Slowdown in China Bears Watching Ahead of 19th Party Congress

new chinaEconomic data from China have been softer than expected for the second straight month.  This comes ahead of the important Communist Party conference next month.  Meanwhile, we remain sanguine about the yuan’s outlook. 

POLITICAL OUTLOOK

The 19th National Congress of the Communist Party of China starts October 18.  It is held every five years and sets the tone for the ensuing years until the next one is held.  The growth target was 6.5% for the current five-year period.  The target that’s set for the next period will be a very important signal as to whether policymakers can tolerate a slowdown while structural reforms are enacted.

President Xi and Premier Li are widely expected to remain in power for their second (and final) terms.  However, five of the seven on the Politburo Standing Committee will probably step down under the unwritten rule of retirement at 68.  Xi is expected to use this opportunity to promote his allies to important posts and consolidate his power.  There are rumors that Xi may eventually seek a third term in 2022, but it’s way too early to speculation on this.

Relations with the US remain in flux.  The US just rejected a China-led purchase of US chipmaker Lattice on national security grounds.  Chinese officials warned that blocking sensitive investments should not be used as a protectionist tool.  Trade will likely be an ongoing sticking point in bilateral relations.

This comes even as the US is pushing China to exert more influence on North Korea.  China is facing a delicate balance act here, but it did vote in favor of UN sanctions on Korea that left out an oil embargo.  China has also taken some bilateral moves, such as not buying North Korean coal.

China has improved in the World Bank’s Ease of Doing Business rankings (78 out of 190 and up from 80 in 2016).  The best components are enforcing contracts and registering property, while the worst are dealing with construction permits and paying taxes.  Under President Xi, China has embraced an anti-corruption drive but there is clearly room for further improvement.  In Transparency International’s Corruption Perceptions Index, China ranks 79 out of 176 and is tied with Belarus, Brazil, and India.

ECONOMIC OUTLOOK

The economy has picked up in recent quarters, due in part to a pick-up in new loan activity this year.  GDP growth is forecast by the IMF to remain steady at 6.7% in 2017 before decelerating modestly to 6.4% in 2018 and 6.2% in 2019.  GDP rose 6.9% y/y in both Q1 and Q2, up from 6.8% in Q4 2016 and 6.7% in Q3 2016.  However, data so far (trade, retail sales, IP) suggest Q3 will see a slowdown.

Underlying data paint a mixed picture of the economy.  Rail freight remains strong, rising nearly 20%.  New loans also remain robust, while PMI readings are ticking up.  On the other hand, cement production (-3.7% y/y) and electricity output (5.8% y/y) have been softening.

Price pressures bear watching, with CPI accelerating to 1.8% y/y in August from 1.4% in July.  This is the highest rate since January, and accelerating PPI (6.3% y/y in August) suggests further upside for CPI.  The inflation target for 2017 is 3%.

For now, we believe the PBOC will remain on hold.  It has not moved official rates since the last 25 bp cut back in October 2015.  However, the central bank has snugged some market rates higher this past year.  Looking ahead, we believe the PBOC will maintain a tightening bias in light of rising inflation.

Fiscal policy has remained prudent.  The budget deficit came in at an estimated -2.0% of GDP in 2016, down from -3.4% 2015.  The OECD expects the deficit to remain around -2% of GDP in both 2017 and 2018.

The external accounts are deteriorating modestly.  The 12-month trade surplus has fallen to $445 bln in August, as imports have grown faster than exports.  The current account surplus was 1.8% of GDP in 2016, and the IMF expects it to narrow to 1.3% in 2017 and 1.2% in 2018.

Foreign reserves have risen seven straight months after falling over the course of 2014-2016.  At $3.09 trln in August, they cover over 18 months of import and are over 4 times larger than the stock of short-term external debt.  We do believe that the PBOC will allow greater market forces in determining the exchange rate, so that changes in foreign reserves will be driven largely by capital flows, not FX intervention.

INVESTMENT OUTLOOK

The yuan has done better after a subpar 2016.  In 2016, CNY fell -6.5% vs. USD and was ahead of only the worst performers ARS (-18%), TRY (-17%), and MXN (-16%).  So far in 2017, CNY is up 6% YTD and is amongst the top EM performers.  This compares well to the best performers MXN (+17%), THB (+8%), TWD (7%), and CLP (+7%).  Our EM FX model shows the yuan to have VERY STRONG fundamentals, so this year’s outperformance should continue.

Whilst campaigning ahead of the election, President Trump threatened to cite China as a currency manipulator “on day one.”  China has not been cited yet, nor will it likely be cited in the next report due in Q4.  Before this week’s bounce, USD/CNY had traded to its lowest level since December 2015 last week.  While we do not believe the bilateral exchange rate is a very comprehensive measure, recent yuan gains would seem to take some of the heat off China.

Just as the pair notched a cycle low of 6.4390, the PBOC announced that it was loosening up restrictions on trading forwards.  While we do not think that the PBOC is targeting or protecting any particular level for the exchange rate, the move signals discomfort with what had become an increasingly one-way market.  Note that near CNY6.4355, the dollar had retraced 62% of its rally against the yuan from the October 2014 low near CNY6.1083.

Chinese equities are outperforming EM after a poor 2016.  In 2016, MSCI China fell -3% vs. +7% for MSCI EM.  So far this year, MSCI China is up 44% YTD and compares to 28% YTD for MSCI EM.  This outperformance should continue, as our EM Equity model has China at a VERY OVERWEIGHT position.

Chinese bonds have underperformed recently.  The yield on 10-year local currency government bonds is about +59 bp YTD.  This is behind only the worst performer Czech Republic (+64 bp) and ahead of Romania (+44 bp).  With inflation likely to continue rising and the central bank on hold, we think Chinese bonds will continue underperforming.

China just announced plans to issue its first USD-denominated bond since 2004.  The $2 bln issuance will mostly serve as a benchmark for corporate issuance, as the sovereign clearly does not need to raise foreign currency.  At the same time, China announced that it will issue only CNY14 bln of so-called dim sum bonds in Hong Kong this year, the smallest since 2010.

Our own sovereign ratings model shows China’s implied rating steady at A+/A1/A+.  We see some downgrade risks to S&P’s AA- rating, which is supported by Moody’s recent downgrade in May to A1.  Both that and Fitch’s A+ appear to be on target now.