After more than seven years of expansion, the global economy faces several potential pivots in the direction and scale of monetary, fiscal, trade, geopolitical and exchange rate policies. One in particular will help determine the long-term outlook for China and emerging Asia: How will Chinese policymakers navigate economic, trade, leadership and geopolitical developments following the 19th National Communist Party Congress later this year?
In our view, there is a wide range of possible scenarios given the considerable uncertainty that surrounds President Xi Jinping’s intentions and ability to deliver as an economic reformer. China also faces considerable challenges in liberalizing its financial markets, dealing with excessive leverage and its shadow banking system, and managing the costs of shifting resources and capital out of its state-owned enterprises (SOEs).
Under our baseline scenario, Chinese growth will slow gradually to about 5.5% from about 6.5% currently, and following the 19th Party Congress, President Xi will move China away from the “growth at any cost” model. Our baseline calls for an orderly crawling depreciation of the Chinese yuan, and we expect remaining capital controls will be sufficient to limit reserve losses.
Brighter outlook possible…
There is the potential for a more optimistic scenario: President Xi could pull off a clean sweep at the 19th Party Congress and use his enhanced stature to end policy paralysis and embark on a major reform agenda that improves the economy’s efficiency. The transition away from an investment/export-led model to a consumer/services-oriented economy could be achieved. In this scenario, China’s growth could remain above the current pace of 6.5%, disruptive devaluation would be avoided, and the glide path to a floating exchange rate would be a smooth one.
President Trump and President Xi could strike a grand bargain on trade, currency and geopolitical spheres of influence, perhaps including an acceptable freeze or wind-down of North Korea’s missile program.
…but downside risks are greater
However, there is also a bearish scenario for China. In this left-tail view, the 19th Party Congress does not jumpstart structural reform, instead setting off a vicious cycle of policy misfires.
In this downside scenario, the economy stalls, defaults mount, the shadow banking system implodes and GDP growth collapses. The U.S. levies across-the-board tariffs against Chinese imports, triggering a bilateral trade war. China follows with a globally disruptive currency devaluation, which accelerates capital flight and leads to a huge drain on foreign currency reserves. The People’s Bank of China tightens policy in a vain effort to maintain some control over the exchange rate. However, with property and equity markets in free-fall, the central bank gives up on the peg, the yuan floats and capital outflow intensifies, causing a risk-off jolt to global markets and confidence.
While the most likely scenario is the baseline, we do believe the risks to China are skewed somewhat to the downside. China remains a key source of risk, both for global growth and for emerging markets.
For more on our long-term outlook for the global economy, see our 2017 Secular Outlook, “Pivot Points.”
Isaac Meng is an emerging markets portfolio manager with a focus on macroeconomic and financial analysis of China. Luke Spajic leads emerging markets portfolio management in Asia and manages Asian credit portfolios.