Risk drivers and outlook

  • Internal stability remains new President Xi Jinping’s top priority. Faced with significant political and social challenges, he will have to launch reforms in order notably to restore the Communist Party’s credibility and reverse a widening wealth gap.
  • With a more assertive China, tensions will remain high in China Sea.
  • China has entered a new era of lower but still robust growth. While the economy is rebounding, the necessary rebalancing of the model towards consumption is expected to be long and tricky.
  • China’s economic outlook is clouded, besides a weaker external demand, by a real estate bubble and deterioration of the banking sector.
  • Public finances are sustainable despite high local government debts.
  • China presents low external illiquidity and insolvency risks.

Facts & figures

Pros

  • Political stability
  • Strong economic fundamentals
  • Large financial capacity (net external creditor) and low debt ratios
  • High private and corporate savings

Cons

  • Banks threatened by real estate bubble and local government debt servicing problems
  • Increasing social unrest
  • Reform boost hindered by State capitalism and vested interests
  • Adverse demographic dynamics

Main export products

  • Electrical machinery & equipment (20% of current account receipts), machinery and mechanical appliances (16%), textile/garments (10.3%), base metals & articles (5.7%), vehicles & transport equipment (4.6%)

Income group

  • Upper middle income

Per capita Income (USD)

  • 4,270

Population

  • 1.34 bio

National Party Congress

  • Every five year; to be held in 2017

Prime Minister

  • Li Keqiang (as from March 2013)

President (as from March 2013) and General Secretary of the Chinese Communist Party

  • Xi Jinping

Country risk assessment

New political leadership faces big challenges

Last November, a new generation of leaders of the Chinese Communist Party (CCP) – with a Politburo Standing Committee (PSC) reduced from nine to seven members, all new - was selected for five years during the 18th National Party Congress. In March, Xi Jinping and Li Keqiang, China’s two new strong  men, will formally succeed Hu Jintao and Wen Jiabao as president and prime minister respectively after their ten years in office. This once-in-a-decade political transition has been opaque and the occasion of infighting amongst CCP factions, particularly between conservatives and reformists. The loudest victim has undoubtedly been Bo Xilai, the popular former party secretary of Chongqing and rising star of the conservative clan. He was seen by some as a possible contender for the highest position and, as a neo-Maoist, he was in favour of a partial restoration of Maoist teaching and values. However, the CCP expelled him for being involved in a large scandal of corruption and abuse of power. In fact, his eviction was probably as much motivated by the ideological and power struggle with the reformists.

New president Xi Jinping is expected to adopt a consensual profile and will definitely aim to preserve political stability under the single communist party. Like his predecessor Hu Jintao, despite hopes of reforms, he might disappoint in essentially trying to ensure continuity within what appears to be a still largely conservative PSC. However, even though no radical policy change is expected due to collective and balanced decision-making within the PSC and resistance from multiple and strong stakeholders (e.g. army, state-owned enterprises…), it seems inevitable that Xi Jinping will have to launch at least minor reforms.

After all, to ensure long-term survival of the communist party’s power, China’s president will have to make adjustments to the political system that reflect China’s fast evolving society and meet growing expectations, notably from a larger middle-class, in terms of openness and transparency. This will depend on Xi Jinping’s ability to make pragmatism prevail over status quo in an outmoded political framework. The credibility of the CCP, at a local level mainly, has been seriously tarnished over the years by corruption scandals involving party officials and by enrichment of elites and vested interests. While the CCP’s monopoly is anything but threatened, political restructuring might include a change towards (party) elections beyond the local level and enhanced transparency as a way to improve governance. Cracking down on deeply-rooted local corruption and expanding the social security system will be two important goals on which Xi Jinping’s presidency will be assessed.

Xi Jinping’s mandate is likely to be more challenging than Hu Jintao’s given the CCP’s legitimacy crisis due to tougher economic conditions and a widening wealth gap that exacerbates the sense of social injustice. Hu Jintao’s repeated goal of building a harmonious society has thus so far clearly failed, despite continued double-digit growth. Mass protests (over 180,000 events in 2011), which are fuelled by disgruntlement over working conditions, pollution or land confiscation, continue to increase constantly at a local level. Nonetheless, the risk of nationwide unrest will increase over time in the absence of reforms. In this context, granting land rights to peasants and improving the status and social rights of migrant workers could be two major positive steps forward. Further social mobilization and public pressure on the authorities are expected following the huge development of social networks which strengthen the civil society by raising awareness through the spread of information, faster and to a wider audience, thereby hindering the CCP control.

Heightened tensions in China Sea

While China faces long-standing domestic security risks in the Tibet and Xinjiang provinces, recent tensions have mainly come from island disputes with its Asian neighbours. Due to unresolved sovereignty issues, maritime clashes over islands in the East China Sea (Senkaku/Diaoyu islands) and the South China Sea (Spratly and Paracel islands) are likely to be the growing and main external security risk for the coming years, with the potential to make Asia the world’s hot spot of cross-border conflict risk. China has been flexing its nationalist muscles over the past months, showing greater assertiveness in the region. This periodically leads to strained relations with regional peers (i.e. Vietnam, the Philippines…) involved in the dispute, the latter having chosen to tighten military cooperation with the US and increase defence spending.

Tensions have become particularly high with Japan over the Senkaku/Diaoyu islands, triggered by Japan’s nationalization of the islands. Mass protests in China have significantly hit Japanese businesses and exports. Due to their turbulent and sensitive common history, together with regional economic competition, the outlook is bleak as a more confrontational stance is feared. On the one hand, Xi Jinping will want to assert his new leadership and on the other hand, Japan is governed by a more nationalist and militarist prime minister since December 2012, which bodes ill for a softening of tensions between Asia’s number one and number two economy. Although realpolitik and pragmatism will remain the priority, there is a clear risk of escalation in case of miscalculated clashes between vessels in these areas.

Meanwhile, with bilateral relations with Taiwan having become more peaceful despite the latter’s unresolved future status, the situation remains more hazardous with China’s North Korean ally due to its nuclear program and after a recent successful launch of a long-range missile. Even though hopes of any substantial political evolution or change in belligerent rhetoric under younger leader Kim Jong-un are thin in the medium term, small economic reforms including some hint of openness and better relations with new South Korean leader might nevertheless take place. China is likely to continue giving its diplomatic, economic and financial support to Pyongyang while maintaining regional instability risks due to the uncertain nature of the Stalinist regime.

A new economic era marked by lower growth has begun, before consumption becomes the top engine

China’s fast economic activity growth model (over 10% in the last 30 years) based on cheap labour and intensive natural resource production, driven primarily by investments – nearly 50% of GDP - and exports has become unsustainable. China needs more than mere adjustments to avoid the middle-income trap. It needs a change of economic model where domestic consumption – currently at 34% of GDP - is a top engine, production moves up in the value chain and is less energy intensive, capital is better allocated and quality overcomes quantity. Such a change would result in lower average growth which might be tolerated in China’s ageing society, with the workforce expected to start declining in 2015.

China_Graph1EN

The fact that the Chinese economy, which has been on a soft landing since 2011, has reached in 2012 its lowest growth (under 8%) of this century is not fortuitous or clearly cyclical but reflects a new macroeconomic reality and international environment. This is a consequence not only of the monetary tightening from 2011 and of corrections on the property market, but also of lower FDI and an enduring lower external demand from the in- crisis EU and US.

China_Graph2EN

Moreover, the Chinese export sector has seen its competitiveness eroded over time by steadily increasing wages and operating costs which tend to make China’s inner provinces and “low-cost” Asian countries  (e.g. Cambodia, Indonesia, Vietnam) more attractive destinations for (re)locating manufacturing activities. Therefore, China has to reduce its external vulnerability and rebalance its economy. Beside an upward trend in retail sales from a larger middle-class, this objective entails a decisive step forward in developing China’s social safety net. It is indeed necessary to stimulate consumption and reduce the huge household saving rate (25% of disposable income). Hence the government pledged to build up a broader pension and health care system by 2020.

China’s high saving rate is one of the factors to explain the large current account surplus, the ratio-to-GDP of which has progressively and sharply decreased since 2007 though, from 10.1% to an expected 2.3% in 2012. The external imbalance reduction has mainly been a result of the drop in exports caused by the global economic crisis, and then more moderate growth due to weak foreign demand. Beijing’s gradual  and cautious approach to a structural change of economic model, a continued geographical diversification of exports towards developing countries and limited appreciation of the renminbi (RMB) might contribute to a slowly rising current account surplus in the medium term.

Contention with the US over RMB undervaluation has progressively abated given the RMB’s gradual appreciation in nominal terms against the USD (+5% in 2011 and rather stable in 2012), bringing their exchange rate closer to a balanced level and contributing to the narrowing Chinese current account surplus. Moreover, the People’s Bank of China (PBoC) decided last spring to widen the daily trading band against the USD from 0.5 to 1%, making it more flexible and reactive to market demand. Although not significant, the move showed further China’s willingness to rebalance its economy and reduce imported inflation pressures. The trading band enlargement also allows temporary depreciation when China’s economic momentum is weaker. In the medium term, RMB appreciation will be more limited than in the past years as Beijing will also be wary of not harming a suffering export sector.

Central authorities have in part integrated the necessary new paradigm in their 12th Five-year Plan (2011-2015) by setting a 7% growth target, i.e. a less ambitious rate than in the past. The problem to achieve it lies in usually divergent objectives from local authorities, which aim to reach higher growth levels as a way to get higher fiscal revenues, to favour career ambitions within the CCP and is a result of vested interests with State-owned enterprises (SOEs). Therefore, in the future, it is essential that Beijing better monitors and guides local governments towards ensuring economic sustainability and successful policy implementation. Central government action will also be hampered by political resistance and limited  degree of social acceptance - given the need of lower labour intensity and gradually higher-skilled activity - so that the rebalancing process might take quite a long time.

Meanwhile, the medium-term economic outlook remains positive with an 8.5% average GDP growth forecast by 2017, which confirms stabilized growth at a lower but still strong level. China is thus expected to consolidate further its role of economic superpower and remain the first engine of world growth. Economic recovery is fuelled by a gradual and moderate expansionist monetary policy – made possible by the return of price inflation to levels well under the 4% government target - and particularly infrastructure projects (notably transport). However, the central government has learned the lesson of not launching a huge investment-driven stimulus package as in the aftermath of the 2008/2009 global financial and economic crisis. This is no longer an option given that Beijing wants to avoid a further widening of structural imbalances such as a real estate bubble, rising local government debts and banks’ bad loans, and overcapacity in various sectors (e.g. steel, car manufacturing, solar industry…).

Real estate bubble and deteriorating banking sector: two risks clouding the outlook

Besides a tricky economic transition, China faces three main (interrelated) downside risks to its economic outlook. Firstly, the threat of a real estate bubble burst – a result of excessive savings and a construction boost from local governments - has not disappeared, even though corrective measures have temporarily cooled down the property market through a moderate drop in prices and sales. However, since last summer, prices have bounced back in the largest cities due to persistently high demand from high-end incomes. That is why, while showing continued determination to contain price increases through administrative restrictions, central authorities support large investments in social housing to make prices more affordable to the many low-income households and avert social instability. Beijing will need to get the balance right between keeping a restrictive policy to avoid fuelling further the bubble and supporting a major segment of the crucial construction sector for the national economy (i.e. 12% of GDP and about half of China’s fixed investments). Although it can be mitigated by continued fast urbanization, there is a high risk that sooner or later prices will eventually collapse and hit property developers, banks and the national economy.

China_Graph3EN

Secondly, the banking sector is another potential future weakness. Still dominated by State-owned banks (SOCBs), the sector is quite solid and well-capitalized but has been deteriorating with the colossal 2009-10 stimulus programme as SOCBs have massively lent to SOEs and local governments for their investments in construction activity, with many of poor quality. As a consequence, non-performing loans (NPLs) have increased substantially, most likely far exceeding the official low levels of a few percentage points. They should grow further as these are vulnerable to the economic slowdown and faltering housing projects, thereby increasing default risks. Nonetheless, the situation is still manageable and, since 2011, controlling measures have been taken to reduce excessive credit supply and cap bank lending.

In addition to a permanently limited access to credit from SOCBs, private companies have been compelled to find alternative financing sources. Therefore, in order to circumvent restrictions on the official banking system, the less regulated “shadow banking system” – i.e. outside the regular banking system where multiple entities (e.g. mainly trust companies, but also securities or industrial companies) grant loans at much higher interest rates - has flourished. In a climate of slower economic growth, the banking system is deteriorating and consequently fuelling overall financial risks. The worst-case scenario would be a wave of bankruptcies among investors (e.g. SMEs, property developers) unable to repay interest charges, triggering a wave of defaults among “shadow banking” entities. This could also affect commercial banks through their cooperation with trust companies. The systemic risk has increased as financial products are getting more sophisticated and total value of financing is estimated to have reached a whopping 25% of GDP. Therefore, it is imperative to better regulate the informal banking sector.

Moreover, cleaning up NPLs, improving risk management practices and also reforming the real estate sector is required. Some of the latter measures are however hampered by strong interest groups (e.g. SOCBs). Despite high profitability, SOCBs operate in a tougher environment as these have to cope with stricter regulations (e.g. higher capital requirements), higher market competition (boosted by the central bank) and rising default risks from local governments (see below). In this overall context of increased vulnerabilities, together with the need of financial sector reform, recapitalizing SOCBs remains a likely measure somewhere in the future.

Manageable public finances in need of fiscal reform

Thirdly, heavy local government (i.e. cities, provinces and counties) debts – soaring after massive borrowing from SOCBs to finance infrastructure projects in 2009-2010 - continue to constitute the main burden to China’s public finances. While China’s total government debt is officially reported to be around 43% of GDP, its ratio is higher according to non-official sources and could amount to 60-70% when including contingent liabilities (e.g. future losses related to NPLs, unfunded pension liabilities...). Faced with the spectre of default on short-term maturities, Beijing urged SOCBs last February to restructure the local government debt and extend maturities by up to four years, i.e. when investments generate cash. Given local governments’ poor liquidity, which is exacerbated by lower land sales and prices that lead them to contract new debts, another deadline extension applied to loans expiring in 2013, i.e. half of the total, could be decided.

Beijing is concerned by the refinancing issues and has therefore already undertaken a few pilot actions such as bonds issuance by a few metropolises and provinces, and a property tax programme. However, given the magnitude of the problem – with 30% of local government debts in default risk - and the risk of further deterioration, expansion at a larger scale is much needed. A major reform of the fiscal system is inevitable to avoid over-borrowing. It would aim to improve structurally local government finances as they account for 70% of China’s public spending while getting less than 50% of total fiscal revenues.

The size of China’s total public debt might constrain future fiscal stimuli. However, so far, considering particularly local government debt servicing problems, China’s public finances face more of a liquidity than a solvency risk. After all, with a government debt nearly essentially denominated in RMB, a strong GDP growth rate to remain higher than the interest rate on government debt, a chronically small budget deficit, and a sovereign debt level far from those reached among advanced economies, China’s public debt still appears to be sustainable.

Financial liberalization slowly moves forward

In spite of its heavy and growing weight in world trade and economy, China is still in transition to a market-based economy given that State capitalism maintains SOEs’ pre-eminence in large segments of the domestic economy – and supports them first in crisis periods - and many prices are still centrally administered. Dynamic and innovative private companies account for an ever increasing share of domestic growth but Beijing does not consider any reduction of the large State presence in major industries (oil, telecom, airlines, banking, coal, steel…) in the coming years. On the contrary, renationalization or extension of State participation re-appears in several sectors when economic momentum abates. There are nevertheless examples where liberalization and structural reforms are underway, notably concerning interest rates (i.e. liberalization resumed last June), the capital account and use of RMB. Further steps have been taken to loosen capital controls and expand the internationalization of the RMB, principally via Hong Kong and bilateral trade mainly with Asian countries. The liberalization policy will continue at a gradual pace but the RMB’s full or broad convertibility is still a remote prospect as Beijing – especially  CCP conservatives – wants to keep the financial system largely protected from external shocks and speculative flows.

Favourable debt dynamics, ample external liquidity

China’s external debt in nominal value, of which only 5% is from the State - a sign of the State’s approach to mainly get financing from the domestic market, has strongly increased since 2009, more than doubling from USD 428.7 bio to USD 944.2 bio expected in 2012. However, resilient and robust economic output has contained somewhat the external debt ratio hike from 8.6 to 11.4% of the GDP. This upward trend, which is mainly due to short-term debt evolution, is expected to continue from very low levels though and will consequently not take China’s total external debt away from sustainable territory.

External liquidity is even more comfortable because China, as one of world’s biggest creditors, owns massive foreign exchange reserves that account for more than three times its external debt. After having grown tremendously the last decade, fuelled by strong exports and FDI, foreign exchange growth has decelerated significantly (to a single-digit level) since 2008, mainly as a consequence of a shrinking  current account surplus. Therefore, import cover has come down to less than one year and a half, which is still huge and removes any external illiquidity fears for China.

Risk outlook

Political and commercial risk classifications will remain unchanged in the near future. Any deterioration of these risks will be directly or indirectly related to negative developments regarding the Eurozone crisis in particular, the committed but difficult shift in terms of economic model, the broadening of the social security system, the real estate bubble, political reforms and tensions in the China Sea.

Analyst: Raphaël Cecchi, r.cecchi@credendogroup.com