China 2014: The year to re-adjust GDP growth ambitions?

Is China on the verge of an economic crisis?

China’s monetary policy and the financial sector are facing winds of change, during which risks and uncertainties are raising questions and weighing on confidence towards the ‘Big Panda.’

At this juncture in China’s economic cycle, it is important to situate the challenges being faced into context and make a distinction on the type of key issues traders should pay most attention to in 2014. Are fears based on real fact-supported threats that may jeopardize the economy or are some of the worries somewhat overdone and exaggerated for the sake of creating headlines?

While China has been able to meet most of the demanding growth targets during the year 2013 (around 7.5% annual growth - not confirmed), top officials no longer shy away from the fact that China may slow down its GDP in 2014, as the economy faces complex structural challenges.

However, one should not forget that any setback on China’s 7.5% growth/year promises, as said, should be put into context, as the numbers would still show an impressively positive picture if compared to developed economic powers in the West. As years go by, the logic suggests that a gradual GDP reduction should be nothing else than a natural process. The real question lies at what pace China’s GDP deceleration takes place, therefore, looking at the divergences between actual and expected quarterly GDPs will be key.

One should not buy into alarming comments of softer Chinese growth in 2014 unless it comes well below 2014 consensus (around 7%).

On one side of the debate, economists are arguing that prospects for economic growth in 2014 are encouraging due to the reform agenda made by the recently concluded CPC meeting in November, which includes reforms to increase inland consumption, further urbanization to continue the transition from country-side areas into cities, easier accessibility to the local, develop modern agriculture, service, etc.

On the other side, the big risk lies on failure to adapt to the new economic landscape, one in which the current approach of generating gains by the mass mobilisation of capital and labour is no longer sustainable without profound reforms.

A pressing issue to address by China in order to prevent more dangerous risks from materializing is productive capacity in the country, far exceeding current demands. And with demand globally less than meet the eye by historic standards – yet sustained by the flooding of cheap money - , some analysts are talking about China’s unused capacity forcing prices to recede, leading to poorer returns on investment, which implies greater risk of companies filing for bankruptcy, thus causing undesirable consequences in bank’s balance sheets.

If that were to occur, consumers and entrepeneurs may be badly hit as banks become more rigid on lending practices, which in turn sees private sector investment slide while jobs may suffer, and ultimately see China only accumulating more debt as it tries to inflate the economy by monetary means outside other more morally correct such as fiscal tightening, which may result in a further setback in growth.

However, based on recent economic indicators in key industrial and manufacturing outputs, there is tentative evidence indicating that growth in the country is stabilizing.

Another major issue to keep an eye on for 2014 is the ballooning credit expansion. After the unprecedented level of credit access, measures are now being taken to curb lending practices, especially those known as shadow banking, in which trillions of total credit are extended by opaque non-bank financial institutions. Such “shadow channels” create significant risks to the economy as loans are given to low quality borrowers that can’t afford bank lending – sounds familiar? -, and since most of the shadow banking transactions are connected to banks, China has another potential recipe for disaster.

China is likely to crack down further on reducing aggregate financing in new yuan loans, with the ideal scenario by Chinese authorities being reduction in credit growth to instead produce additional growth in real activity, including domestic demand and exports. And even if stricter credit conditions make it harder to achieve 7-7.5% growth targets, there should be a realization that they need to minimize dangers of a financial crisis, which sometimes it requires to re-adjust one’s growth ambitions. Politicians in China are aware that the pace at which lending has soared since the GFC - overall credit has grown from $9 trillion to $23 trillion - can lead to unwanted consequences, as reference the late 1990s Asian crisis.

In a research paper published by International Monetary Fund staffers Malhar Nabar and Papa N'Diaye: "In other economies, credit expansions of this kind have often been associated with large mispricing of risk and a build-up of crisis vulnerability”, adding that “history suggests that failure to adapt … contributes to further macroeconomic and financial imbalances and ultimately ends in crisis.”

Whether or not China finds itself stuck in a destructive feedback spiral in the years to come or comes triumphantly stronger, the answer will be largely dependable on the ability of its leaders to push and implement reforms through in all areas of the economy and society while speeding up economic restructuring and public services.

How will the relationship between China and the US shape in 2014?

As per the relationships between the US and China, there is no major changes expected, as both countries rely way too much on each other’s economic and political stability to commit any foolish move that may lead to unwanted disruptions in what is perceived as formal/cordial ties. Yet one should rest assured that relations between the US and China will remain hugely complex, a mix of cooperation and contention.

As David Lampton, Director of China studies at the Johns Hopkins School of Advanced International Studies, brilliantly explains:

“Don’t ever expect a kind of nirvana of peaceful, cooperative productive U.S.-China relations. I can't see that. We're always going to have a complex mix of compatible interests and conflictional interests. We have a far different history, far different political system. I think we have to sort of get off this notion that its going to be easy to deal with the Chinese -- it's not. And the Chinese, incidentally, don't think it's easy to deal with us. But be that as it may, we have important interests with the Chinese, and we have to manage this relationship so we can get the maximally productive relationship, the most help we need on the most urgent problems. And we're going to have to subordinate some of other aggrievances.”

What consequences will the cap on China´s purchases of US dollars have?

A major development worth highlighting during 2013 was the surprising move by China to limit purchases of US Dollars, after the PBoC said it no longer sees any benefit in increasing its $3.66 trillion foreign currency reserves –the world's largest. “It’s no longer in China’s favor to accumulate foreign-exchange reserves,” said Yi Gang, a deputy governor at the central bank.

The action taken is a subtle intelligent move, intended, in large part, to help limit the depreciation of the Yuan, despite allowing a wider daily trading range in 2013 and knowing that they still keep accumulating USD, although at a lesser degree. Nonetheless, decreasing the influence of the US dollar and a basket of other currencies gets China a step closer to “float” its currency in the foreseeable future.

Against what some USD detractors may think, according to Marc Chandler, Head of FX at BBH: “This was not a policy indication as China appears to be still accumulating reserves. Moreover, while some pundits read this as a blow to the US, this has been the US Treasury position for a long time.”   

It is also important to highlight the growth rate at which the Yuan is being used in international transaction after a very large currency swap agreement with the Eurozone was struck earlier on the year, seen as a pivotal point to carry out further progress towards freeing up the Yuan in the international market in years to come. Back in June, China signed another major currency swap agreement with the U.K.

“The swap deal will allow more trade and investment between the regions to be conducted in euros and yuan, without having to convert into another currency such as the U.S. dollar first”, said Kathleen Brooks, a research director at FOREX.com. "It's a way of promoting European and Chinese trade, but not doing it with the U.S. dollar," said Brooks. "It's a bit like cutting out the middleman, all of a sudden there's potentially no U.S. dollar risk."

SWIFT said that the Yuan now stands as the 12th most used currency for transactions on its global payments system in October. 

The direction for the Yuan in 2014

While the Yuan is still dancing on its own, disconnected from free floating currency standards, it is inevitable that further down the road – 5 years appears to be the market consensus - it will fully enter the world’s currency markets.

However, the process will remain one in which huge doses of calmness are required, just in line with Chinese’ philosophy of life, one by which a great gift lies in the virtue of being imperturbably patient, a trait not as notorious - in general terms - in the life style of Western economies/policy-makers, more keen to rapid changes.

Overtime, expect China to increasingly move towards a managed float with more flexibility – almost 100% convertible -, but at this stage, critical reforms in China’s interest-rate system still pose some barriers that will take years to clear up, thus making a fully floating Yuan a 2018/2020 story.

Short term, the direction for the Yuan is expected to be one of gradual depreciation as the daily trading band widens, with some routinely small to mid-scale intervention conducted to prevent excess of speculation in the foreign-exchange market. As a reminder for readers, the central bank in China allows the Yuan to fluctuate around 1% above or below the fixing rate, which is set on a daily basis.

This would be very much in line with the latest comments from Zhou Xiaochuan, Governor of the People's Bank of China. "We will in an orderly manner expand the Renminbi (Yuan) trading band according to the development of the FX market and the economic and financial situation," Mr. Zhou said. "We need to strengthen the two-way flexibility of the Renminbi exchange rate and keep the rate at a basically stable and reasonable level”, he added.

As the market awaits for China to widen the Yuan's trading band from the current range of 1%, the fact that the currency has seen solid demand returning to the market near year-end, may potentially dissuade policy-makers from taking any hasty decision, thus, as mentioned, the Yuan will continue being a story in which lots of patience is needed.