Will China Finally Loosen Up To Boost Weakening Economy?

The author is Song Yu, China economist at Goldman Sachs Gao Hua

Premier Li Keqiang visited Inner Mongolia on May 22 to 23. In our view, there was a significant change in his tone on monetary policy. We believe policy will become incrementally looser and that this could serve as a buffer for any downside risks to economic growth in the near term.

Regarding monetary policy, Premier Li stated that the government will keep its prudent and steady stance, and continued to emphasize reforms in the structure of the financial system, while utilizing existing capital in the financial system and the real economy.

However, we believe his comments suggested a more supportive tone than in the past, including references to "appropriately using the policy tool box", "fine tuning policy stance", maintaining "appropriate" money and credit growth, and creating a "solid financial environment".

Although some of these terms were not necessarily introduced for the first time, the combination of such wording was a clear breakaway from the much more dovish tone in recent policy statements.

Premier Li also discussed his views on waste water, other waste treatment and underground sewage systems. We believe these will likely be one of the government’s key areas of investment in the future.

We believe after decades of relative underinvestment, China’s underground sewage system is in need of an upgrade. For example, even tier-I cities, such as Beijing and Shenzhen, have seen flooding during torrential rains in recent years.

Premier Li believes these projects will be beneficial for social welfare and in stabilizing economic growth. The Premier also talked about renewable energy development, which he sees as an area with substantial potential in Inner Mongolia.

Premier Li summarized the difficulties currently faced by entrepreneurs: 1) Difficulty in obtaining financing; and 2) difficulty in getting "stamps," or government administrative approval. We describe this dilemma as either "having no money to spend" or "having money but cannot spend it".

We believe this is an area that will likely be in focus for any policy changes in the coming weeks, although we note there have already been a number of changes put in by place since the leadership transition, including relaxing administrative approvals.

We believe Premier Li’s comments signal increased likelihood of policy loosening. While this may appear counter-intuitive, given sequential activity growth has become modestly stronger in the last couple of months vs. January-February, we think activity growth still remains below its potential as the output gap has continued to widen since the start of year.

The property sector, in particular, has seen weak demand thus far in 2014 and is the biggest source of downside risk to China’s GDP, in our view. We believe on-the-ground anecdotal evidence corresponds more to the output gap, rather than the change in the country’s overall GDP.

We now see greater likelihood of monetary loosening measures, which could potentially include:

1) incremental loosening of the credit quota.

2) relaxation of the Loan-to-Deposit (L/D) ratio requirement, possibly changing what counts as deposit and loan, rather than the ratio itself. We note this restriction may ultimately be removed given that China is moving towards adopting international standards, such as the Basel 3.

3) more open market operations (OMOs) and re-lending to maintain ample liquidity in the financial system.

4) cuts to the RRR and benchmark interest rates. We continue to believe this last scenario is less likely, given that RRR cuts is a high profile tool that is not typically viewed as associated with social reforms.

Fiscal and administrative easing could step up as well, in our view, such as less stringent policies with regard to the down payment requirements for home purchases, mortgage rates, as well as with administrative purchasing restrictions using the hukou/family registration system.

(The article has been edited for clarity)

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