Five reasons why the consensus reading of China’s 2017 economy was so wrong
This year has turned out to be one of positive macroeconomic surprises. The global economy grew at its strongest and most synchronised pace in years, with benign inflation keeping central banks at ease. Financial markets were sheered by fading political risks in Europe and reduced protectionism concerns from the US.
While geopolitical tensions in North Korea and Catalonia’s declaration of independence have, at times, dominated news headlines, these were mostly sideshows that were readily shrugged off by investors. With no major hiccups in the coming weeks, the global economy is on track to deliver their best performance in seven years.
Closer to home, the remarkable turnaround in China has been a big surprise to many. Contrary to intense hard-landing concerns that had led to equity and credit market sell-offs, the renminbi’s depreciation and massive capital outflows in the last two years, 2017 has turned out to be a year of redemption, with stellar performance in many Chinese markets that blew away even the wildest expectations.
Take equities as an example; the MSCI China Index has surged by a whopping 52 per cent year-to-date, on track to be the best performing market globally.
The renminbi has appreciated by 5.1 per cent onshore (CNY) and 5.4 per cent offshore (CNH) against the US dollar, a result that no one would have considered possible 12 months ago. Even capital outflows, which were feared of leading China to an impending crisis, have eased off markedly, leading to a rebound in China’s foreign exchange reserves to above US$3.1 trillion.
These dramatic shifts in asset prices and investor sentiment have made China, in our view, the biggest macro surprise of all in 2017.
What was behind all these surprises that caught the consensus on the wrong foot in such a massive scale?
The gross domestic product (GDP) is not the answer. The Chinese economy grew by an average rate of 6.9 per cent in the first three quarters, and is set to end the year at 6.8 per cent. A marginal – one tenth of a percentage point – acceleration from last year’s 6.7 per cent is clearly not enough to drive such a turnaround in financial markets.
Neither does external influence matter much for China, given its strictly controlled capital account has historically limited correlated movements between local and international markets.
The answer, instead, lies in the policy surprises from Beijing. We discuss five key policies here, as parts of President Xi Jinping’s supply-side reforms, that have had profound impact on China’s economic rebalancing and rejuvenating markets:
•Overcapacity reduction was ranked top on the agenda when Xi introduced supply-side reforms in late 2015. A diligent implementation of the policy has led to a substantial reduction in steel and coal capacities in the last two years. These reductions have subsequently bolstered industrial prices, turning around the Producer Price Index (PPI) from deeply entrenched deflation. Combined with policies to cut costs via fiscal and credit means, industrial profits rebounded strongly, providing a fundamental support for the equity market rally this year.
•A reduction in property market’s stockpile had been carried out forcefully since 2015 against a backdrop of record-high housing inventory. The monetised subsidy scheme, as part of the shanty town renovation, helped to revive the market in third-tier and fourth-tier cities. For the economy, the housing recovery was important in lifting growth across the real estate supply chain, which ranges from raw material production, construction, to real estate services and retail sales of household appliances. For the market, commodity prices were boosted by higher construction demand, while improved balance sheets of developers were supportive of property stocks and credits.
•Financial deleveraging started in the third quarter of 2016, and has gained further momentum this year to the surprise of markets. Many had thought the action of the People’s Bank of China to “de-risk” the interbank market was one-off, and would be called off in a year of leadership transition when stability is treated as a priority. As it turned out, not only did the deleveraging campaign continue in earnest, the scope was also broadened to cover a wider range of activities. The recently announced new regulations for the asset management industry suggests that tight financial conditions for shadow banking and risky borrowers will be long-lasting, keeping interest rates elevated and bond market volatile going forward.
•Environmental protection was the latest move by Beijing to transform China’s development model to be more environmentally sustainable. Significant production curbs in heavy-polluting sectors have weighed on industrial output and fixed asset investment. At the same time, investment in clean and renewable energy has accelerated. These differentiating impacts should help to rebalance the economy, and drive diverged price actions between green and non-green sectors of the market.
These policy actions, to the degree that few had considered possible, were the key reasons why the consensus estimates on China’s 2017 economy had been so wrong.
The question for investors is whether these policy-induced market actions and economic rebalancing will continue in 2018. Stay tuned for our final update of this column for 2017.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers