For much of the past year, China’s market volatility—signs of slower economic growth, overcapacity in core sectors, swings in stocks and its currency—has captivated investors around the world. From a macroeconomic perspective, three policy dilemmas are at the heart of the debate over how China’s policy makers steer the economy in this phase of transition:
High Growth vs. Return on Capital
Traditionally, policy makers in China have operated with a growth target to guide decisions. In its 13th Five-Year Plan, announced late last year, the government maintained its goal to double GDP and disposable per-capita income by 2020, from 2010 levels, implying annual GDP growth of around 6.5%.
We believe that 6.5% average annual GDP growth over the next five years will be a challenge, given what’s likely to be weak support from external demand (structurally slower developed-market growth outlook), decline in its working-age population from 2016, high levels of corporate debt, and the starting point of excess capacity in old economy sectors.
Moreover, targeting a relatively high rate of growth will mean having to keep investment-to-GDP ratios relatively high, at the cost of weak capital productivity and poor returns on capital employed. Indeed, we estimate that, at current GDP growth rates, for China to achieve the same capital efficiency it did from 2000 to 2007, the optimal level of investment-to-GDP should be around 24%, instead of its estimated 42% in 2015.
Slower vs. Faster Cuts to Excess Capacities
Since the credit crisis, high levels of investment to GDP, against a backdrop of structurally slower export growth and weakening demographic trends, have led to a buildup of excess capacities and deflationary pressures. Producer prices and the GDP deflator, which have fallen 46 months and 12 months, respectively, are the clearest indicators of the overcapacity challenge.
Policy makers have signaled that they intend to address these issues. The key question, however, is the pace of adjustment they will adopt. Considering the scale of excess investments, a faster pace of cutting excess capacities and recognizing nonperforming loans could carry social-stability risks (potential sharp rise in unemployment) and an elevated risk of a near-term financial shock.
However, opting for a more gradual pace of adjustment will mean that deflationary pressures could become generalized and entrenched.
Monetary Easing vs. Currency Depreciation
Against the backdrop of a weak productivity trend, private corporate capital expenditure has been slowing, adding to growth headwinds. This, coupled with the persistence of deflationary pressures, has meant that nominal GDP growth in China had slipped to a post-credit-crisis low of 6.0% in the fourth quarter of 2015, from an average of 18.5% four years back.
Weakening growth has prompted policy makers to cut interest rates to mitigate downside pressures. However, those rate cuts have made it more challenging to manage pressures of a trilemma—flexibility of exchange rate, openness of capital account, and control over domestic interest rates—as an environment of poor returns and narrowing real rate differentials with the US have intensified capital outflows and, consequently, depreciation pressures on the yuan.
To mitigate some of the pressures, policy makers had moved on Aug 11, 2015, to a new currency management regime, from managing the yuan to hold stable against the US dollar to anchoring relative stability in a trade-weighted index. However, in January, the intensification of capital outflows renewed the trilemma pressures. In this environment, if policy makers were to proceed with a relatively fast pace of monetary easing, it could quicken the pace of currency depreciation.
Our base case outlook for China: Growth will continue to slow, deflationary pressures to persist, monetary easing will proceed at a gradual pace, as will currency depreciation. Under this environment, debt-to-GDP ratios also will likely keep rising.
Five Steps to Sustainable Growth
To address the deflation risks and transition to a slower but sustainable productive growth cycle, we believe policy makers should adopt the following five-step approach:
- Accept slower growth, in line with changing potential growth dynamics due to structural factors, such as a decline in the working age population, high levels of debt and slowing productivity growth;
- Address the moral hazard risks in the banking system and/or tightening prudential norms, and cut back on excess capacities to ensure efficient capital allocation. This will invoke a period of risk-aversion in the financial system and could entail significant job losses;
- Cut real interest rates to incentivize private-sector borrowing for productive investment. However, cutting real rates in an aggressive fashion could trigger intense capital outflows and currency depreciation pressures. In this context, policy makers will also have to allow exchange-rate adjustments;
- Initiate structural reforms to encourage productive private-sector investment and improve potential growth;
- Provide temporary fiscal stimulus to boost consumption.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (Feb 21, 2016) series. Ask your Morgan Stanley representative or Financial Advisor for the latest coverage on China's economic outlook. Plus, more Ideas.
