China in 2017: A Year of Uncertainty

Our global fixed income team discusses a wide range of issues facing China’s economy in 2017, from the selection of Xi Jinping’s successor, to relations with U.S. President Donald Trump, to the outlook for China’s One Belt One Road initiatives in Asian infrastructure development. With a number of macro forces in play, we conclude that the potential for volatility in China’s efforts of economic transformation and anticorruption still exists, but we also see a clear trend toward a weaker Chinese yuan renminbi. With much at stake, we expect policymakers to steer a course toward stability, with the idea that long-term planning by China’s policymakers outweigh many of the global risks.

China’s planned transition to consumer-led economic growth is proceeding, although in a year with notable political change in the wind. During 2017, as the Chinese leadership moves to establish a new relationship with the Trump administration in the United States, it also faces the important task of appointing a candidate to succeed China’s president Xi Jinping. Both events are noteworthy, and have largely unknowable outcomes.

In our view, however, while China’s economy will continue to be a source of volatility this year, it may be to a lesser degree when compared to 2016, or not as much as some may expect. China’s general path toward stability in both social and economic growth is well established, and we believe that the priority Chinese leadership places on staying the course in its economic planning and reform outweighs many of the external influences. In effect, China’s secular economic planning is a stabilizing factor, larger than seasonal politics. Certainly, however, politics and the economy are intertwined, as seen in the following summary of our views on China’s economy in 2017.

Progress in a monumental task

In 2016, economic growth in China was “managed” to a rate of 6.7%. That, of course, was a drop from the 7.0% growth rate in 2015. Meanwhile, exports declined 7.6% year-over-year in U.S. dollar terms in this same period. This figure excludes depreciation of the yuan against the U.S. dollar, which would make the export decline 1.78% (source: Bloomberg).

Some internal economic indicators showed China’s economy actually rebounding in 2016, more so than decelerating. For example, manufacturing, as measured by the Caixin Manufacturing Purchasing Managers Index — recovered from a contraction level reading of 49.4 in January to an expansion of 51.4 in December. Last year producer prices also reflated — from -5.3% year-over-year in January, to 5.5% in December (source: Bloomberg).

In many ways, the Chinese government has proven to be up to the monumental task of successfully slowing the economy’s growth trajectory in a measured way, while continuing its transformation, all amid an ongoing effort to take aim at reducing corruption. But let’s look at potential challenges ahead when it comes to continuing that careful balance over the next year.

Hurdles to maintaining a balance

One challenge lies in the levels of debt within the Chinese economy. These debt levels — including public, non-financial corporate, and personal debt — are continually deteriorating. For example, new yuan-based loans rose 8% in 2016, albeit at a slower rate than in the year before.

Meanwhile, capital flows that turned negative in early 2015 have continued on a general downward trajectory. Both personal and institutional debts continue to accumulate faster than the gross domestic product (GDP) growth rate. In order to service the debt efficiently, at some point in the medium term, China will need major fiscal reform, likely comprehensive reform, including the areas of taxation, public spending, and social welfare.

Currency trends

With all of this, the yuan deterioration against the U.S. dollar is not surprising to us. In the past few years, China foreign exchange reserves declined rather severely, from $513 billion in 2015, to $320 billion in 2016. In our view, both the yuan weakness against the U.S. dollar and the outflows of capital seem inevitable trends that should continue in 2017, despite the detailed guidelines in place that allow only $50,000 in annual currency transfers per person. We see the developments in many ways as a positive step toward a more balanced economy with sustainable growth.

That said, we do expect the trends to be volatile, as currencies can be expected to be heavily influenced by reactions to unfolding U.S. trade policies. Also, we need to factor into the volatility issues such as the U.S. Federal Reserve monetary policy, Chinese government controls of the capital outflows, the purely excessive target returns of some speculative investors, and the liquidity of dollar demand.

We suspect that China will go to great pains to manage the yuan in a way so as not to draw too much attention to the appearance of disorderly devaluations. The flip side, however, is that we expect bouts of dollar strength and consequently yuan exchange volatility throughout 2017.

Generally, we believe that as the yuan has entered its second year of inclusion in the International Monetary Fund (IMF) Special Drawing Rights currency basket, yuan stability will be restored as speculative market positions dissipate, and China grows more confident in controlling that market.

The global arena: Politics and policy

In the third quarter of 2017, China’s Communist Party leaders will need to identify a successor to Xi Jinping, as Xi begins his second and final five-year presidential term. To date, many outside observers have appeared to view this process as something of a non-event for markets, surmising that it doesn’t much matter who gets selected, given Xi’s current status and influence.

In October 2016, Xi was given the title of “core leader” by the Communist Party. This honorary title was bestowed only once before — upon party founder Mao Zedong. While it doesn’t come with any specifically delineated power, it clearly provides Xi a measure of special stature. Perhaps more importantly for markets, it sends a clear signal that Xi’s agenda and reform policies are expected to be followed.

It’s just another example, in our view, of how the policy course in China is often of the highest importance. Chinese leaders know that in order to ensure a smooth political transition, the government needs to maintain a relatively stable and healthy economic growth, using available policy tools.

For one, this means continuing Xi’s anticorruption efforts in 2017. Anticorruption reforms, like other reforms, represent something of a balancing act for China. Anticorruption efforts, which clearly tend to impinge upon China’s outsized growth, continued during 2016, but the number of cases declined, suggesting another policy that is being carefully managed.

One Belt, One Road

Perhaps nothing illustrates the scope of master planning quite like Xi’s One Belt One Road initiative (OBOR) that began in 2015. A major part of China’s current five-year plan, OBOR is a massive policy undertaking, aimed at allowing China to export its overcapacity, while fostering relationships with upwards of 60 neighboring countries around Asia and beyond. OBOR refers to a gradual reshaping of Asian trade routes by sea and by land, expected to come primarily through infrastructure development, effected via intergovernmental and public-private partnerships.

Notably, OBOR is also intended in large part to help kick-start the Asian Infrastructure Investment Bank, China’s first supranational bank and its alternative to the IMF. OBOR has the potential to affect 6.6 billion people, or 63% of the world’s population, and $21 trillion of the world economy, or 29% of world GDP (source: Xinhua news).