China Economics: Journey into Autumn: An Imported Soft Landing In 2008

A dichotomy: Risks of domestic overheating and external recession
Despite some tentative signs of moderation in activity, the Chinese economy overall still expands at a brisk pace, while headline inflation remains at a stubbornly high level (see China Chartbook: Tentative Signs of Moderation; Risk of Out-of-Control Inflation, November 19). Against this backdrop, the Political Bureau of the Chinese Communist Party – the de facto highest decision-making body in China – held a meeting on November 27. It discussed the broad economic policy agenda for 2008. According to the press statement, the authorities made prevention of economic overheating in general and entrenched inflation in particular the key policy objectives for 2008 (see China Economics: Broad Economic Policy Agenda Set for 2008, November 28).

At the same time, as the US subprime crisis deepens, the probability of a recession in the US and an attendant synchronized slowdown in G3 is on the rise. Dick Berner, our Chief US Economist, recently pointed out that a materialized credit recession would threaten a real recession (see US Economics: The Credit Recession, November 5) and wrote “the risk of US recession is higher now than at any time in the past six years”, as “US consumers face the toughest challenge since the recession of 2001” (see US Economics: Perfect Storm for the American Consumer, November 12). Eric Chaney, our European Chief Economist, considered an “orderly slowdown” as most likely for Euroland.

This dichotomy – co-existence of domestic overheating risk versus external recession risk – constitutes a challenge to formulating the outlook for China. Amid these tremendous uncertainties about the outlook for external demand and the domestic policy stance, we characterize the potential scenarios for 2008 outlook as four seasons of the year: Autumn featuring ‘an imported soft landing’, summer featuring ‘overheating’, spring featuring ‘a policy-induced soft landing’, and winter featuring ‘an outright hard landing’.

Autumn scenario for 2008 (60% probability): An imported soft landing
We expect the Chinese economy to achieve a soft landing in 2008, aided primarily by a significant moderation in export growth due to weak external demand. We therefore call it ‘an imported soft landing’ and attach a 60% probability to this scenario. Here is why.

First, concerns about the risk of overheating in 2008 are not unwarranted. Investment and exports have been the main drivers for growth in China. Since interest rates are still largely controlled at below market-clearing levels and the renminbi exchange rate remains substantially undervalued, these price signals tend not to constitute effective binding constraints for investment decisions, in my view.

In this context, the investment cycle tends to reflect the macro policy stances, which are influenced heavily by the political cycle in China. Since the early 1990s, fixed-asset investment growth rates have reached a peak every five years, and the year of peak growth rate ‘happened’ to be the year of change of government. The next change of government is due to take place in March 2008. If this pattern persists (i.e., investment cycle driven by political cycle), there appears to be a considerable risk of acceleration of investment growth next year, especially in view of the low interest rates, undervalued exchange rates and still-strong corporate earnings. An acceleration of investment from the current levels – which are already deemed high – could easily drive the economy into overheating territory, in my view.

Second, there will likely be a significant deterioration in China’s external environment in 2008. China’s export growth is still sensitive to changes in activity in major industrial countries, and we expect that China’s export growth in 2008 will decline from the high levels (i.e., nearly 30% per annum) reached in the last several years. Past experiences suggest that a significant decline in export growth should have a meaningful disinflationary/deflationary impact on the economy. China has suffered two episodes of deflation in recent history: one during the Asian financial crisis and the other in the aftermath of the NASDAQ stock bubble burst. The deflation either coincided with or occurred in the immediate aftermath of a collapse in export growth.

Third, moderation in China’s export growth due to weak external demand in 2008 should be a welcome development that would help the economy to achieve a soft landing. In my opinion, it is very challenging – if ever possible – to realize a policy-induced soft landing of the economy at the current juncture, given that Chinese authorities are pursing multiple objectives – including growth, inflation, stock market performance, job creation, the financial performance of state-owned banks and enterprises – but with limited policy tools. In particular, the effectiveness of both interest rate and exchange rate policies are seriously compromised by some objectives that do not have a direct bearing on the macroeconomy. In this context, weakening external demand should serve as a healthy headwind and thus help slow the economy that is constantly on the verge of overheating.

Under the ‘imported soft landing’ scenario, we forecast China’s GDP growth to decline from 11.5% in 2007 to 10% and CPI inflation from 4.5% to 4.0% in 2008. Our forecasts envisage a modest rebalancing in growth drivers in 2008: relatively weak exports – whose growth declines from 26% in 2007 to 16% in 2008 – to be offset by sustained strong domestic demand. Consequently, the current account surplus (as a percentage of GDP) will narrow, as import growth outpaces export growth, albeit both at lower levels.

We envisage that the investment-growth-dampening effect of slower export growth will be largely offset by the investment-growth-boosting effect stemming from the political cycle. Therefore, aggregate fixed-asset investment growth will likely be broadly stable. Moreover, we expect consumption growth to maintain its upward momentum; however, we do not expect a major acceleration in consumption growth. We believe that the structural factors – including lack of widespread asset ownership by households and a financial repression development strategy in favor of the returns to equity at the expense of investment income to the households – that contribute to weak consumption (relative to investment) can only be addressed over time (see China Economics: Our Views on the Economy in a Single Diagram, June 25).

Policy outlook for 2008: Muddling through
Under our baseline scenario of ‘an imported soft landing’ in 2008, the policy outlook will likely feature a continued muddling through. The authorities’ current policy priorities are addressing the risks of overheating in general and entrenched inflation in particular. However, given that Chinese authorities are pursing multiple objectives with limited policy tools, the authorities may have to increasingly resort to administrative measures (e.g., quantitative controls over bank lending and tighter controls over investment project approval) to achieve the intended policy effect.

The welcome downturn in external demand and its attendant cooling-off effect should be able to provide a breathing period for the authorities and ease the urgency to take aggressive policy actions with blunt policy tools. We therefore expect a continued muddling-through approach in policy implementation in 2008 featuring ‘three No’s’: No campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no aggressive rate hikes.

No campaign-style administrative tightening: In setting the 2008 policy agenda, the authorities have reiterated the need to tightly control investment growth. We, however, do not expect them to launch a new round of campaign-style administrative tightening of the same intensity as seen in 2004. In our view, these most recent policy statements suggest that the authorities are aware of the risk of a major political-cycle-driven acceleration in investment growth in 2008 and are willing to take pre-emptive measures to prevent it from materializing instead of attempting to bring down investment growth substantially from its current levels. In this context, and in the event of a significant downturn in China’s external demand, the likelihood for a campaign-style administrative tightening will become even more remote, in my view.

No large one-off revaluation of the renminbi exchange rate: We reiterate our call that the probability of another large one-off revaluation of the renminbi exchange rate is very low in 2008. We expect the authorities to stick to the gradual appreciation strategy and forecast the USD/CNY exchange rate to reach 6.80 by end-2008. Specifically, we believe that for the Chinese authorities to make such a bold move as a more-than-10% revaluation, at least one of the following two conditions would need to be met: i) domestic CPI inflation moves out of control (i.e., headline CPI is above 8% for a protracted period); or ii) such a sizeable revaluation would produce an international political gain vis-à-vis China’s major trading partners (e.g., the US and EU) that would be sufficient to make the currency move worthwhile. However, neither condition will likely be met in 2008, in my view (see China Economics: Fasten the Seatbelt, October 22 and China Economics: Fasten the Seatbelt: an Update, November 12).

Moreover, as export growth declines, opponents of renminbi appreciation – whose influence within the policy-making circle appear to have waned considerably since early this year – will likely voice their strong concerns again, making such a bold move as another large one-off revaluation even more unlikely, especially given the consensus-driven policy-making style of the current government.

No aggressive rate hikes: A confluence of factors – including the ‘mini-tightening cycle’ launched after the conclusion of the 17th CPC Congress Meeting in mid-October, the continued tightening bias into 2008, and weakening in external demand – should together help contain inflationary expectations and thus prevent them from getting entrenched (see China: Expect Further Rate Hikes, Faster Appreciation, and Tighter Credit, September 30 and China Economics: Runaway Monetary Growth Points to a Mini-tightening Cycle in the Coming Months, October 14). These should ease the burden of relying on hiking interest rates to managing inflationary expectations. Moreover, large SOEs, which are the main long-term beneficiaries of low-cost bank financing, may step up their lobby effort against aggressive rate hikes through various ministries and semi-government agencies. We therefore only expect 1-2 27bp hikes of the base interest rates over the course of 2008, depending on the pace of headline CPI inflation decline.

In the event of a deeper-than-expected external downturn, we expect the authorities to stand ready to ease existing macro controls – as a first line of defence – and even pursue expansionary monetary and fiscal policies – if warranted – to head off any risk of a major economic downturn. We believe that maintaining strong GDP growth is still the highest political priority, and the authorities may well intervene, rather than letting an external shock do the ‘cooling off’ job, allowing GDP growth to slow cyclically toward 8-9% next year. Between ‘high and balanced’ growth and ‘low and balanced’ growth, we believe that the authorities will prefer the former, even if doing so entails policy intervention that may risk perpetuating the underlying imbalances in the economy (e.g., through boosting investment).

The authorities have not only the intention to deliver strong growth; importantly, they also have the capacity to do so, especially in the short run. This is because there is a large cushion built into the economy that allows the authorities to run expansionary macroeconomic policies to stimulate domestic demand. Specifically, China’s government debt level is quite low by emerging market economy standards. As of end-2006, we estimate that China’s government debt was only about 18% of GDP, much lower than the 45-50% GDP levels in other emerging market economies. This low debt level indicates considerable room for expansionary fiscal policy, financed by government bonds, to boost the economy before the government runs into a debt sustainability problem.

Summer scenario (25% probability): Overheating
While we envisage ‘an imported soft landing’ with the help from a welcome slowdown in external demand, what if there is no meaningful external slowdown to import in the first place? If this is the case, the risk of overheating would rise substantially, in my view. We attach a 25% probability to this scenario.

Specifically, if the subprime crisis remains largely a market event instead of an economic one, there should be no recession in the US economy and global synchronized slowdown. Under this scenario, we would expect China’s economic growth to remain robust, with exports still the main growth driver. At the same time, in the aftermath of the turmoil in major financial markets and the heightened degree of risk-aversion, we would expect a substantial amount of overseas capital inflows into China and the region at large. These capital inflows would serve to boost domestic liquidity, with the attendant risk of economic overheating and asset price inflation (see China Economics: Potential ‘Non-linear’ Impact of the Subprime Crisis, August 17).

Moreover, the authorities are expected to continue muddling through in policy implementation with no major policy direction shift. In this context, investment growth will likely accelerate from the current high levels, as the political-cycle-driven investment cycle plays out fully. Under this scenario, economic overheating will materialize in force, with GDP growth and headline CPI inflation likely to reach as high as 12% and 6%, respectively.

Overheating under the summer scenario in 2008 may trigger a much harsher policy response from the authorities in late 2008 and 2009. This could potentially result in a policy-induced hard landing in 2009, we fear (see China Economics: Runaway Monetary Growth Points to a Mini-tightening Cycle in the Coming Months, October 14 and China Economics: Risk of Out-of-Control Inflation on the Rise, November 14). In fact, the expansionary phase of the current cycle that started in 2003 has not been tested by the political cycle yet.

Spring scenario (10% probability): Policy-induced soft landing
Spring is the best season of the year in most parts of China. Under the spring scenario, we envisage that the authorities would seize the opportunity when the global economy is still delivering robust performance and take proactive measures to address the imbalances in the economy and cool off the economy from a position of strength. By implementing an appropriate set of policy tools, the authorities may be able to bring about a soft landing of the economy, thus achieving the same effect as under the autumn scenario when there is a synchronized global downturn.

A much faster appreciation of renminbi exchange rate should be the most important element of the policy package that could potentially bring about a soft landing when the global economic environment remains favorable. According to the latest IMF research, a 10% appreciation of the renminbi will result in 2% reduction in export growth. We estimate that a 20% appreciation of the renminbi under the spring scenario, together with the secular softening in export growth, should be able to produce roughly the same magnitude of export growth decline as under the autumn scenario.

However, we only attach a 10% probability to this scenario. The Chinese authorities – known for their hallmark gradualist approach in implementing reform programs – are unlikely to make such a bold move as 20% appreciation in 2008 unless it becomes absolutely necessary for them to do so. But as discussed above, we do not believe that the two conditions – domestic inflation out of control or sufficient political gain as a result of large revaluation/appreciation – will be met in 2008. Until then, the authorities will most likely stick to the gradual appreciation strategy and try various alternative measures, including by progressively relaxing capital account controls (e.g., through QDII, QDRI) to induce capital outflows.

Winter scenario (5% probability): Outright hard landing
The winter scenario features a double-whammy impact on the Chinese economy: aggressive policy tightening chokes off domestic demand, exacerbating the impact of a global synchronized downturn and resulting in an outright hard landing of the economy.

At first look, it appears the most likely scenario at the current juncture: while the risk of a US recession is looming large, the Chinese authorities have been very vocal lately in warning against the risk of overheating and inflation and vowed to take tough tightening measures to control rapid investment growth.

We, however, attach the smallest probability, of only 5%, to this winter scenario. This is essentially a ‘gigantic policy mistake’ scenario. We believe that delivering high growth and job creation is still of paramount political priority, and the authorities will not tolerate a sharp slowdown in growth, which has serious political and social consequences. As such, the authorities’ policy stance tends to be biased toward promoting high growth, and the threshold for the authorities to take action to boost growth is not high. More importantly, as discussed above, there is large cushion built into the economy that allows the authorities to run expansionary macroeconomic policies to stimulate domestic demand. It is almost inconceivable that authorities would sit on their hands watching the economic growth tumble.

In this context, we caution against overreacting to the authorities’ rhetoric to take tough measures to cool off the economy. We believe that the authorities will not take any signs of external slowdown lightly and stand ready to reverse the course of tightening policies.

Market implications
Under our baseline scenario of an imported soft landing, the Chinese economy – in adapting to a weak external environment – will likely be able to realize a welcome rebalancing (away from external to domestic demand) that would otherwise be unachievable, thus boding well for a sustained and robust expansion over the medium term.

While this growth rebalancing should be positive to the equity market over the medium term (i.e., 1-3 years), the stock market performance will likely be moderately negative in the near term (i.e., 6-12 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit, as firms in those sectors may attempt to hold on to their market shares by squeezing their profit margins in order to remain competitive. At the same time, domestic market-oriented sectors – especially those exposed to capex spending supported by the government – should do relatively well, as government increases in spending shore up domestic demand, offsetting weakening external demand.

Under the ‘imported soft landing scenario’, trade surpluses will narrow but remain large, and the liquidity implications and renminbi appreciation pressures will persist. In this context, as long as investors remain confident in the growth outlook over the medium term, the stock will unlikely be subject to prolonged downward pressures, in my view.

While the broad market implications under the spring scenario will be similar, the sectoral implications will differ from under the autumn scenario in that sectors exposed to domestic consumption of non-tradable goods will likely do relatively well due to the renminbi appreciation effect.

Under the summer scenario where there is economic overheating, the market will likely do well in the near term, but the good performance should not be sustainable, as fear of more aggressive tightening down the road and the attendant negative impact on the economy would significantly weaken investors’ confidence.

The winter scenario would prove disastrous for the stock market in both the near and medium term.

By Qing Wang Hong Kong
Morgan Stanley
December 4, 2007