After a long period of investment-driven growth, China is changing its policy playbook.
In recent months China has rolled out tax cuts and incentives to boost consumption over investment while taking steps to further open its capital markets – a shift in approach that seems to accept a natural slowing in growth over time and to acknowledge the costs of an overreliance on credit growth. However, the targeted nature of stimulus announced thus far, together with regulatory efforts to limit the adverse side effects of past and present easing, suggest a longer, more arduous process toward stabilizing growth.
We believe further policy measures, including monetary easing to complement fiscal stimulus, will be necessary. Moreover, with high debt levels constraining the government’s policy ammunition, exchange rate policy may end up playing a bigger role in stabilizing growth than in the past – and the way in which the yuan adjusts could have global consequences.
Lessons from the past
In many ways, China’s transition to a new policy playbook and slower growth rhymes with the rest of Asia’s historical difficulties balancing the competing objectives of external stability (reflected through stable currencies) and persistent, robust domestic growth.
A central lesson from the 1997–1998 Asian Financial Crisis was that rigid exchange rates were incompatible with rapid debt-driven growth. Access to cheap debt allowed fast-growing Asian economies to maintain high investment rates long past their due. Current accounts deteriorated; growth slowed in the face of currencies pegged to a sharply appreciating dollar; and eventually countries were forced to devalue their currencies as capital flows reversed and foreign reserves dwindled.
A decade later, in the wake of the global financial crisis, China likewise relied on easy credit to maintain high investment and growth rates. Aggregate debt surged to 270% of China’s GDP in 2018 from 150% in 2008, and the current account surplus fell from 9% of GDP to less than 1% over the same period.
Headwinds to stable growth
The state sector’s growing role in China’s economy and political sensitivities about using exchange rate depreciation to support growth add to the cyclical headwinds. Moreover, Western challenges to China’s participation in the global trading system and inconsistencies between its old and new policy playbooks have created uncertainty about China’s growth trajectory.
These uncertainties may give rise to negative feedback loops. Risk-averse lenders may shun private-sector borrowers that lack solid collateral in favor of loans to the state sector (due to their implicit government guarantees), reversing progress made toward reducing the role of the less-efficient state sector. A lack of alternative financial assets tends to herd savings into the property market, where high prices compel consumers to borrow more to buy property, denting consumption. And the bias toward infrastructure investment crowds out services spending (on education, healthcare and financial inclusion), thereby preventing the economy from producing what consumers want.
How to get out of a fix?
To be clear, we think the near-term risk of a crash or a crisis in China remains low. Despite limits imposed by higher debt levels, China retains plenty of tools, both fiscal and regulatory, to stabilize the economy.
However, any shift in routine comes with the risk of an accident, and we are particularly watching exchange rate management, which could constrain monetary policy from supporting stimulus efforts. China is currently unwilling to ease monetary policy out of a reluctance to accept currency depreciation, in part for geopolitical reasons but also recalling its negative experience with currency flexibility in August 2015. But with debt service costs now equating to 70% of the total monthly flow of credit, we believe interest rate cuts have become imperative.
The risk can be summed up in a single chart (see below). The ratio of China’s M2 money supply (cash in circulation and short-term monetary liabilities) relative to foreign reserves has reached levels not seen since the early 2000s. Unless capital controls are perfectly binding, the rising ratio highlights a dearth of foreign dollars to help stem potential domestic capital outflows and maintain a stable currency. The lesson from the Asian crisis is that when this ratio rises, so does the risk of a sharper exchange rate adjustment. The catalyst is typically a significant slowdown in GDP growth.
In sum, we believe if China fails to ease monetary policy as a complement to fiscal stimulus, it risks falling into a trap similar to what befell its Asian peers in the late ’90s. To avoid a sharper, more destabilizing fall in the yuan, we believe it is necessary to stabilize growth quickly, before doubts about the economy’s longer-term trajectory deepen.
For more of our views on factors driving investment in Asia, see “Asia Market Outlook 2019: Recovery, Rebalancing and Rotation.”