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China’s recent economic revival looks set to reverse
Although China broadly appears to be less impacted by Brexit, it’s still likely to bias the country to ease monetary policies further to support growth, which could pressure China to allow further depreciation of the renminbi, but at a relatively gradual and moderate pace.
Cem Karacadag and Kristine Li 29 Jul 2016
 
     
China’s recent economic rebound may be short-lived. Despite the better than expected performance of the Chinese economy so far this year, serious questions still exist around the sustainability of its rebound. Improvement appears to have come from the “wrong” sources, namely infrastructure and property. 
China’s economic problems stem partly from a structural imbalance in the economy: the government-controlled banking system allocates most of its resources to the less efficient state-owned companies, resulting in high and rising leverage, poor profitability of the corporate sector and less than optimal growth.
Failing to address these problems and facing the pressure of maintaining short-term growth, China has to repeatedly resort to the “old ways”: providing debt-financing to sectors that may not yield the highest returns and keeping alive state owned companies in sectors with excess capacity and low or no profitability.
If China continues down this path, the country will likely compound the structural imbalances in its economy and fail to sustain current growth rates. China will therefore remain a risk factor for commodity demand, global growth outlook and risk sentiment.
Babson sees six main issues that China is currently facing in its economic situation:
1. The rebound in activity has failed to stem the decline in private sector investment and sentiment
Government-led infrastructure and property investment, fueled by cheap credit to SOEs and individuals, have been the primary sources driving China’s recent rebound. In contrast, the private sector has stayed on the sidelines, as reflected in the sharp divergence of fixed asset investment growth between the public and private sectors. While the government has pursued a rather accommodative monetary policy, banks have remained risk-averse, preferring to make collateralized mortgages or lend to the government rather than businesses which are perceived to be too risky.
 
 
2. The property market rebound highlights the imbalance of the sector
In our opinion, home purchases have been much more investment driven during this recent rebound. In contrast to Western and Central China (areas with high inventories and bearing the bulk of real estate investment), the first and some second-tier cities are recording rising prices.  This was driven by a combination of cheap mortgages with lower down-payments, a lack of alternative investment options and the expectation of continued government policy support to sustain the property market.  This has driven up land prices, meaning that condo prices will have to rise significantly to justify current land prices for developers.
In effect, credit is fueling speculative home demand, secondary market activity and higher prices in places that have less potential for more real estate investment, aggravating the structural imbalance in the property sector. Our assessment is that this is unlikely to become a sustainable source of growth for China’s real estate investment.
3. SOE reforms are more challenging than expected
In recent years, the government announced several structural reforms, including restructuring inefficient SOEs. Yet progress has been disappointing because consensus around implementation plans and the commitment to execute them have been lacking. Shutting down excess capacity and closing SOEs would be politically costly to the central and local governments, meaning that the banking sector would be required to deal with the bad debts incurred by loss making companies accumulated over the past decade. As a result, the government and banking system are left to face the adverse consequences: SOE profits keep falling and their leverage keeps rising.
4. The banking sector is highly correlated with the economy and policy
Non-performing loans (NPLs) have risen from a very low base of 0.96% three years ago to 1.75% as of March 2016. NPLs could rise substantially if the economy slows and banks decide to no longer support the loss-making SOEs. Although the banking sector is highly exposed to the property sector, the imbalances in the sector are not a large risk factor for the financial system for now: loan-to-value ratios are still low and even though third and fourth-tier cities with high inventories account for most of the construction activity, it is first and second-tier cities represent the bulk of the value in the Chinese property sector.
5. Policy consensus and stability are weak
China is lacking strong consensus on structural reforms and policy management. It has stuck to its old ways: pumping more credit into infrastructure investment and SOEs to sustain growth at levels that are likely to be unsustainable in the long run. More recently, the government started openly debating its policy credit-fueled output growth, reigniting concerns of a hard economic landing. Less unified, less coherent policies have caused many local observers to lose confidence in economic management and policy consistency. As a result, concern is growing that the recent rebound will last only a few quarters.
6. China likely to depreciate its currency, but only gradually
We believe that the Chinese government wants a weaker currency, but only gradually, so as to not create the negative side effects of a loss of investor confidence and capital flight. What pace of annualized depreciation might that be? Our forecast would be for a 5% annualized depreciation, all other things being equal.  We think the PBoC can control the pace of CNY depreciation, rather than be overwhelmed by market forces.
Conclusion
Our analysis leads us to conclude that China’s recent economic revival looks set to reverse course in the quarters to come.  Although China broadly appears to be less impacted by Brexit, it’s still likely to bias the country to ease monetary policies further to support growth, which could pressure China to allow further depreciation of the renminbi, but at a relatively gradual and moderate pace.
In terms of emerging markets (EM), we believe most EMs are well positioned to handle a potential China slowdown. If China slows down significantly, EM FX could face some weakness as currencies adjust to the cycle. Most of their sovereigns and corporates are strong enough to weather more headwinds; only a select few with direct links to China that are poorly managed will suffer materially.
 
Cem Karacadag is co-manager of Babson Emerging Markets Sovereign & Local Debt Group while Kristine Li is a member of Babson Emerging Markets Corporate Debt Group 

 

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