China: Bumpy ride off the peak – RBS

Harrison Hu, Research Analyst at RBS, suggests that July’s jolting economic data does NOT alter China’s cyclical position - ‘lacklustre swing’ off the peak.

Key Quotes

“The ‘sweet spot’ of March-April has passed, but real activities have remained steady since the beginning of Q2, helped by earlier stimulus.

• Industrial production still held up in July, while aggregate demand deteriorated. July’s IP growth edged down from 6.2%y/y previously to 6.0%y/y, but with slightly faster m/m growth (from 0.50% previously to 0.52%). In contrast, nominal fixed investment (FAI) growth slid sharply from 7.4%y/y previously to 3.9%y/y in July, and likely contracted in real GDP terms according to our estimation. This is compounded by softer real retail sales (from 10.3%y/y to 9.8%y/y) and real export volume (from 3.7%y/y to 1.4%y/y).
• Underlying the softer demand is fading momentum of property and infrastructure activities. Property sales and new starts accelerated slightly in July (19%y/y and 8%y/y respectively), though at a weaker pace than H1’16 (28%y/y and 15%y/y respectively) and seasonally adjusted absolute levels have plateaued off. Property investment slowed visibly as well from 3.5%y/y previously to 1.4%y/y. Meanwhile, infrastructure investment also stumbled from 22%y/y previously to 12%y/y in July. We see the downtrend of property and infrastructure is now well established.
• New credit stumbled in July, though likely exaggerating the fluctuations of demand. We estimate new credit to non-financial sectors (TSF excluding equity plus government bond) almost halved from the same period last year, leading to a plunge in credit impulse (new credit as % of nominal GDP) and dragging down overall credit growth from 17%y/y previously to 16.4%y/y. To some extent, this reflects fading demand from the real economy (i.e. property and infrastructure) from stimulus being tapered. But local governments’ faster debt repayment on tightened discipline has also removed the froth in credit expansion.

Larger downward pressures may materialize towards the end of this year:

• Slowing property sales should have significantly depressed new property construction and investment going into Q4.
• The intensive release of infrastructure projects late 2015 - early 2016 should have run its course by end of this year.

With key leading variables (e.g. property, credit, new investment projects) all rolling over, our leading index of China IP has already peaked, pointing to more weakness in Q4.

Policymakers, staying on the side-lines now, may ramp up supports in Q4, though major easing is not on the horizon. Although downward pressures are accumulating on the demand side with property market cooling down and the binge in infrastructure investment fading, production growth has remained steady along the desired ‘L-shaped’ trajectory. This should keep Chinese policymakers on the side-lines for now, saving policy options for more adverse scenario.

We expect modest and targeted policy supports to come in Q4, when downward pressures intensify. These may include:

• Bringing forward some new infrastructure projects;
• Allowing 2016 fiscal deficit to exceed target (3% of GDP);
• The PBoC lowering MLF and PSL operation rates, with larger volume of liquidity injections;
• Targeted RRR cuts to support reconstruction of flooding areas, restructuring of over-capacity industries, etc.

However, with property and infrastructure activity already stimulated during the past year, we see no room for another round of full-blown easing in the coming year.

Taking into account both the underlying momentum of the economy and likely policy response, we expect real GDP growth to stay flat at 6.7%y/y in Q3, before moderating to 6.6%y/y in Q4.

Yuan’s stability period may extend till October. After another stress test during June-early July, the CNY has stabilized against USD and against its baskets, as (1) the market has believed that the PBoC will cap USDCNY at or below 6.70 in the short term; (2) the PBoC has been resisting pressures for additional monetary easing; (3) the dollar has softened again across the board since July. We think Chinese policymakers may want to safeguard the yuan’s stability period till October, when the currency will be formally included in SDR.

Nevertheless, we see the yuan’s stress on the rise towards end of this year. We see the yuan’s underlying depreciation pressures remaining intact, and the currency will likely face rising stress towards end of the year, on faltering domestic growth, heightened domestic financial risk, and likely intensifying external stress. We continue to expect the yuan to trade to 6.80 against the dollar by end of this year.”