19 April 2017

The Chinese economy in 2017 – stability is key

Ahead of China’s most important political assembly in five years, Beijing wants to ensure that there are no economic surprises.

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There is one theme that will dominate the Chinese economy throughout 2017 – stability. Towards the end of the year, the Communist Party of China will hold its 19th National Congress – a key political event held every five years that typically involves a reshuffle of top-level leaders.

Ahead of the Congress, officials across the country will be working hard to make sure that there are no surprises that could overshadow the meeting. The drive towards stability will therefore be felt in every aspect of the economy.

In addition to maintaining steady economic growth, the government will be trying to avoid shocks in the financial system, as well as ensuring that there is no volatility in the exchange rate.

"The question we need to ask is how easy is it for this policy to be achieved," said Qu Hongbin, Co-Head of Asian Economic Research and Chief Economist, Greater China HSBC Hong Kong.

Mr. Qu was speaking at HSBC’s Asian Outlook & RMB Forum, held in Kuala Lumpur, where his outlook for the Chinese economy in 2017 focused on the challenges that Beijing faces in achieving a stable year.

He started however, with the positives. There is an ongoing reflationary story underway in China, as the year started with a rebound in the producer price index (PPI) and stabilization in the consumer price index (CPI), at around 2.5 per cent year-on-year growth.

This is a sharp change from just one year ago, when the economy was slowing, inflation was low, and some observers were even discussing the possibility of future deflation. PPI, which is a proxy for the corporate sector’s pricing power, was contracting; while CPI was increasing little more than 1 per cent year-on-year.

Deflation has eased

"The risk of China falling into a deflation trap has significantly reduced," said Mr. Qu, who described the pick-up in inflation as the most important positive development for the Chinese economy in 2016.

Also on the plus side, there has a recovery in nominal GDP growth, which is highly relevant to the corporate sector as it suggests that there is a similar trend in revenue growth, and is another indicator to show that the pricing power of companies is increasing. Furthermore, profitability in the industrial sector has improved, which should make it easier for companies to service any debt they may have.

It is not all good news. "The economy still faces challenges," said Mr. Qu. "So in order to maintain stability in the economy, the government needs to work hard against a number of headwinds."

One cause for concern is overseas trade, as exports have been weak for more than a year. The rising chance of protectionist policies in the US, means that the situation will remain difficult for companies that are reliant on foreign markets.

Another area that attracts considerable attention is China’s property market, with housing prices enjoying a strong recovery in 2016. The fear is that cost of real estate has risen too quickly, increasing the likelihood a sharp correction in the market. The problem is most evident in China’s most developed cities – such as Beijing, Shanghai, and Shenzhen. As a result, local authorities are already imposing purchasing restrictions to cool down the market.

Mr. Qu predicts that demand for housing will soften in 2017, but that a serious collapse in prices is only a remote possibility. The most serious issue lies in the first-tier cities, which account for around 30 per cent of total housing sales. If one third of the market corrects, he said, while property prices in the rest of the country enjoys gradual growth, the net result on the overall market will be moderate softening.

Housing prices: not a national rally

"Even a modest correction in the housing market is likely to import downside risk to investment demand," said Mr. Qu. "The government needs to find additional demand somewhere else within the economy in order to offset any correction in housing."

The investment gap left by a weaker property market could be filled by the private sector, said Mr. Qu. But the problem is that business sentiment remains low. Not only are companies facing weak export demand, the cost of doing business remains high – especially with regards to labour costs and taxes.

All this restrains profitability, which in turn disincentives companies from expanding their business. This is not to say that firms have stopped investing completely, as there is an ongoing trend of overseas investment, with Chinese companies completing a large number of foreign acquisitions in recent years. Beijing needs to find a way to redirect this offshore investment towards domestic projects.

"When confidence in the local economy improves, there will naturally be less willingness to invest in the overseas market," said Mr. Qu.

Domestic private investment has decelerated sharply while outbound investment is surging

From a monetary policy point of view, there is not much that the government can do. Lower interest rates could boost business sentiment, but Mr. Qu said that the People’s Bank of China has already missed the window to cut rates further, as the US dollar has firmed up and the US Federal Reserve has already started to hike rates.

There is more room to manoeuvre in fiscal policy. On top of maintaining strong infrastructure investment, the government could deliver a meaningful reduction on the corporate sector’s tax burden. The employer’s contribution to employee social security in China, pension and medical care, is the highest in the world – accounting for approximately 40 per cent of the total wage bill.

With a fiscal deficit of around 3 per cent and government debt still below 50 per cent of GDP, the government is in a strong financial decision to offer tax cuts, which would make the business community more assured about making domestic investments – especially among small to medium sized enterprises.

In addition to a short-term boost, tax cuts also relate to more long-term economic developments. Revamping China’s substantial state-owned enterprises is much-anticipated reform that is essential to maintaining healthy economic growth over the coming years.

By eliminating inefficient SOEs, the banks that lent these so-called zombie companies money will be forced to recognise bad debt, said Mr Qu. "The earlier you allow a bank to recognise a bad loan, the better. The more delays, the greater the problems in the systems".

The biggest downside to closing SOEs is the potential of mass unemployment, as many workers will lose their jobs. Tax cuts could help by increasing the willingness of the private sector to hire new employees, thus offsetting some of the negative impact of reform. Continued infrastructure investment will also help absorb laid-off workers, as labourers will be needed to construct everything from railways and subway systems to airports and port facilities.

"A combination of fiscal expansion with fiscal reform is in my view the only solution for China’s near term and mid-term challenge," said Mr. Qu. If the government can implement both these measures, it will not only be able to enjoy stable economic growth of around 6.5 per cent in 2017 but also in the years to come, he said.

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