China's Economy: Touching Bottom, Mild Recovery

  • China’s economic growth has bottomed out but in view of pending headwinds we do not expect a steep recovery.
  • We think that despite various risks China should be able to grow 7.5-8.5% in 2013 in a range of scenarios as the government still has space to ease the macro stance if needed. In our base outlook, the macro stance remains supportive to growth but major stimulus is not forthcoming.
  • Despite a desire for more market-oriented financial policies, we expect that – in the face of re-emerging balance of payment surpluses – the PBOC is likely to step up intervention in the FX market in 2013 to prevent the CNY from strengthening too much.
  • We do not expect a rapid change in the orientation of economic policy or speeding up of implementation of reforms after the leadership transition, although the government could possibly formulate a more comprehensive approach to rebalancing the pattern of growth.
The economy at end-2012
Looking at the drivers of growth, a fall in exports in November reduced the sequential momentum after a pick-up in export levels in earlier months, although we expect exports in real terms to be up 7.6% on a year ago in the fourth quarter of 2012. Exports to high-income countries, particularly to the EU, continued to be weak recently, while those to emerging markets have held up much better.
Domestically, fixed-asset investment (FAI) growth has remained solid, supported by a bottoming out of real estate investment growth and a comeback of infrastructure investment buoyed by the acceleration of project approvals and accommodating financial conditions.  But weak infrastructure investment in November calls for caution.
Corporate investment – which makes up half of total FAI – has been weighed down by spare capacity and weak profits in many manufacturing sectors.  The profit weakness has been caused by a price squeeze, absorption of an involuntary build-up of inventories, and wage-cost pressure reflecting a divergence of wage and productivity growth.
Profits picked up year-on-year in October, but the recovery is not likely to be steep. Household consumption has remained robust, buoyed by solid wage growth on a still-healthy labour market. Amid these expenditure developments, industrial production growth rose from a trough of 8.9% in August to 10.1% year-on-year in November.
Meanwhile, some progress has been made with destocking in industry after the involuntary build-up of inventories earlier in the year, although the destocking still has further to go. In all, headline year-on-year GDP growth slowed further in the third quarter to 7.4%. However, sequential (quarter-on-quarter) GDP growth rose in the third quarter, after having troughed in the first half of 2012.
Inflation has remained low despite a recent pick-up in food prices. Notwithstanding subdued exports, the trade surplus is on course to rise from US$158 billion in 2011 to US$224 billion in 2012 (on a customs basis), as imports also have been weak and the terms of trade shifted in China’s favour in 2012 due to soft commodity prices.
The outlook for 2013
Two key features underlie our growth outlook for China in the coming years. First, with ample room remaining for productivity catch-up and domestic growth drivers still in place, potential GDP growth remains robust, although it is trending down gradually from around 8.5% now to 8% in 2015 and 7% in 2020.
Second, China’s macroeconomic vulnerability – which could lead to turmoil and a downturn in spite of growth drivers – remains fairly low, even if macro robustness is lower than four years ago.
Our medium-term outlook is anchored by a supply-side-oriented framework that incorporates the impact of future demographic trends and its impact on labour accumulation, assumes some rebalancing and its influence on capital accumulation and calibrates total factor productivity (TFP) growth with an eye to the experience in other East Asian countries.  
In our view, indicators on overall fiscal and external sustainability as well as ample national savings imply that risks stemming from local government debt, banks’ balance sheet problems, shadow banking and housing market vulnerabilities are unlikely to cause systemic macroeconomic problems.
Nonetheless, leverage in China’s economy has risen in recent years. Our simple estimate of overall leverage, using the central bank’s total social financing data excluding equity and bonds, stood at 164% of estimated 2012 GDP at end-November, compared with 119% in November 2008.
Although the bulk of that leverage is between domestic parties and total leverage in countries such as the US, Japan and South Korea is significantly higher, the rapid increase in leverage has rightly affected the appetite in Beijing for stimulus. Policymakers are emphasising the negative effects of the 2008-10 stimulus, especially local government debt, bank balance sheet weaknesses and higher housing prices.
Looking ahead, we expect sequential (quarter-on-quarter) GDP growth to pick up in 4Q 2012. Given several headwinds, we do not expect a steep rebound in growth, but the modest sequential recovery in 2H 2012 supports the growth outlook for 2013. On a whole-year basis, we expect GDP growth of around 7.6% in 2012 and, with a modest recovery, of around 8% in 2013.
Inside the forecast
Moving to the specifics, in our view the global outlook is more constructive than it was a year ago, with financial risks having receded. Nonetheless, we think exports will continue to face headwinds in 2013 from the subdued global growth outlook, especially shipments to the EU, China’s largest export market, even though emerging market demand strength partly compensates for that.
Assuming global import growth of 4%, compared to 2.7% in 2012, and global market share gains as in 2012, we project 6.8% export growth in 2013 in real terms.  
Domestically, we expect fixed investment to grow 8% in 2013 in real terms after 8.5% in 2012 (according to the national accounts definition that we find more meaningful than the inflated FAI growth numbers). Real estate investment is likely to benefit from increasing housing sales and real estate activity.
Infrastructure investment should remain robust, supported by a favourable approach in Beijing to project approvals and accommodating financing conditions. However, we think infrastructure spending will be curtailed by the financial constraints of many local governments and the more cautious attitude in Beijing about stimulus.
We think growth of corporate investment will face some downward pressure from spare capacity and lower profitability. Positive year-on-year profit growth in industry in October suggests that the worst is over, but we do not expect a steep rebound in profit.
While destocking in industry is not yet finished, we expect investment in inventories to contribute to growth in 2013, after having subtracted in 2012. While we expect consumption growth to remain solid, it is set to moderate in the coming quarters because we expect wage growth to decelerate from the rapid pace in 2012, given the subdued profit situation and modest growth outlook.
In our view, inflation is likely to rise moderately. Having receded to around 2% in recent months, we expect it to rise, largely because of an increase in global corn and soybean prices earlier this year and the formation of a new pork price cycle.
However, global raw commodity prices have retreated recently, including those of corn, soy beans and oil. Also, in our view, the still fairly subdued global economic outlook and spare capacity in many manufacturing sectors globally and in China are set to dampen price pressures and we expect the rise in CPI inflation to remain contained to around 3.5% by end-2013.
Macro policies
Our outlook for 2013 assumes a broadly unchanged macroeconomic policy stance, with continued support for growth but no major stimulus forthcoming. Preceding the December Central Economic Work Conference, the Politburo meeting of early December called for broad continuity in the macro stance, including for fiscal policy to remain “proactive” and monetary policy to remain “prudent,” in line with our view that the leadership change has had no major impact on the macro policy stance.
In the monetary area, we expect the People’s Bank of China (PBOC) to continue to opt for low-profile ways to support growth, such as condoning active shadow banking and injecting liquidity via open market operations as long as growth prospects remain decent. If prospects were to deteriorate significantly, we would expect more high-profile steps such as lowering reserve requirement ratios. The pending uptick in inflation makes interest rate cuts less likely, in our view.
In the fiscal area, in addition to the constructive attitude to approval of infrastructure projects, we expect the budget for 2013 to be approved by the National People’s Congress in March 2013 to include some measures to boost household income and consumption and to support SMEs. We also expect something on improving the “income distribution mechanism,” although the latter is unlikely to lead to macro-economically significant measures, in our view.
The renewed enthusiasm in the real estate market has made relaxation of tightening measures there less likely.
Our medium-term macro and exchange-rate framework suggests that the renminbi will have to appreciate trend-wise by some 1.8% per year on a real effective basis to prevent the current account balance from swelling again, which implies around 2.5% vis à vis high-income countries such as the US.
But what does this mean for the Chinese currency in 2013?
In 2012, the PBOC had at times allowed the exchange rate to respond to market pressures, leading first to an appreciation against the US dollar and later to a strengthening. In our view, policymakers would, over time, like to move to a more market-oriented exchange-rate regime, both for its own sake and in order to help promote the internationalisation of the RMB. We also think policymakers would, if possible, like to see more two-way volatility.
However, we think pressures on the FX market will complicate movement in that direction. In our view, balance of payment pressures will rise again after a temporary lull, since the apparent “outflows of hot money” are temporary. These are caused by arbitrage in response to changing exchange-rate expectations amid increased leeway offered by the setting of RMB internationalisation, while the underlying drivers of balance-of-payment surpluses – current account surpluses and net inflows of FDI – are set to remain large.
Indeed, we project a rise in the current account surplus to 3.6% of GDP in 2012 and 3.9% of GDP in 2013. Since we believe real economy considerations remain paramount in the setting of financial policies, we expect the pressures to lead to continued heavy management of the exchange rate.
The biggest risk to our outlook is still a larger global downturn combined with financial turmoil. The main domestic risk is probably weaker corporate investment. Clearly, in such scenarios, we would expect the macro policy response to be more forceful, with more monetary easing, possibly more infrastructure investment and less appetite for a stronger CNY. There are also upside risks, including a possibly better global environment.
What about the politics?
Senior positions in the Communist Party of China (CPC) changed hands after the 18th National Congress in early November, but it will take until March 2013 before the top government positions will change hands and also a while before the new leadership will start to make its mark on economic policy.
The impact of new leaders on policymaking and reform is easily overestimated. China has increasingly moved to collective leadership and consensus-based policymaking. Also, the political economy of reform will not change easily while the Five Year Plan (5YP) provides further continuity.
 The objectives of 12th 5YP that kicked off in March 2011 can be summarised as (1) transforming the pattern of growth more towards consumption and services and (2) upgrading the industrial structure and moving up the value chain. Its significance for the orientation of policy is underscored by the fact that the report presented by President Hu Jintao to the 18th National Congress of the CPC on 8 November followed it quite closely.
To combine rebalancing, upgrading and sustained growth China needs reforms to (1) channel resources to new and growing sectors and products and services and (2) support more full migration, so that migrants can behave and spend like urban citizens.  
So far, progress on this agenda has been mixed. There is progress in areas such as financial reform and raising the government’s role in health, education and social security. But there is little movement in areas such as levelling the playing field between state-owned enterprises and other firms, and reforming the intergovernmental system to ensure that local governments have the resources and incentives to provide public services to migrants – areas where political economy issues are key.
In our view, in China as in other countries, ideological issues and resistance from vested interests are key factors explaining this differential progress, and will continue to play an important role.
Given the starting position and challenges, expectations of a rapid implementation of outstanding reforms are likely to be disappointed. However, new leaders have some room to put their stamp on the reform process.
Li Keqiang, who as the likely new premier will lead economic policymaking, has written and spoken quite a bit about boosting the role of domestic demand, and the key role of more balanced urbanisation and social policies as part of an overall rebalancing and restructuring strategy. Given these views, the new government could possibly outline a more ambitious and comprehensive approach to rebalancing, restructuring and full urbanisation.
About the Author

This article is excerpted from “The Year Ahead Asia: A More Constructive 2013," a report by Royal Bank of Scotland and affiliated companies that was published on 18 December 2012. It has been re-edited for conciseness and clarity.