Given recent data releases and policy announcements coming out of China, we at Investec Asset Management have grown more and more convinced that the government is committed to rebalancing its economic model and managing — though not reversing — the resulting slowdown in headline gross domestic product growth. Although this has been the stated aim of Beijing for the past five years or so, short-term policy has tended to focus more on ensuring steady, stable expansion. Over the past few months, however, the government seems to be taking a longer view when mapping out the trajectory of the world’s second-largest economy.
Industrial production, retail sales and growth in fixed-asset investment in China all fell short of economists’ forecasts during the first quarter of 2015. Some observers and indicators saw this contraction coming: The Xiben New Line steel sector purchasing managers’ index, one of our preferred indicators, has been anticipating this moderation since the fourth quarter of 2014. The government in Beijing has resisted the temptation to provide further cheap credit to sectors of the economy already suffering from overcapacity, such as steel. This is a positive policy trend for China’s long-run potential growth, as it limits further misallocation of capital. The negative impact of such policy is likely to be felt not in China itself but in those countries whose economies have become too reliant on commodity exports to China. China’s shift toward prioritizing the long term means that, on the commodities front anyway, it’s a case of “My economy, your problem.”
Meanwhile, China has continued to move ahead gradually with a host of reforms that should contain the risks built up during the previous decade of high growth while fostering sustainable expansion. Among the more notable policies meant to rein in previous imbalances is the recently announced swap and restructuring of as much as 60 percent of outstanding debt in local government financing vehicles, or LGFVs, into guaranteed municipal bonds or taking the debt onto the formal budget.
LGFVs are state-owned enterprises (SOEs) set up by local governments to generate funds for real estate and infrastructure development projects; they have been highlighted as a particular risk to China’s banking system. We estimate LGFV debt at around 30 trillion yuan ($4.83 trillion), equivalent to 30 percent of GDP and accounting for more than one third of the total debt buildup since the 2008–’09 credit stimulus. The comprehensive plan unfolding involves restructuring up to 60 percent of that debt into guaranteed municipal bonds, while the remaining, less well conceived debt will be converted into less fully guaranteed structures to reduce moral hazard. Project revenue-backed bonds will also be issued in the future. These steps will put downward pressure on local government spending in the short term but significantly reduce long-term risks.
There are also gradual reforms taking place at major SOEs aimed at getting these institutions aligned with shareholder interests and profit maximization. These reforms will likewise reduce some of the support SOEs have traditionally provided for growth but raise the economy’s overall return on capital in the long run. The government’s willingness to tolerate a continued slowdown in the real estate sector also fits within the theme of a more-tempered approach to economic expansion.
In a subsequent article, we at Investec will consider how policy easing and credit-led investment growth play into China’s economic rebalancing strategy.
Mike Hugman is a strategist on the emerging-markets fixed-income team at Investec Asset Management in London.
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