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Global Economic Outlook
China: 2011 Outlook
By Adam Wolfe and Rachel Ziemba
- The hangover from China’s fiscal and monetary stimulus is beginning to set in, with inflation rising and growth slowing.
- Fighting inflation will be the primary goal of monetary policy for at least the first half of 2011, though we do not expect an excessively restrictive lending quota for the banking sector.
- On the bright side, private consumption may finally start to drive China’s growth in 2011.
Growth Dynamics: The Hangover
China achieved a soft landing in 2010 as policy makers began to wind down the “modestly loose” monetary policy implemented in late 2008. In 2011, the hangover from the massive stimulus will set in, in the form of higher inflation and weaker growth. Since our September Outlook update, we have tweaked our forecasts for 2010 and 2011 to reflect stronger-than-anticipated growth in Q3, higher inflation in Q4 and a revision to our U.S. predictions. More resilient growth and stronger inflation will require more tightening from Chinese policy makers in 2011 than we had anticipated previously. We now expect at least 100 basis points (bps) of interest rate hikes by the end of 2011.
Figure 1: Chinese Growth to Moderate in 2011
Source: National Bureau of Statistics, RGE
Investment continued to buoy the economy in the first three quarters of 2010, contributing 6.3 percentage points (ppts) of China’s 10.6% growth rate. Next year we expect the contribution from investment to decline to about 4.3 ppts as the fiscal stimulus wanes and credit growth faces tighter constraints. Rising wages and deposit rates will benefit private consumption, while increased social spending by the government will limit fiscal consolidation in 2011. Total consumption will provide around 4.2 ppts of growth, and net exports should add 0.2 ppts. As a share of GDP, China’s current account surplus will decline from nearly 6% in 2010 to less than 5% in 2011, helped by an appreciating RMB.
Though our forecast for 2010 growth matches the Bloomberg survey consensus, we are anticipating a slightly sharper 2011 slowdown: Our forecast is 8.7%, while the consensus is 9.0%. Our somewhat bearish outlook for 2011 is based on our assumption of a balance-sheet-constrained recovery in advanced economies and our long-standing call for China’s investment growth to slow. Investments in low-income housing and the service sector will only partially offset the slowdown in infrastructure building, while higher dividend payments from state-owned companies and energy restrictions will constrain investments in heavy industry. We expect fixed-asset investment growth to slow from about 24% in 2010 to around 20% in 2011.
Although private consumption growth may narrowly outpace China’s overall growth in 2011, the benefit to global rebalancing will be minimal. Private consumption will benefit from rising wages and the government’s plan to expand the supply of low-income housing. A smaller boost will come from rising interest rates and policies to rebuild the social safety net, detailed in the Five-Year Plan set to launch at the start of 2011. Investment will decelerate faster than China’s savings rate, resulting in a nominal increase in the current account, though it will fall as a share of GDP.
Despite the higher cost of wages and stronger RMB, Chinese goods will remain competitive in 2011, and we expect exports to increase nearly 15% in nominal USD terms. Emerging markets will absorb most of the new exports. China’s import bill will increase by a similar margin, led by energy imports as underlying demand and official stockpiling continue. As investment growth slows, base metals and other construction-related commodity imports will see only marginal gains. Trade’s net effect on growth is likely to be marginally positive in 2011.
Figure 2: China Looks Beyond the G3 for Export Growth (USD, bn, trailing 12m sums)
Source: General Administration of Customs, RGE
Risks: Watch Those Banks
There are two mutually exclusive upside risks to our forecast for 2011: looser-than-anticipated credit conditions and stronger-than-anticipated consumption growth. New bank loans probably will decline to about RMB7 trillion in 2011 from about RMB8 trillion in 2010, pulling lending growth down to 14.7% from 19% in 2010. Though policy makers may seek a slightly lower target for lending growth, we doubt they would stick to such a target past midyear, as doing so would result in more nonperforming loans (NPLs) and put growth at risk.
Conditions seem ripe for a surge in private consumption in 2011, which could overshoot our expectations. Still, conditions for a consumption boom—rising wages, better access to credit, an improving social safety net—have been present for years in China, but private consumption has fallen as a share of GDP. This time may be different, but it is unlikely to be that different.
The downside risks to our forecast are largely centered on the banking sector. We applaud the efforts of the China Banking Regulatory Commission (CBRC) to get ahead of the coming surge in NPLs, with stress tests on real estate and local government lending, but we worry the increase in provision requirements may not be enough. There will be at least RMB1.7 trillion in new NPLs by the end of 2013, which could raise solvency questions about the banking sector in the coming years.
Financial repression looks to be mutating but not disappearing, which may also put the banking sector at risk in the medium term. The narrowing of the spread between the minimum lending rate and maximum deposit rate for longer-dated maturities in October 2010 was a positive step toward removing the main subsidy for banks. Yet, with required reserve ratios (RRRs) at record highs, we have to ask ourselves whether China intends to reform or destroy its banks. In 2010, the People’s Bank of China (PBoC) all but abandoned open-market operations and instead hiked RRRs for the state-owned banks in order to lower the sterilization costs of its FX purchases. With China’s current account surplus expected to increase slightly in 2011, the PBoC may hike RRRs to more than 21% from the current 18.5% for China’s largest banks. Forcing banks to keep nearly a quarter of their deposits at the central bank, where they earn less than 2%, will only push them into riskier loans to defend their net-interest margins.
Figure 3: PBoC Relying More on Reserve Requirements for Funding (RMB, tr)
Source: PBoC, RGE
China’s broad money supply (M2) has increased 54% since Lehman Brothers collapsed in September 2008, well in excess of the 24% increase in nominal GDP, unleashing inflationary pressures that will prove difficult to contain. Nearly all of the increase was due to the government’s loose monetary policy, not hot money inflows, which only picked up after the M2/nominal GDP relationship had normalized. Instead, a 58% increase in bank lending was the main driver of M2 growth. Putting this genie back in the bottle will be nearly impossible without a surge in NPLs, a decline in GDP growth and probably a recapitalization of the banking sector. Chinese policy makers will likely opt to muddle through with a mix of higher inflation and weaker growth for the next few years.
Localized bubbles in luxury real estate pose another risk to future growth, but not to China’s financial sector. There are numerous explanations for China’s luxury real estate prices skyrocketing in recent years—negative real interest rates, massive stocks of “grey” income, few alternative investment options—but the notion that empty apartments can be used as a store of value will be proven false when investors try to realize their gains. A property tax could encourage investors to do so in 2011, but we doubt it will be set high enough in the trial phase. Future investment and construction would be hurt, but not the domestic financial sector, as buyers paid with cash and developers have been raising more funds abroad. A drop in land values, if broad-based, would be troubling for China’s financial sector, however.
Policy Implications: ‘Prudent’ Monetary, ‘Proactive’ Fiscal
Between the conclusion of the Central Economic Work Conference in mid-December and the end of 2011, the PBoC will impose at least four additional 25-bp hikes as China shifts to “prudent” monetary policy. Some of these hikes may be asymmetrical to narrow the margin between lending and deposit rates, which would discourage credit growth, give more bite to price signals and protect against the erosion of deposits. However, deposit rates would need to increase by 200 bps for the real rate of return to move into positive territory. Banks also will face higher RRRs in 2011, possibly including a mandate to keep a portion of their reserves in foreign currency. Considering that banks already face record RRRs, hikes may be limited to 100 bps. The PBoC will have to resume its open-market sterilization efforts in 2011 and pay higher yields on its bills.
Figure 4: Food Prices Drive China's Inflation Cycle
Source: National Bureau of Statistics, RGE
The RMB is likely to appreciate 4-6% against the USD in 2011 to help contain rising inflationary pressures. In real terms, RMB appreciation will be nearly 10% due to rising unit labor costs in China. The number of currencies against which the RMB is allowed to trade will continue to increase, but the crawling peg probably will not shift from the USD to a real basket of currencies. Policy makers will make it easier for Chinese companies to hold USD abroad, and RMB use for current account transactions will increase in Asia and among commodity exporters. Still, given the U.S. monetary stance and expectations for a stronger RMB, capital will continue to flow to China, requiring the PBoC to buy USD assets in 2011.
Despite the removal of the stimulus measures launched in late 2008, China’s fiscal policy will remain relatively loose. We expect a fiscal deficit of about 2.2% of GDP in 2011, down from about 2.8% in 2010, with a greater emphasis on social spending and less on infrastructure. New mechanisms for local governments to tap capital markets directly, instead of selling bonds through the Ministry of Finance, could be launched in 2011. This would be supportive of growth, but, given that state-owned banks would be the main buyers, it would do little to abate risks to the financial sector from overstretched counties and municipalities.