Risk drivers and outlook

China is in economic transition; the era of double-digit GDP growth is over. Mostly deteriorating macroeconomic indicators suggest that the structural soft landing could be accelerating. As a result, Beijing is pursuing an accommodative economic policy mix with further stimuli expected in the coming months to ensure stability. The property market correction, financial instability and sizeable shadow banking are downside risks to the outlook, in addition to the huge overall debt. Those systemic factors represent a heavy burden and will inevitably keep the growth potential at a lower level (below 7%), particularly with persisting industrial overproduction and a weaker foreign demand, which are fuelling deflation. The confidence crisis, exacerbated by the stock market crash and the surprise RMB devaluation during the summer, is evidenced by rising capital outflows and is threatening the credibility of the Communist Party (CCP). However, China has a strong financial capacity and robust fundamentals, notably a low external debt, huge foreign exchange reserves and a savings rate to withstand adverse conditions. Hence the ST and MLT political risks are repeatedly rated low, in categories 1/7 and 2/7 respectively. Domestic stability under the CCP’s rule is an additional mitigating factor whereas externally, China’s nationalist policy translates into recurrent tensions surrounding the disputed islands in the South China Sea.

Bringing China on to a sustainable path will depend on adequate socio-economic management to address increasing social instability, and on the pace of reform. Despite resistance from vested interests, a strong President Xi Jinping is committed to reforms, including a large-scale anti-corruption campaign launched three years ago to preserve CCP legitimacy. Although economic liberalisation and the private sector are to be further promoted, the State is expected to maintain a dominant role in key and strategic economic sectors. The uncertain legal system and poor economic momentum make the business environment difficult and this mainly explains China’s high commercial risk (C on a scale of A to C). Payment arrears and defaults have increased and will expand in the future, particularly in overcapacity sectors (e.g. real estate), as the unsustainable implicit State guarantee could wane over time.

Facts & figures

Pros

  • Political stability
  • High savings rate
  • Large financial buffers for central authorities
  • Robust fundamentals

Cons

  • Risk of negative political and social consequences (credibility of the Party and social unrest) from economic slowdown
  • Massive national debt
  • Implicit State guarantees favour moral hazard
  • Reform process hindered by vested interests

Main export products

  • Machinery & mechanical appliances (19.5% of total current account receipts), electrical machinery and equipment (18.7%), textiles (12.8%), base metals and articles (7.7%), factor income (7.1%)

Income group

  • Upper middle

Per capita income

  • USD 7,380

Population

  • 1,364m

President and General Secretary of the Chinese Communist Party (CCP)

  • Xi Jinping

National Party Congress (5-year cycle)

  • Next meeting at the end of 2017

Prime Minister

  • Li Keqiang

Country risk assessment

A large-scale corruption crackdown led by a strong President

Never since Deng Xiaoping has a Chinese president concentrated so much power and exercised as much authority on the CCP as Xi Jinping. In two and a half years in office, he has brought China’s key powers under his authority (Party, army, security, but also economic reform, among other things) and undermined the role of the Prime Minister. His expansion of power is boosted by the biggest ever anti-corruption campaign, which has hit hundreds of thousands of Party officials and business people, resulting in many jail sentences. The purpose of this huge crackdown is twofold. One reason is arguably to sanction and hold off Xi Jinping’s main political rivals and high-ranking officials opposed to reforms, and the other is to increase discipline, restore morality within a deeply corrupt political system and ultimately preserve the CCP’s legitimacy as the sole ruler. President Xi’s 'second cultural revolution' does not contest China’s socialist capitalism but purges the CCP by discouraging the corrupt practices of officials at all levels (particularly local). The process is supported by a population that is demanding good governance and anti-graft measures against shockingly wealthy officials. Nonetheless, it also raises the question of impartiality as it’s opaque and isn’t led by an independent judicial body. Consolidation of power should allow political continuity, despite some political resistance, and a renewal of Xi Jinping’s mandate at the 2017 National Party Congress.

In this political context, China is experiencing increasing social unrest fuelled by poor working conditions and environmental damage, as well as income inequalities and land expropriations. Hence bold structural measures are required to maintain CCP legitimacy, particularly in view of the economic slowdown (i.e. related job losses and wage arrears), widespread use of social media and population ageing. A number of reform plans are slowly going in this direction, such as the revision of the 'hukou' registration system, which should gradually allow rural migrant workers to access social benefits in urban areas. In addition to increasing land rights for farmers and the broadening of the social safety net for all citizens, Beijing hopes the implementation of these policies will progressively help to defuse social tensions in the medium to long term.

Security risks dominated by regional conflict threats

In spite of a surge in ethnic riots in Xinjiang and Tibet, Beijing is keeping the domestic situation under control. Yet, an uncompromising approach to ethnic issues will fuel further unrest and terrorist attacks, especially from Xinjiang’s Uighurs. Another potential source of instability is Hong Kong, where an 'umbrella revolution' gathered record protests against the city’s pro-Beijing policy last year and called for fair universal suffrage. The risk of contagion to mainland China is low, but this is a wake-up call, given the rising demands of the Chinese middle class in terms of rights and governance. Defiance against China is also noticeable in Taiwan since massive student protests prevented a bilateral trade agreement. A victory for the pro-independence party in next January’s general elections could strain cross-Strait relations after years of improvement, even though Taiwan’s status quo should still be preferred.

These adverse events are occurring at a time of strengthening nationalist policy. This is part of Xi’s 'Chinese dream', which consists in glorifying the nation in every aspect, notably by regaining the position of a respected and influential global player (e.g. through ever growing economic and trade links worldwide and the setting up of a multilateral Asian Infrastructure Investment Bank in Beijing) and above all, the position of Asia’s regional leader. Such ideology demands an assertive stance in the South and East China Sea disputes. Last year was marked by violent anti-Chinese riots in Vietnam and clashes with Japanese vessels. There could be worse to come, given the elevated risk of new maritime clashes and China’s building of artificial islands on disputed reefs in the South China Sea. Sino-Japanese relations have warmed up but represent the highest potential conflict risk. Nationalist and power policies on both sides (see Japan’s contested change to its pacifist constitution), despite strong economic interconnections, could bring the risk of war to a higher level as China’s arms race proceeds at a sustained pace.

A soft economic landing

Since 2012, the Chinese economy has embarked on a transition phase after decades of double-digit growth based on low-cost, resource-intensive industrial production and unwavering State support. Over the next decade, private consumption and services – already making up the highest share of GDP – are due to become the main growth drivers while letting investments gradually fall from an unsustainable weight of over 45% of GDP. This rebalancing is still a long way off, whereas the economic slowdown is an increasing source of concern not only for China but also for many emerging countries that are hit by its lower demand for commodities. After having fallen to an average of 7.6% in 2012-2014 from a much larger basis compared with some decades ago, future Chinese growth is forecast to be less than 7% as the government is expected to prioritise a progressive reform process.

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The current slowdown could be more pronounced than the officially reported 25-year low of 7% for the first three quarters of 2015. The series of contracting economic indicators, from mining and manufacturing production to trade flows, showing their worst performance since the 2008/2009 crisis, as well as the sharp drop in commodity prices, weaker credit supply and deflation pressures, would indeed tend to indicate GDP growth deceleration of a higher magnitude. Hence the use of a range of measures to stimulate the economy and prevent a hard landing. Beijing is pursuing an accommodative policy mix, with several cuts in interest rates and bank reserve ratios on the monetary side, and a strong increase in public and infrastructure spending (e.g. transport, energy, water, renewables) by the central government. Moreover, China unexpectedly opted to devalue the renminbi (RMB) by 4.5% against the USD in mid-August as a way of supporting exports harmed by an ongoing weaker demand from advanced economies. Even though the RMB was faced with depreciating pressures, such a move corroborates worrying views on the current poor economic momentum and difficulties for policymakers in stabilising the economy and de facto extends the transition process. Crucially, after a long period of gradual appreciation, the RMB is no longer a one-way bet as the authorities have pledged to let market forces play a greater but still managed role in determining the RMB exchange rate. Therefore, in today’s economic deceleration context, the RMB is likely to depreciate further, albeit at a slow rhythm as the Central Bank sells (many) foreign exchange reserves to support its currency and stock markets and avoid fuelling capital flight and triggering a currency war with Asian partners.

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Beijing has tools to avert a crisis, notably in the cooling property market

A dominant factor behind the Chinese slowdown since 2014 is the downturn of the key real estate sector, as it accounts for around 15% of GDP and is interconnected with many other sectors. Up to now, the sector’s landing has been cushioned by government measures and has even seen a slight rebound in prices and sales recently. Nevertheless, the industry adjustment will continue for a few more years given the high sector debt, millions of unsold housing units and the ageing of the population (the recent end of the one-child policy comes too late), which are likely to affect real estate demand. Therefore, the risk of a snowball effect in defaults – from property developers to banks and local governments – hitting the real economy will linger for some time. Still, the State is expected to intervene to withstand a crisis. A systematic bailout policy of State-owned enterprises (SOEs) is costly and unsustainable as it favours moral hazard, fuels overcapacity and delays the necessary adjustments. In consequence, the principle of an implicit State guarantee could gradually evaporate (see below). Given the increasing corporate default risks in overcapacity sectors (steel, shipbuilding, solar panels, etc.), consolidating SOEs is an option that Beijing is choosing in order to reduce risks.

Overall, the Chinese authorities still have room to manoeuvre to prevent an economic crisis thanks to robust fundamentals. China has the world’s largest foreign exchange reserves (on a constant downward trend this year), a positive balance of payments with a permanent current account surplus (at 3% of GDP this year) strengthened by lower commodity imports (China is the world’s largest oil importer, for example) and a cheaper RMB that helps to export excess production from overcapacity sectors. Nonetheless, China’s financial account is deteriorating fast as a result of capital flight from foreign banks and Chinese corporates exacerbated by the RMB devaluation and economic uncertainty.

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Also, Chinese FDI outflows are significant and should soon exceed inflows as they are rising rapidly from globalising Chinese State companies and huge infrastructure projects planned worldwide, notably the long-term building of the ambitious 'Silk Road Economic Belt'.

Financial turmoil after equity bubble burst

China’s turbulent year has also been marked by stock market crashes during the summer. True, a bubble burst was in the air after a 150% annual jump. However, persisting volatility despite Beijing’s historically massive (liquidity) interventions to restore financial stability is further evidence of the challenges experienced by the country. After all, equity market connections to the real economy are small in China but the confidence dimension is crucial for the CCP’s credibility. Higher financial risks could come from the sizeable shadow banking (above 35% of GDP and close to 20% of total credit in 2014) even though its growth has strongly decelerated since 2014 thanks to new banking regulations that compel State-owned commercial banks (SOCBs) to report off-balance-sheet assets on their books with the aim of bringing them into the formal banking system and better supervising them. Still, systemic risks have not gone away as trust entities face rising default risks, especially related to the real estate sector correction, which could spill over to the banking sector.

Rising financial uncertainty and risks are much mitigated by the State’s huge financial capacity and domination of the banking sector and relatively insulated capital account. As long as financial volatility remains and stability is uncertain, financial liberalisation is likely to slow. Nonetheless, the recent crisis could eventually encourage the authorities to move forward with financial market deepening after having introduced a deposit insurance scheme last spring that puts an end to the implicit State guarantee for banks and savers. A central measure in the government pipeline remains the long-awaited liberalisation of bank deposit rates, seen as an underlying cause of excessive investments on the equity markets.

Economic potential constrained by heavy overall debt

A major economic concern for the Chinese authorities lies in the country’s huge total debt, which is clouding growth prospects. Overall debt has exploded from 150% in 2008 to more than 250% of GDP, primarily because of real estate companies, SOEs in overcapacity sectors and local governments.

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Therefore, any economic stimulus has limited efficiency as long as economic excesses are not structurally reduced. Since debt is largely domestic and borne by the public sector, and given China’s strong external position, there is a low risk of a foreign debt crisis. Yet, debt default risks are rising while a long-term threat lies in a continued debt spiral whereby new loans are mainly taken out to repay existing ones.

Beijing has launched fiscal reforms to tackle heavy local government debt, which accounts for the largest share (about 40% of GDP) of China’s public debt, far above a low 16.8% of GDP for the central government. Faced with decreased land sales and related revenues which complicate debt servicing, local governments have been given the power to issue bonds (because of an amended law, the State bailout is in theory no longer implicit), and can benefit from huge debt swaps in exchange for long-term, low-interest bonds. Restructuring of local debt is assimilated to a bailout by large SOCBs. At the same time, policy banks are granted a heightened role in investing in local infrastructure projects (e.g. housing) and boosting growth, given a weaker loan demand from deleveraging corporates and local governments (also hit by the corruption crackdown) within China’s flagging economy.

Those extra heavy financial commitments should affect the health of the banking sector. Hence liquidity injections in the banking system are likely to be decided on in the future, particularly as the economic slowdown is leading to rising payment difficulties among Chinese companies, thus increasing the risks for weaker small and medium-sized banks. On the fiscal side, further reforms are in the pipeline to offset fiscal sustainability deterioration, including contingent liabilities (i.e. costs relating to ageing and the potential recapitalisation of the banks), whereas China’s high domestic saving rate (48% of GDP) still mitigates the overall risks.

The reform drive will proceed on the Party’s endorsement

The potentially sharper-than-reported economic slowdown and higher job losses justify Beijing’s decision to use a battery of stimuli but also to proceed with multiple reforms. Xi Jinping shows strong commitment to reforms but it’s unclear whether they will be fully implemented and at what pace, given vested interests and the short-term negative impact on growth. Besides fiscal and financial measures (see above), one can certainly point to the anti-corruption campaign, which is causing a substantial decline in luxury spending by Party officials, the government’s war on pollution, following pressure from the middle class, by means of tighter environmental regulations and pledges for increased energy efficiency and green technology investments. Last but not least, reforming SOEs and giving greater weight to the private sector in driving growth was again outlined in September. This raises mixed feelings as only partial privatisation of SOEs is planned in several sectors where competition is harsh, with the aim of building up national champions. Meanwhile, SOEs will maintain a wide majority in strategic sectors and sectors of high economic interest, thereby reflecting the Party’s conservative faction’s opposition to reformists.