China: a trio of dilemmas
For much of the past 12 months, the volatility in China’s capital markets has captured investors’ attention. From a macroeconomic perspective, Morgan Stanley Asia Limited experts think that the following three policy dilemmas are at the heart of this debate:
1) Choosing between high growth rates versus returns on capital
Traditionally, policy-makers in China have operated with a growth target which has guided their policy decisions. In the 13th Five-Year Plan announced late last year, the government had maintained the plan of doubling GDP and disposable income per capita by 2020 from 2010 levels, implying an annual GDP growth rate of around 6.5%Y. We believe that achieving this 6.5% average GDP growth over the next five years will be challenging, considering the likely weak support from external demand (structurally slower developed world growth outlook), decline in working age population from 2016, high level of debt on corporate balance sheets, and the starting point of excess capacity in old economy sectors. Moreover, choosing to target a relatively high rate of growth will mean that investment to GDP ratios will have to be kept relatively high, at the cost of weak capital productivity and poor returns on capital employed. Indeed, we estimate that if China were to have the same capital efficiency as seen in 2000-07, for the current GDP growth rates, optimal level of investment to GDP should be around 24% instead of the estimated 42% in 2015.
2) Choosing a slow versus fast pace of adjustment in cutting excess capacities
Since the credit crisis, the high levels of investment to GDP against a backdrop of structurally slower exports growth and also weakening demographic trends have led to a buildup of excess capacities and deflationary pressures. The clearest indication of the excess capacity challenge is in producer prices and the GDP deflator, which have been in deflation for the past 46 months and 12 months, respectively.
Policy-makers have signaled their intentions to address these issues. However, the key question is with regard to the pace of adjustment in which they are opting for. Considering the scale of excess investments, a faster pace of adjustment in cutting back excess capacities and recognizing non-performing loans will entail social stability risks (potential sharp rise in unemployment) and elevated risk of a financial shock in the near term. However, opting for a more gradual pace of adjustment will mean that deflationary pressures could become generalized and entrenched.
3) Pace of monetary easing versus pace of currency depreciation
Against a backdrop of weak productivity trend, private corporate capex has been slowing, adding to the growth headwinds. This, coupled with the persistence of deflationary pressures, has meant that nominal GDP growth in China has slipped to a post-credit crisis low of 6.0% in 4Q15 from an average of 18.5% four years back. The backdrop of weakening growth has prompted policy-makers to cut interest rates to mitigate the downside pressures but has led to another challenge of managing the trilemma (flexibility of exchange rate, openness of capital account and control over domestic interest rates) pressures – as an environment of poor returns and narrowing real rate differentials with the US have led to an intensification of capital outflows and consequently depreciation pressures on the currency.
Morgan Stanley experts said that their base case outlook for China “is that 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 will also likely keep rising”.
Source: Chetan Ahya, Co-Head of Global Economics and Chief Asia Economist (Morgan Stanley Asia Limited)