent in the first half of the year.


Macro analysis

Engineering economic stability

China’s economic performance so far this year has matched President Xi Jinping’s 19th Party Congress announcement that the country has entered a new era. 2017 is set to be an impressive year with growth in the upper bounds of the 6.5 to 7 percent growth target, despite a slight slowdown in the third quarter of 2017. At the same time, the government declared that progress was made on reducing debt and overcapacities, implying that all of that was possible while maintaining the current high growth rates. But keep in mind: if it sounds too good to be true, it probably is.

In all fairness, the Chinese economy has many bright spots: consumers are happily spending and China’s dynamic internet economy is contributing to service sector growth. Macroeconomic indicators such as industrial production, investment, and foreign trade are all positive. As a result of capital controls, exchange rate depreciation is no longer a concern. Positive developments in asset markets round off the rosy picture: stock market prices are picking up and real estate price growth has begun to slow down.  The MERICS China Confidence Index (first published here) also reflects these developments. It remained above 100 in Q3, indicating an overall positive mood. The index was largely carried by demand for property and stocks while other components started to weigh it down.    

But the real problem is: China cannot break its reliance on credit.  The government is aware of the problem and has attempted to deleverage by strengthening regulatory oversight of the financial system. But the efforts have not been successful: there has been no real reduction of debt levels. Over the third quarter, total credit kept expanding at a higher pace than GDP growth. There was some success in reducing corporate debt issuance, but these advances were offset by rising shadow banking and consumer loans. Making matters worse, credit’s ability to generate GDP growth has been declining. This suggests that new credit is not making its way into the real economy. It might instead be flowing into the financial system for refinancing and speculative investments. Other than reshuffling the structure of debt, the deleveraging campaign has achieved little.

Credit-fueled growth is here to stay. The government’s efforts to deal with structural problems head on are constrained by the ambitions to keep the economy humming along. Policy makers understand that raising interest rates would hit the economy hard and could potentially cause a crisis. So far they have refrained from tightening monetary policy. Instead, their preferred tool for maintaining financial stability is micro-management. As problems arise, the government tries to contain each by targeted intervention. Meanwhile excessive liquidity shifts to new areas, creating new problems that call for the government’s attention. The latest such trouble spot is the growth of consumer loans, which the government has begun to tackle by unleashing new regulations.

It is becoming evident that achieving deleveraging and maintaining high economic growth simultaneously is not possible. Steps to reduce the Chinese economy’s reliance on credit will remain timid as the government tries to keep GDP growth within a corridor of 6.4 and 6.8 percent in order to reach its target of doubling GDP and income by 2020. This is a narrow band to navigate within and limits the government’s policy flexibility.

The MERICS China Confidence Index measures households and businesses’ confidence in future income and revenues. 
The index is equally weighted between household and business indicators. It includes the following indicators: stock market turnover, future income confidence, international air travel, new manufacturing orders, new business in the service sector, urban households’ house purchase plans, venture capital investments, private fixed asset investments and households’ consumption share of disposable income. All components have been tested for trends and seasonality. 
The MCCI was first developed in Q1 2017.


Financial markets

Efforts to rein in credit growth is largely unsuccessful

Containing financial risk remains important to Chinese policy makers. If left unaddressed, China’s alarming levels of debt could cause financial breakdown. The growing awareness of this risk has caused the government to act by discouraging risky lending, improving oversight, and attempts to bringing shadow banking products back onto banks’ balance sheets. Regulators have also cracked down on online lending and fundraising.

The problem is that the largely regulation-driven campaign has enjoyed little success: credit is still growing at a faster pace than the economy. Corporate bond issuance has slowed, but this has not been enough to offset the growth of shadow banking and households’ borrowing. Households’ consumer loans are especially concerning. In part these loans have been misused to purchase property in the overheated real estate markets. Despite a recent slowdown, consumer loans are still growing at high speeds: these loans grew 29.1 percent year on year in September.

Perhaps fearing that constricting liquidity too much would eventually hurt growth, policy makers have left their most effective deleveraging tool, tighter monetary policy, in the box. Following two incremental increases of the People’s Bank of China’s reverse repo rate, economy-wide interest rates increased at the beginning of the year but have since stabilized close to 2014 levels. Open market operations have been relatively balanced. Citing a need for improving financial inclusion, the central bank lowered reserve requirements for banks which lend to private SMEs by as much as 1.5 percent. Almost 90 percent of banks are expected to qualify for the reduction. The lowered reserve requirements will thus free up a large amount of liquidity.

The stock markets appear to have dismissed the concerns in the capital markets. Strong growth of 8 percent since the beginning of the year has allowed the Shanghai Composite Stock Index to reach a two-year high. The Shenzhen index has grown at the much slower pace of 2 percent. The big winners in the stock markets have been large financial firms and SOEs. Financial firms have benefitted from higher interest rates: the financial index, a sub-index of the Shanghai stock exchange, has grown 18 percent since the beginning of the year.