China: Five Key Themes for 2017

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China’s economic growth stabilised during 2016 and deflation in producer prices eased. But can this trend continue in 2017, despite rising uncertainty? We see five key themes to watch: 

1. Reflation is the over-arching theme. Strong infrastructure investment, a housing-market rebound, cuts to industrial over-capacity and rising global commodity prices helped turn a 6% annual fall in domestic producer prices in 2015 into an increase in 2016. Raw materials such as iron ore, oil, coal and copper rose fastest.

Easing deflation helps profit margins recover and reduces the real burden of debt. This especially helps state-owned enterprises, whose borrowings account for half of China’s total debt.

We expect the expansionary fiscal policy to continue into 2017, with infrastructure investment remaining key while stable demand and easing deflation encourage private-sector investment. Yet consumer-price inflation should remain below 3% for 2017, with GDP growing at 6.5% and no need to change interest rates.

2. Private investment accounts for more than two-thirds of all Chinese investment. But, after peaking at more than 30% a year, growth in private-sector investment fell below 10% in 2016.

That could have shaved 0.3 percentage points off nominal GDP growth. It also adversely affected productivity expansion. However, improving profits, prices and corporate confidence may avert further falls in private-sector investment. Lower taxes and social-security contributions would also help.

3. Trade between the US and China featured strongly in Donald Trump’s presidential campaign but we think proposals such as imposing a 45% tariff on all Chinese imports are more likely be used as bargaining chips.

Both the Chinese and US economies have changed substantially since China joined the World Trade Organization in 2001, so a new framework of understanding based on mutual needs is necessary. Backward-looking, punitive policies are unlikely to benefit either side.

For example, the US can tie its demand for fewer subsidised heavy-industrial products to the prospect of China gaining ‘market economy status’. And Beijing’s capacity-reduction measures negate some US complaints about China’s state-sector ‘dumping’ cheap exports.

A bigger area of negotiation lies with investment. The US wants a level playing field for its firms in China’s growing services sector while increasingly globally-minded Chinese firms want to move up the learning curve. These goals require complex entry-requirement and regulatory standards.

A major imminent breakthrough may be unlikely, but there is too much at stake for starting a trade war.

4. Property prices for new homes rose almost 30% in Beijing and Shanghai in 2016. But since early October, more than 20 cities have limited sales to non-residents and increased down-payments.

There are already signs of sales and prices starting to soften. However, we expect the growth impact of the slowdown to be less than in past cycles. First, the rally was limited to a few cities; second, this time it did not coincide with increasing economic growth or inflation that prompted monetary tightening.

5. Infrastructure investment, financed by China’s policy banks, will offset the impact on growth of a softer property market. The wide array of financing options available means such investment should remain resilient.