China: Be Prepared For Potential Policy Shift

Heightened downside risks

The decisive move by the FOMC to cut interest rates by 125bp in the last two weeks has served as a wake-up call to the Chinese policymakers, making them start to fully appreciate the large downside risk facing the US economy and the attendant negative impact on the Chinese economy, in our view. These latest developments call into question the premise − that the US economy would do just fine − on which the Chinese authorities formulated the macro-control measures back in November 2007.

On the domestic front, the worst winter storms in half a century have swept central and southern China since January 10. The snowstorms paralyzed the transportation system, stranded millions of people on the way home for the forthcoming Chinese New Year, disrupted power supply, damaged crops, especially of fresh food, and led to the disruption of industrial production in some areas. Six provinces in the central and southern region have been hit the hardest. According to the government, direct losses from the storms were estimated at about CNY 54 billion (about 0.22% of GDP) as of February 2, but the damage could rise, as the bad weather conditions continue.

Signs of potential policy shift

On January 30, major Chinese media reported a speech made by President Hu Jintao at a meeting of the Chinese Communist Party’s Political Bureau − the de facto highest decision-making body in China. In the speech, President Hu stated that the government “…should correctly understand the global economic developments and their impact on China, fully recognize the complexity and changeability of China’s external environment, scientifically manage the pace and intensity of macroeconomic controls, with a view to prolonging stable and relatively fast economic growth”. Separately, Premier Wen Jiabao was quoted on January 28 as saying that “2008 could turn out to be the most difficult year as far as the economy is concerned”, noting in particular the heightened uncertainty in the external environment.

We believe that the remarks by President Hu and Premier Wen signaled an important shift in the policymakers’ tone: from an emphasis on ‘risk of economic overheating’ only about a month ago to attention to downside risks stemming from the unfavorable external environment.

In responding to these calls from the top leaders, the PBoC issued an urgent notice on February 1 asking commercial banks to increase bank lending to support the current effort to combat bad-weather difficulties. Moreover, the CSRC, the securities watchdog, recently approved two new closed-end stock funds, ending a five-month freeze on new funds, and this is widely perceived as an effort to contain the fall in domestic equities. It had suspended the launch of new funds late last year in reaction to the surging domestic stock market. Various other government agencies including the Ministry of Finance have taken corresponding measures to increase financial support to the regions that were affected by the snowstorms.

Déjà vu: 2003 SARS outbreak or 1998 massive flood?

Could this be a repeat of the experience of the SARS outbreak in 2003, which suggested that any policy easing was temporary? Or could it be a repeat of the experience of the massive flood in 1998, which served only to make the authorities more decisive in implementing their policy easing in the aftermath of the Asian financial crisis?

Back in early 2003, while the government was already concerned about rapid credit growth (18%Y in 1Q03), the policy response was delayed by the SARS epidemic in 2Q03, and credit growth was allowed to accelerate to 21%Y in 2Q03 and 23% in 3Q04. With the end of the SARS outbreak in July, the PBoC changed its policy stance swiftly by announcing an increase in the reserve requirement ratio by 100bp effective September 2003 and by a further 50bp in April 2004. The PBoC also engaged in ‘window guidance’, reducing bank lending and tightening lending standards in sectors experiencing overinvestment.

When the massive flood happened in the summer of 1998, China’s monetary policy easing to offset the negative impact of the Asian financial crisis was already well underway, with the 1-year benchmark lending rate having been cut by 216bp from October 1997 to June 1998. This rate was then cut by 99bp in July 1998, in part reflecting the authorities’ effort to boost the economy, which was exacerbated by the flood. It was then estimated that the flood had caused damage to the tune of 1.5% of GDP.

Be prepared for potential policy shift

These latest policy measures initiated in the context of combating the serious snowstorms will likely represent the beginning of policy easing during 2008, in our view. We think that the authorities’ appreciation of the large downside risks to China’s external demand, together with the damage caused by the severe snowstorms, will likely prompt an easing of macro controls as originally envisaged under our ‘imported soft landing’ baseline scenario (see China Economics: Journey into Autumn: An Imported Soft Landing in '08, December 3, 2007).

Under our baseline scenario, we expect the policy stance to remain tight through 1Q or 1H and then turn neutral or ease in the remainder of the year. In short, we expect that the authorities’ macro controls will be front-loaded. In fact, in light of the FOMC’s 75bp rate cut, we changed our original PBoC call from “two more rate hikes in 1H08” to “no rate hike” in 2008 (see China Economics: The Probability of Imported Soft Landing in '08 Rising, January 22, 2008).

These latest developments may even prompt an earlier policy easing than we originally envisaged. In our opinion, the policy shift will likely begin with relaxing the administrative controls over bank lending and investment approval sometime in 2Q. Therefore, the ‘risk of overtightening by policy mistake’ is now substantially lower, we believe (see China Economics: Two Types of Overtightening, January 4, 2008).

When exports weaken, government capex steps in

Would China still be able to achieve a soft landing if external demand were to deteriorate as much as in the previous global downturn in 2001-02? This is the question many clients have in mind. Under our baseline scenario, we expect the authorities to stand ready to ease existing macro controls – as a first line of defense – 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 priority, and the authorities may well intervene, rather than let an external shock do the ‘cooling off’ job, allowing GDP growth to slow cyclically toward 8-9% this year.

Experiences from the last global economic downturn support our arguments. China’s exports have suffered two major downturns in the last decade: during the Asian financial crisis and in the 2001-02 global recession triggered by the bursting of the internet bubble. During the Asian financial crisis, China’s export growth plunged from a peak of 30%Y in May 1997 to -11%Y in November 1998. After the internet bubble burst, China’s export growth dropped from a peak of nearly 40%Y in March 2000 to barely zero growth in October 2001.

Despite the sharp decline in export growth in these two downturns, the impact on China’s GDP growth was much less significant, with the respective GDP growth rates declining by about 1.5 percentage points and 0.1 percentage point from their pre-recession levels. A key reason is that countercyclical government-led capex was able to largely offset the weaker exports such that overall economic growth remained robust.

During the Asian financial crisis and when the internet bubble burst, as soon as export growth started to show a marked decline, there was an equally sharp increase in capex financed from the government budget. And when export growth recovered, there tended to be a correspondingly significant decline in government-led capex.

More importantly, government capex appears to have served as ‘seed money’ to catalyze investment from non-government sources such that when exports are down, overall fixed-asset investment tends to pick up the slack. In reality, the increase in government-led capex is an indication of easing in the macro policy stance.

Moreover, in part reflecting countercyclical investment that dampens the impact of a slowdown in exports and underpins employment and income growth, domestic consumption − as proxied by retail sales − tends to be broadly stable amid deep downturns in China’s exports.

But what about inflation?

Can the Chinese authorities afford to ease policy controls when CPI inflation remains stubbornly high? This is the question many clients raised during our discussion about the prospects of a potential policy shift. In fact, many clients wondered whether we should not expect further tightening measures (e.g., rate hikes) if CPI inflation in January and February were to post new highs. Indeed, another high CPI reading now appears very likely, as the prices for some food items (e.g., fresh vegetables) will likely register sharp increases in the aftermath of the serious snowstorms.

However, even if inflation were to surprise to the upside in the near term, we attach a low probability to additional tightening measures (e.g., rate hikes, tighter administrative controls on bank lending and investment) that could threaten the outlook for 10% GDP growth in 2008. First, as discussed above, the latest developments suggest that in balancing between inflation and lower growth risks, the government now appears to have shifted toward boosting growth.

Second, the fact that China tends to experience disinflation/deflation when there is a significant decline in exports provides some degree of assurance to the policymakers that inflation will eventually be brought under control, albeit with a lag. With a sharp decline in external demand, Chinese producers would have to turn to the domestic market to sell their products. This added supply in the domestic market would likely depress prices.

Third, a one-off jump in the price level due to supply shocks (i.e., bad weather) is normally not viewed by the policymakers as higher inflation, which is defined as a sustained increase in the price level, and thus should not trigger immediate policy actions.

We therefore expect that in combating inflation, the authorities would rely primarily on further hikes in the ratio for required reserves (RRR) to help control money (M2) growth and faster renminbi appreciation to anchor inflationary expectations and ease imported inflationary pressures, as reflected in high international prices for food, energy, raw materials and so on. We expect the RRR to be raised on a regular basis, as was the case in 2007, and we look for the accelerated pace of renminbi appreciation since late last year to be sustained.

Also, in view of the current inflationary pressures, we expect that the current price controls will be maintained well into 2Q, and we think that they may even be broadened to include additional items.

Catalysts for policy shift

The recent signs of policy shift have reflected the authorities’ reaction to news (e.g., the global market sell-off and the FOMC’s sharp rate cuts). The news served as a wake-up call for the authorities to start to appreciate the potentially large downside risks facing the US and global economies and put them on alert.

Going forward, we suggest paying close attention to external developments and key policymakers’ statements to gauge the timing of an actual policy shift. In this context, the NPC annual meeting scheduled to take place on March 5-15 should provide an opportunity for the authorities to formally clarify their policy intentions.

The authorities are unlikely to make a meaningful policy shift until they have an opportunity to reassess the domestic and external economic situation based on 1Q08 data around mid-April. In particular, if export growth were to register a significant decline (say, to below 20% for the first time since 3Q02), the policymakers would likely respond with a meaningful policy shift, in our view.

By Qing Wang Hong Kong
Morgan Stanley
February 06, 2008