While China should again contribute around 1 percentage point to global growth in 2020, we found on our latest research trip to Beijing that secular risks remain biased to the downside.
In prioritizing stability over all other objectives, China is borrowing from future growth while reducing policy ammunition to counter unexpected shocks. Given the renewed rise in already high debt levels, growing fiscal deficits and declining foreign exchange reserve coverage of monetary liabilities, we judge that it is becoming increasingly costly for China to buy time. Our macro conclusions, based on discussions with government policymakers and corporate executives, are two-fold:
First, China’s strategic growth plans – prioritizing quality over quantity – are hamstrung by the paramount objective of stability. The definition of stability in the Chinese context has morphed from one of upholding the government’s legitimacy via policies to support high growth, full employment, and ever-rising living standards to one of risk management – namely, preserving financial independence and popular legitimacy by mitigating financial stability risks, reducing ecological threats (pollution) and alleviating poverty.
However, these risk management efforts are stymied by fear of triggering the very financial and social chaos that the authorities seek to avoid. Banks’ longstanding preference to lend to state-owned enterprises (SOEs) over private firms and merge weak firms with stronger ones has created too-big-to-fail entities in various sectors. Meanwhile, slowing real wage growth, rising household debt and anecdotal evidence of weaker labor market conditions suggest that the desired rebalancing toward consumption is becoming challenged.
Second, the government seems to be betting on market opening to foreign financial firms and the rise of fintech to surmount the key problems of a bad debt overhang and lack of willingness to lend to the private sector and small and midsize enterprises (SMEs), respectively. Market opening offers both opportunities and risks for investors, while the fintech boom could induce risk-seeking behavior that may prove challenging for regulators to contain.
With stability objectives paramount, we expect Chinese asset prices in 2020 to be range-bound. Given the signing of the Phase 1 trade deal on 15 January, which includes a provision for exchange rate stability, we expect a broadly stable yuan exchange rate. The currency may outperform if there are further tariff reductions, which we view as unlikely in the near term. But Beijing has few incentives to allow significant appreciation given the volatility it would generate in the event of renewed Sino-U.S. tensions. The downside risk – a renewed U.S. escalation of the trade dispute – is modest given the U.S. election calendar.
We are constructive on Chinese fixed income, but more for secular than cyclical reasons. While official aversion to re-stimulating the property market argues against an aggressive monetary policy easing cycle, the negative skew of macro risks argues for lower yields over time. As the impact of the recent spike in pork prices on overall consumer price inflation fades, there will be greater scope for incremental rate cuts. These could simply reinforce the floor under Chinese GDP growth amid debt deleveraging efforts. Chinese rates can also serve as a hedge against either domestic financial stress associated with further corporate failures or a negative global growth shock.
Finally, after speaking with policymakers, we have a better sense of how the authorities will deal with weaker corporations and banks. The lesson policymakers have taken from the unexpected interbank market contagion stemming from one large bank failure last summer has been that financial firms are in general too interconnected and there will be too large a cost were they allowed to fail.
However, while market discipline will be allowed to prevail on weak SOEs and potentially even some local government financing vehicles, defaults will likely be handled in a manner that aims to avoid contagion across credit markets with pragmatic steps to involve stronger SOEs as white knights to contain risks.
We believe these trends underscore the need for vigilance in how we invest across the Chinese credit spectrum. Bottom-up credit analysis will become ever more important as the authorities attempt to break the perception of uniform implicit guarantees across the credit complex.
The bottom line is that the U.S.-China trade dispute has reinforced a pre-existing bias toward economic policy conservatism as the authorities focus on defusing financial, income inequality and pollution risks. With stability the mantra, we recognize that policy insurance is being traded off in favor of time. This is good news for the global economy in 2020 in the absence of external shocks, but the strategy also reduces room for maneuver in the event of fresh shocks, including a re-escalation of U.S.-China trade friction.
For more on our outlook for China and the rest of the world, please read our Cyclical Outlook, Seven Macro Themes for 2020.
Gene Frieda is a global strategist based in PIMCO’s London office, and Stephen Chang is a portfolio manager in the Hong Kong office. Both are contributors to the PIMCO Blog.