Dec 08, 2017 06:25 PM

Opinion: Three Questions Ahead of China's Economic Work Conference

China’s annual Economic Work Conference in mid-December should help shed some light on what the country’s long-term objectives and policy directions laid out during the 19th Party Congress in October mean for 2018.

At least three questions are high on investors' agenda. Will China significantly lower its annual growth target or abandon it altogether? Will the People’s Bank of China (PBOC) raise interest rates in light of rising inflation? And will deleveraging lead to significant credit market volatility and a serious credit event?

Firstly, we expect a slightly lower growth target.

We expect the government to set a GDP growth target for 2018 to help anchor expectations and guide macro policies, which, as usual, will be announced at the National People's Congress next March.

Although President Xi Jinping's speech at the 19th National Party Congress did not specify a growth target for the long term, we think the government still intends to achieve the goal of doubling 2010 GDP by 2020, as an essential part of achieving its "moderately prosperous society" objective. To achieve this goal, China needs a 6.3% annual real GDP growth rate for the next three years.

As such, and since the government is also keen on continuing with supply-side reform and deleveraging, we think the growth target will be set lower and deemphasized. For example, the target could be a range of 6%-6.5%, or 6%-7%, or set at around 6.5%, without the phrase "strive to achieve more" that was in the target for this year. As such, we expect no serious tightening policies in the property market, and deleveraging to be gradual.

Secondly, the central bank may raise interest rates in 2018 if China’s inflation and U.S. rates rise more than envisaged.

In light of China's higher-than-expected producer prices so far and an upward revision of our in-house oil price forecast, we have revised up our 2018 PPI forecast to 2.8% from 1.6%, and the CPI forecast to 2.5% from 2.2%. We are assuming a continued pass-through of production costs to consumer goods prices in 2018 and a roughly 3% rebound in food prices.

We expect the PBOC to maintain a "prudent and neutral" monetary policy stance, letting tighter regulations do the heavy lifting of pushing up market rates rather than raising benchmark interest rates. However, it the U.S. Fed hikes rates more than twice next year, we think the PBOC will raise repo rates. And if CPI inflation surprises on the upside by approaching 3% for a few months, we would expect the PBOC to raise benchmark rate by 25 basis points in the third quarter of 2018.

In either case, 10-year government bond yields may stay above 4% in 2018 and corporate bond yields and other non-loan credit costs would still increase more than bank lending rates.

Thirdly, deleveraging will likely continue to tighten liquidity conditions.

The government's drive to deleverage was reaffirmed when senior officials spoke about containing financial risk after the Party Congress, and when the proposed rules on overseeing asset management products were recently released. Liquidity has tightened and market interest rates have moved up further.

With the upcoming inclusion of negotiable certificates of deposits in PBOC's Macro-Prudential Assessment framework in the first quarter of 2018, the implementation of the asset management product rules, rising inflation expectations, and with major central banks normalizing monetary policies, we expect credit-market liquidity conditions to remain tight - if not tighten further - especially in the beginning of the year.

Many asset managers will likely unwind some of their investment, or look for new types of financing to fund it, while the supply of corporate and local government bonds are set to increase.

Investors are worried that strict implementation of the current asset management product proposal might lead to massive unwinding of shadow bank and credit market assets, leading to severe liquidity squeeze and rate spike. Investors are also worried that banning channel businesses could lead to a sharp increase in defaults; and without guaranteed payment, there could be serious credit events.

The risk – of tighter liquidity, higher interest rates and more credit defaults – could be higher towards the end of 2017, around Chinese New Year as well as towards the end of the first quarter of 2018. But we think what may happen could be similar to June 2013, and any major market calamity is unlikely.

Since the government's main objective in deleveraging was to reduce financial-sector risk, regulators will likely adjust the degree and pace of regulatory tightening based on market reactions to avoid causing excessive market volatility.

We expect the PBOC to more proactively adjust liquidity offerings to the market to help keep rates from rising too abruptly or too much, and see increased dialogue and communications with market participants.

If growth slows more than we currently envisage or the government's growth target is threatened, we could see the government ease current tightening measures, including controls on infrastructure financing (for example, by allowing more issuance of project-specific local government bonds), and environmental and other types of production cuts. The government may also boost investment in rental housing and urban cluster development, as well as in new industries.

Wang Tao is a China economist at UBS

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