China in 2017: Why Stability – not Growth – Is the Goal

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Political transitions on both sides of the Pacific will figure heavily in China’s efforts to keep its economy on track in 2017. Uncertainty over what U.S. President-elect Donald Trump will do with trade policy once he takes office is overshadowing the outlook for China and the rest of Asia in myriad ways. At the same time, China has its own politics to consider: With the once-in-five years Communist Party Congress coming next fall, the leadership in Beijing will be hell-bent on keeping growth on an even keel.

President Xi Jinping looks set to stay on for a second term, but five of the seven members of the powerful Politburo standing committee are due to retire. “The Party Congress and the Trump issue are two big question marks for the Chinese economy in 2017,” says Franklin Allen, a professor of finance and economics at Imperial College in London and an emeritus professor of finance at Wharton. For now, that means maneuvering for short-term gain, not tackling big problems like state enterprise reform, he says. “I do not think Chinese government will do a lot of reform ahead of the Party Congress in fall in 2017 because they need stability in the economy.”

The latest data suggest that China has once again fended off a “hard landing,” at least for now. Trump’s unorthodox stances on trade and his antagonistic comments about Beijing are an unwelcome distraction for Chinese planners trying to fine-tune policy to keep growth from faltering while at the same time reducing risks of excess speculative investment in the property sector, says Louis Kuijs, head of Asia Economics at Oxford Economics in Hong Kong.

Official GDP data are due out later in January, but Kuijs says strength in the real estate sector was a big factor behind a revision in his growth estimate, to 6.7% for the year, up from an earlier forecast for 6.5% growth. This year, economists expect the economy to cool slightly, expanding by 6.3% to 6.4% as the government strives to prevent a speculative bubble from getting out of hand. Staunching outflows of capital and keeping the yuan’s exchange rate stable, and curbing excess capacity in major industries such as steel making and aluminum, are other sometimes conflicting priorities.

“The Party Congress and the Trump issue are two big question marks for the Chinese economy in 2017.” –Franklin Allen

Though the one-party ruled country’s political system differs greatly from western democracies, 2017 is the rough equivalent of an election year, and that means the government will be loath to cut spending or impose significant job cuts ahead of the party congress, says Kuijs. “They want to have pretty stable economic growth, so they are unlikely to rein in credit growth before that event.” The report from the annual Central Economic Work Conference, which ended on December 16, showed a slight change in tone regarding key economic objectives and policy direction for 2017: Instead of emphasizing “development” the call was for stability, Kuijs notes.

Politics still play a leading role in China, and factional infighting remains a potential wild card that could further hobble needed reforms and also hinder efforts to prevent big outflows of capital, analysts say. “I would put politics as the number-one risk in China in 2017,” said Chi Lo, a senior economist of BNP Paribas Investment Partners in Hong Kong and author of several books on China. It is unclear who will be replacing whom in the leadership lineup and who will be managing what portfolios, he explains. “If the leadership transition is not certain, economic structural reform is uncertain. This affects Chinese confidence. As long as the uncertainties linger, the Chinese will take their capital out of China whenever they have a chance. So the capital outflow will remain a big risk for 2017.”

The Trump Factor

And then there’s Trump, who has threatened to impose up to 45% tariffs on Chinese exports to the U.S. and has chosen hardliners on trade for many of his cabinet and advisory posts. Some analysts doubt Trump will go so far as to impose blanket tariffs on goods made in China, and customarily, U.S. presidents-elect talk tough on trade and the economy but tend to settle for a more realistic approach once they are in office.

“Trump is a businessman, so he is not likely to do something drastic,” says Yasuo Sone, a professor of economics and director of the Center for China and Asian Studies at Nihon University in Tokyo. Implementing 45% tariffs on Chinese products imported into the U.S. would make those products far more expensive, hurting American businesses. “[Trump] will be more realistic toward China once he becomes president,” Sone says: He could impose punitive tariffs on specific products on a case-by-case basis instead of slapping a 45% tariff rate on all imports from China as he threatened in his campaign rhetoric. There is a precedent for this: President Barack Obama imposed a 35% import tariff on Chinese tires in 2009, Lo notes.

The easiest way Trump could hit back at China would be to officially label it a “currency manipulator.” Over many years, U.S. officials maintained that the Chinese yuan, which is not fully convertible, was being kept too cheap against the dollar, giving Chinese exporters an unfair exchange rate advantage. The U.S. Treasury can declare Beijing a manipulator without Congressional clearance. Taking such an action, even though China actually now is struggling to keep its currency from falling too far or too fast against the rising U.S. dollar, could enable Trump to trigger a series of trade restrictions under the 2015 Trade Facilitation and Trade Enforcement Act against China.  “[It] may well be his first move in addressing his criticism on China,” says Lo.

Declining Reserves

Even before he takes office, the Trump factor is already complicating matters: China’s foreign exchange reserves declined by US$41 billion in December 2016 to US$3.01 trillion, the sixth straight monthly decline, following a US$69.1 billion drop in November 2016. Rising U.S. treasury yields and a stronger U.S. dollar after the November 8 election are drawing in capital from emerging market investors seeking those higher returns. China’s foreign exchange reserves are at their lowest level since March 2011, having declined by US$982 billion from a peak of US$3.99 trillion in June 2014. China still has the highest foreign exchange reserves in the world.

“I would put politics as the number-one risk in China in 2017.” –Chi Lo

“From a policy point of view, China does not want the yuan to fall much further, but whether [the government] can do much about it is another question,” says Rajiv Biswas, a Singapore-based Asia-Pacific chief economist at IHS Global Insight says. Abrupt declines in the yuan, also known as the “renminbi,” or “people’s money,” such as the one that rocked world markets in August 2015, cause too much turmoil. “The Chinese government does not mind some further decline in the renminbi but the main issue is they do not want to be too quick. They do not want a panic but a controlled decline,” says Biswas, who is forecasting that the yuan’s value will drop to slightly over 7.00 yuan to the U.S. dollar by late 2017 and to 7.20 yuan by the end of 2018, from 6.9 yuan at the end of 2016.

China’s State Administration of Foreign Exchange (SAFE) on December 31 announced new regulations that limit Chinese individuals’ foreign currency purchases to current account transactions, which includes tourism, education, business purposes, family visits, non-investment insurance and consulting services. SAFE also said individuals are no longer allowed to use such funds to buy real estate abroad.

On January 2, China’s central bank announced new rules on overseas currency transfers to help control foreign exchange pressures. The People’s Bank of China (PBOC) said banks and other Chinese financial institutions will have to report all domestic and overseas cash transaction of more than 50,000 yuan (US$7,201) beginning in July 2017, sharply lower than the current limit of 200,000 yuan. Banks also need to report any overseas transfers by individuals of US$10,000 or more to the PBOC. The central bank left the $50,000 a year annual foreign exchange conversion quota for individuals unchanged.

“We expect policymakers to continue tightening enforcement of foreign exchange regulations,” Kuijs says. “They could also take further low-profile steps to contain SOE (state-owned enterprise) outbound investment and overseas lending. Recent experience has shown that the authorities want to avoid high-profile measures such as reducing quotas or imposing new restrictions if possible.”

Cooling Real Estate and Restructuring SOEs

In other policymaking initiatives, more than 20 local governments in major cities introduced house purchasing restrictions in October to cool the real estate boom. The measures include requiring down payments from first-time buyers equivalent to 35% of the purchase price, up from 30%. Buyers of a second property must put down at least 50% of the selling price. Such moves will keep real estate construction from being a major driving force for growth in 2017, unlike in 2016, Kuijs says. “I am not extremely worried about a significant decline in real estate construction, though, because during the pickup in sales in 2016, the property developers were quite cautious,” he says.

In the longer term, restructuring major SOEs remains one of China’s most daunting challenges. “State-owned enterprise reform is a mixed bag in the sense that we cannot say that it is moving along at a very rapid pace and we cannot say that nothing is happening,” Kuijs says. Such reforms are inextricably woven into a raft of other problems, such as the massive and growing load of nonperforming loans, soaring corporate debt and slowing investment in construction. Slashing overcapacity is crucial but politically painful given the huge role heavy industries like steelmaking and coal mining play in many areas. Biswas estimates that out of the 45 million tons of steel capacity that was supposed to be cut in 2016, only about 30 million tons actually were reduced. “They still have another 270 million tons to go,” he says.

“From a policy point of view, China does not want the yuan to fall much further, but whether [the government] can do much about it is another question.” –Rajiv Biswas

While putting off difficult reforms can be the politically expedient course for now, by kicking the can down the road China risks allowing its growth potential to gradually shrink due to poor allocation of resources, says Julian Evans-Pritchard, China economist at Capital Economics in Singapore. “The real risk of China is not a hard landing,” he says, but stagnation. Growth could slow to the point where it is only 1% to 2%, he adds.

The past decades of stability and free trade allowed China plenty of breathing room as it industrialized and integrated its once closed economy into global markets. The massive foreign investment and open markets that created millions of jobs, turning the country into a manufacturing and financial powerhouse, are looking less certain with the advent of Trump’s administration.

“Trump is risk, and Trump policy overall all is negative for China in the short term. We are uncertain what Trump wants, and he probably does not know what he wants exactly,” says Lo of BNP Paribas. “He is so unpredictable, and his unpredictability could lead to some [incident], whether it is in politics or economic or military.” Trump’s December 2 phone call with Taiwan President Tsai Ing-Wen took many by surprise since the U.S. does not have official relations with the self-ruled island claimed by Beijing. “China will not negotiate over Taiwan and has zero tolerance about this issue,” Lo says.

Beijing’s response to Trump’s talk with Tsai was measured. Pieter Bottelier, an adjunct professor of China studies at Johns Hopkins School of Advanced International Studies (SAIS) in Washington, D.C., says Beijing was wise to not overreact to Trump. “What the Chinese government can do is to stay calm and play to Mr. Trump’s weakness, which is extreme narcissism. Narcissistic people respond well to flattery, and Chinese are very good at flattery,” he says.

It’s unclear, however, if Beijing intends to take that tack. “Trump and his transition team ought to recognize that creating trouble for China-U.S. relations is just creating trouble for the U.S. itself,” the state-run People’s Daily said in a front-page commentary on December 5.

Past experience suggests China could have some surprises of its own in store. “I think China is likely to try something with Trump once he gets into office,” Imperial College’s Allen says. “Just give you some example, they may lock on Japanese fighters in the [disputed] Senkaku islands, or they may send naval ships to the islands. They could harass some U.S. planes flying over the South China Sea. It is very difficult to know how Trump will react to that; he does not know much about it, and he does not have a very good Asia team. If he reacts wrongly, it could be a big problem.”

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