The Most Difficult Year?
At the beginning of every year since 2008, Chinese newspapers have predicted with monotonous regularity “the Chinese economy’s most difficult year,” warning of the incredible challenges for the year ahead. Certainly, China’s economy has faced substantial difficulties in recent years, but the sky has yet to fall. And so it was that early last month, Xinhua ran a predictable headline that read: “2016 Could Be The Most Difficult Year for Economic Adjustment, Prepare for Hard Times.” But with equity markets losing more than 20% in the first month of 2016, further depreciation of the RMB, a surging debt-to-GDP ratio, and declines in manufacturing and trade, Xinhua’s warning may finally prove to be worth our attention.
At the beginning of every year since 2008, Chinese newspapers have predicted with monotonous regularity “the Chinese economy’s most difficult year,” warning of the incredible challenges for the year ahead. Certainly, China’s economy has faced substantial difficulties in recent years, but the sky has yet to fall. And so it was that early last month, Xinhua ran a predictable headline that read: “2016 Could Be The Most Difficult Year for Economic Adjustment, Prepare for Hard Times.” But with equity markets losing more than 20% in the first month of 2016, further depreciation of the RMB, a surging debt-to-GDP ratio, and declines in manufacturing and trade, Xinhua’s warning may finally prove to be worth our attention. As we come into the fourth year of Xi Jinping’s presidential term, his commitment to reform is under increasing scrutiny. Since the Third Plenum blueprint for market reforms was announced in November 2013, hopes that Xi would usher in major liberal market reforms have been all but extinguished. China under Xi has been characterized by piecemeal economic reforms accompanied by political retrenchment. The reform chorus is all too familiar: China must enact reforms to transition its economic structure. But how long will it take? Can China successfully manage the transition? Will it be smooth or chaotic? And what does it mean for foreign businesses? These questions continue to be the subject of intense debate. In our The Most Difficult Year? Year of the Monkey preview, Ogilvy lays out the major trends in China’s economy, politics and international relations to help frame the challenges China is facing to help you decide for yourself if 2016 will really be “the most difficult year.”
Official GDP growth for 2015 was recorded at 6.9%, China’s lowest expansion in 25 years. Recognizing that growth will continue on a downward trajectory, Beijing has lowered its annual GDP target to 6.5% for 2016 to 2020. As the traditional engines of growth – exports and investment-fueled infrastructure – continue to slow, the transition to a domestic consumption and services-led economy is making gradual progress: consumption increased its share of the GDP pie to 52.5% last year and the services sector overtook construction and manufacturing to make up the largest component of the economy.
Over the past year, China made global headlines as financial turmoil shook markets around the world and showed that investors are losing faith in the Chinese economy. July’s stock market crash, followed by an unexpected change in August to the RMB’s exchange rate regime unsettled domestic and international investors alike. The government’s heavy-handed interventionist reaction to the stock market crash included a halt to trading, orders to SOEs not to sell stocks and a return to traditional financial stimulus measures. Although the exchange rate reform was intended to support the transition toward a more market driven rate-setting mechanism (supporting the RMB’s case for inclusion in the IMF’s Special Drawing Rights basket), uncertainty and confusion about the move triggered major capital outflows. In the second half of 2015, the PBOC spent hundreds of billions of dollars of foreign exchange reserves to slow the RMB’s depreciation. According to a Bloomberg Intelligence estimate, capital outflows reached a record level of $1 trillion, meanwhile foreign exchange reserves dropped by over $500 billion to $3.3 trillion – the first decrease since 1992. Bloomberg estimates that they will continue to fall by about $300 billion in 2016 and 2017.
Even in areas of noticeable progress, there is reason for skepticism: China fully liberalized interest rates in 2015 – allowing banks to pay market rates to savers and charge market rates to borrowers – however the central bank still provides “guidance” to the banks on where those rates should be set. Uncertainty about China’s economy transfers volatility to financial markets around the world, reflecting a growing lack of confidence in the capacity and ability of the authorities to manage financial reforms and the economic transition. Meanwhile, questions swirl over the government’s commitment to the kind of economic reforms believed to be necessary to put China on a sustainable growth path.
DEBT AND SOE REFORMS
Many close watchers of China’s economy note that the biggest threat to growth is the rapid accumulation of debt. Since the 2008 stimulus measures, the nation’s overall debt has more than quadrupled – and despite the stated aim of moving away from credit-fueled growth, China’s financial sector issued a record high $1.77 trillion in new loans in 2015. SOE’s account for roughly two-thirds of total corporate debt, but produce returns far lower than their private peers. Economists say that reforming the state sector is critical to revitalizing growth and moving toward a more sustainable growth pattern, but doing so will be very challenging and require overcoming deeply vested interests. The latest SOE reform plan released by the State Council in September last year focused on the state’s “absolute controlling position” in key sectors, “mixed ownership reform,” and the creation of financial holding companies. The language suggests that reformers in favor of privatization are struggling to win over the more conservative groups. Significant SOE reform is unlikely in 2016 but credit growth must slow if China hopes to deleverage and put itself on a sustainable growth path.
Xi Jinping offered renewed hope for meaningful market reforms in November when he first talked about “Supply-Side Reforms” at the Party’s Fifth Plenum Meeting. He elaborated on the concept at the year-end Central Economic Work Conference and discussed it again at a January meeting of the Central Leading Group for Financial and Economic Affairs – a top economic decision making group led by Xi.
Government statements and Chinese media coverage suggest that he is indeed advocating the supply-side principles of the Reagan era which celebrated free markets, deregulation, and a reduced state role while eschewing the traditional Keynesian demand-side levers of stimulus. China recognizes that Keynesian stimulus measures – namely monetary and fiscal tools – are not as powerful as they used to be. Indeed, state media commentary following the December Work Conference noted cutting housing inventories and eliminating industrial overcapacity, reducing government debt, and cutting costs for businesses as key near-term tasks of supply-side reforms. Time will tell if this is just the latest rhetoric from Party leaders, but the new approach suggests recognition of the fact that policies used to manage the economy in recent years are no longer producing the intended results. If market forces sufficiently replace government management, foreign companies will benefit from greater competition, deepened administrative and tax reforms, and a more equitable playing field with domestic competitors.
THE OUTLOOK FOR FOREIGN COMPANIES
Despite the overall slowdown in the economy and heightened concerns over the commitment to and scope of reform, there are many sectors of the economy with very promising growth such as online retail, entertainment, and financial services. For many foreign companies operating in China, the slowdown is of lesser concern than access to growth markets, many of which – including entertainment and financial services – are highly restricted for foreign companies. Both the US and EU are pushing for completion of Bilateral Investment Treaties to help remove restrictions on foreign investment. Other challenges for foreign firms are likely to continue in 2016: competition from domestic firms, opaque anti-monopoly investigations, consumer day nationalism, and uncertainty regarding digital information requirements linked to China’s new National Security Law passed last July.
The Political Dimension
China’s economy must always be viewed against the backdrop of Party politics and the State. Since taking office, Xi’s consolidation of power, anti-corruption campaign, and crackdown on civil society have injected a heavy dose of politics into the reform process. As the demand for economic transformation accelerates, important political factors are shaping Beijing’s economic decision-making process.
PRESIDENT XI’S CENTRALIZATION
In the past year, Xi has continued to centralize decision-making and promoted ideological work while cracking down on any potential challenges from civil society. An August 2015 warning to retired officials to stay out of politics demonstrated his commitment to prevent meddling in his plan, and made Xi the ultimate decision-maker in Beijing. While that may bode well for bureaucratic efficiency, some worry that he does not fully understand the technical economic issues that he faces and his preoccupation with ideology and corruption not only creates an environment of fear and distrust among policymakers, but also diverts his attention from pressing economic issues. Looking outward, Xi sees the economy as a means to project China’s power on the world stage – but as he busies himself with overseas visits, economic decision-making stalls at home.
ANTI-CORRUPTION & PARTY DISCIPLINE
In 2015 Xi has shared an important message with government cadres: everyone needs to understand and strictly follow the Party’s unwritten “rules” (规矩), and submit to Party “discipline” (纪律), the violation of which will carry heavy consequences. Inside and outside the Party, Xi’s message has stirred talk about over-reach in the ongoing campaign against corruption. Although Xi’s focus on corruption has helped him win favor with citizens and reform-minded officials, the continued stress of the campaign has slowed policymaking as fearful officials default to inaction as the safest way to avoid attention. This fear can partially explain why most of the reform decisions announced at the Third Plenum two years ago have not been implemented.
In 2015 the campaign was further centralized as it spread to all provinces and municipalities. New personnel appointment rules issued last April helped strengthen the CCDI’s top-down control of the system. In December, a CCDI official announced plans to expand the anti-corruption drive, with a goal of inspecting all 280 organizations responsible to the central government by the end of 2017. The timing suggests that the CCDI aims to complete investigations around the 19th Party Congress in October 2017, when five of the seven members of the current Politburo Standing Committee are due to retire. In addition to weeding out corruption, the crackdown is also being seen as a political tool to remove rivals and consolidate power. Critics worry that the expansion of the campaign will further handcuff policymakers, paralyzing any progress on much needed reforms. In the meantime, government officials and SOE executives will keep a low profile. The current environment can only serve to amplify the necessity for foreign companies to align their actions with government interests.
China And The World
China’s slowdown and uncertainty about the reform agenda are sending ripples across the global economy. Industrial decline has significantly hurt commodity exporters and slowed growth in industrial imports will continue to cause pain across Asia. The biggest uncertainty stems from questions about China’s exchange rate reforms – a major devaluation of the RMB could trigger competitive depreciation among exporters in the region.
Reforms aimed at mitigating climate change align with China’s goal to reduce energy-intensive industries. Beijing has announced a plan to reach peak carbon emissions by 2030, a welcome message not only to residents of smog-filled cities, but also to an international community increasingly focused on mitigating climate change. However, China’s commitment to these reforms is unclear. Despite the NEA’s freeze on approval of new coal mines and the closing of 1,000 existing mines, more than 150 new coal-fired power plants were approved in 2015. As the government publicly touts a shift toward a consumer-driven economy and away from dirty industries, long-term strategic initiatives suggest that China in fact aims to maintain capacity of traditional sectors as overseas expansion will allow it to export domestic overcapacity.
Initiatives such as the Belt & Road and the Regional Comprehensive Economic Partnership (RCEP) reflect China’s ambition to open new markets for its exports. Scaling back domestic production would drive up unemployment, risking domestic unrest that would be most unwelcome in Beijing’s eyes. It appears that President Xi intends to temper a drive toward reform with continued government intervention in the market to forestall this possibility.
Forging deeper economic ties in the region keeps China on good terms with its neighbors and in Beijing’s eyes offers rewards to those prepared to get along with China: “take a ride on our express train, all are welcome,” says President Xi. Some scholars believe that the foreign projects Xi has personally spearheaded on his many trips abroad are aimed at showing the Chinese people that China remains strong despite waning economic growth. A prime example is the Chineseled Asian Infrastructure Investment Bank (AIIB) that came online last month. The AIIB targets annual investments of $10-15 billion in infrastructure and connectivity projects in Asia, building goodwill in the region.
The ‘Dominant’ State Vs. The ‘Decisive’ Market
At the World Economic Forum in Davos last month, billionaire investor George Soros warned that “a hard landing is practically unavoidable” in China. Ogilvy doesn’t foresee economic collapse any time soon, however lack of progress on market reforms and indications that political priorities dominate economics portend continued economic pain in 2016.
In addition to the Third Plenum’s decision to give the market a “decisive role,” the same document announced a continued “dominant role” for the state sector. How the political leaders balance the two is the ultimate challenge moving forward. Discussed reforms from currency and equity markets to banking and SOEs will require a decrease of political control, which many leaders are resistant to give up. The tension and pressure of maintaining Party control while simultaneously trying to unleash greater market energy in the economy will likely become increasingly visible as the internal struggle over the direction and scope of reforms continues.
Despite his warning about a hard landing, Soros also noted that “China can manage it.” Their ability to manage the transition will stem from how much power the Communist Party is willing to cede to markets. To better gauge Xi’s intentions, all eyes will be on the March National People’s Congress where the 13th Fiveyear Plan will be ratified and formally released. With no signs of more flexibility in the political realm and continued reliance on the old management model in the economic realm, uncertainty will pervade and 2016 will indeed be one of China’s most difficult years in decades. Nonetheless, a 6% growth year is still growth – more than most of the rest of the world. Our client service professionals look forward to serving you in the Year in the Monkey.
The Ogilvy Public Affairs team in Beijing welcomes feedback.