Further disinflation could undermine corporate profit margins and, consequently, income growth. We expect average CPI inflation of 2% in 2015.
5. Borrowing costs remain high, curbing new investment and consumption. China’s nominal economic growth has fallen dramatically since the global financial crisis, to less than 8% as of the third quarter 2014 from 22% in 2008.
However, the average lending rate has failed to adjust sufficiently, declining by only 0.8 percentage point over the period. This is partly due to the incomplete interest rate liberalization process. The actual lending rate for the private sector, usually for short-term loans, is close to 21% including all expenses, as measured by the Wenzhou private financial index.
6. There are tentative signs of a housing-market recovery. Sales in China’s 31 biggest cities have been recovering gradually since July, according to data from Soufun.
This is the result of targeted policy easing and the release of pent-up demand. However, new investment and construction activity may not re- accelerate until second half of 2015, in our view, as inventories are still high and land purchases remain lackluster.
7. New industries are emerging, preparing China for the long run. Investments in green energy, health care, education, environmental protection and infrastructure have risen in 2014. These industries have been selected by Beijing as part of its plan to transform China into a more innovative, environmentally friendly and consumption-driven economy.
For now, they are not yet big enough to generate much economic growth, as they account for less than 15% of GDP. The housing and manufacturing industries remain the heavyweights, but investment growth in these sectors has been slowing.
8. Leverage growth has been brought under control, and systemic default risk is better contained. Credit growth has slowed significantly in 2014, especially for shadow banking credit, where growth fell to 17% in October from 27% at end-2013.
New regulations rolled out in 2014 have reduced some of the riskier activities in the shadow banking sector, such as third-party guarantees and write-offs of collateral assets used in repo transactions.
Growth in local government debt slowed to about 3% in 2013 from over 20% in 2009 to 2010, according to the latest findings by the National Audit Office.
The revised Budget Law passed in August and subsequent State Council documents have also strengthened the supervision and management of local government debt. Local governments are banned from additional borrowing through financing vehicles, while they are allowed to issue municipal bonds to finance local projects and encouraged to participate in public-private partnership projects.
9. Another interest rate cut is likely in the first quarter of 2015 to support the economic recovery. The PBoC is then likely to pause to evaluate the effectiveness of its rate cuts.
We expect it to cut the deposit rate by another 25 basis points and lift the deposit rate ceiling to 1.3 times from 1.2 times as it moves towards interest rate liberalization.
During the transition period, the PBoC may lower the benchmark lending rate by another 40 basis points. We also expect it to take material steps towards liberalizing deposit rates by end-2015, possibly by simultaneously removing the ceiling for deposit rates and adjusting benchmark rates lower.
10. Mild RMB appreciation and a slightly larger current account surplus are expected in 2015. The USD-RMB exchange rate is likely to stay range-bound in the near term due to weak economic growth and the policy easing stance.
We do not expect material RMB depreciation given that it could trigger capital flight and jeopardize RMB’s internationalization, which could undermine China’s financial stability.
RMB appreciation is also unlikely to be welcome for now given the need to support the economic recovery. We expect the RMB to strengthen in the second half after the economy stabilizes, however. We see the USD-RMB spot exchange rate ending 2015 at 5.95, with China’s current account surplus widening to 2.8% of GDP in 2015 from 2.3% 2014.