News in Charts: Xi’s second term will not lead to ‘good rebalancing’

According to our China Momentum Indicator 2.0 (CMI 2.0), real economic growth in China rose to 7.3% in the twelve months to August. At a five-and-a-half year high, this marks a significant rebound from the trough of 2.4% in September 2015. This pick-up in economic activity will have been actively encouraged by President Xi Jinping in the lead up to the Communist Party’s twice-a-decade National Congress, scheduled to take place on 18 October. Putting on a show of prosperity ahead of this will have been seen as mandatory amongst government officials trying to gain favour with Xi, who will begin his second five-year term as party chief.

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However, at what cost? Of the ten indicators included within our CMI 2.0 (see Fathom Consulting, ‘Our expanded China Momentum Indicator shows growth rebounding – for now’ for a detailed look at our CMI 2.0 indicator), half have expanded at significantly higher rates than in the slump of late 2015: railway and port freight, electricity consumption, real imports and the commodity price index. Meanwhile, growth in those indicators representative of the services sector of the economy remains subdued. This supports our call first presented to our clients in a note in the first half of 2016 (see Fathom Consulting, ‘China’s growth is bottoming out’) that Chinese policymakers have doubled down: recommitting to the model of export- and investment-led growth rather than a reorientation towards the consumer.

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This amounts to a continuation of credit being channelled to unproductive assets within the economy. As we explained in a note sent to clients (See Fathom Consulting,’Productivity puzzle the drugs won’t work’), the accumulation of non-financial debt beyond 250% of GDP stops being effective and starts to damage growth significantly. China passed this point in the third quarter of last year.

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When China’s policymakers said at the beginning of this year that the time had finally come for them to “rein in financial risks”, many took them at their word. At the time, we described this as merely a new chapter in China’s love-hate relationship with credit (click here to see the full note), anticipating that if and when growth fell substantially below the government’s comfort level, the monetary taps would be turned back on. As if on cue, at the beginning of this month, the People’s Bank of China (PBoC) announced the reserve requirement ratio (RRR) will be cut by between 0.5 and 1.5 percentage points at the beginning of next year. Although packaged as a way to encourage lending to small and agricultural businesses by applying the cut only to those banks who lend more to these types of firms, the threshold for eligibility is so low that the PBoC admits there will be few exemptions. So this is really a loosening of liquidity across the economy.

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We agree with the rationale behind the PBoC’s latest move, diverting credit to more efficient firms, not those most closely linked to the state. However, in reality this policy is unlikely to have much of an impact. The ethos introduced in the first Five Year Plan (FYP) in 1953, that large state-owned enterprises (SOEs) should play a central role to the economy, rather than small independent ones, remains intact today. Although a third of industrial firms partially or wholly owned by the state are operating at a loss, they continue to benefit from preferential access to finance and an implicit government guarantee due to the state’s reluctance to allow the forces of creative destruction to eliminate unprofitable firms, prioritising social stability instead. (For more, please see Fathom Consulting, ‘Too close to the state to fail’) Those hoping that Xi Jinping’s second five-year term as party chief will lead to significant progress in tackling overcapacity are likely to be disappointed. Our central forecast for the long term, relating to 2020-25, is for growth of around 4.5%, ending the period close to 3%, as maintaining the tactic of low consumption and continued investment in unproductive assets results in a falling return on capital which undermines growth. Of course, the authorities, under instruction from President Xi Jinping, will likely continue to report faster growth.

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