China’s Key Words In 2016: Capital Outflow, Deleveraging And Bad Debt

The Chinese government faces a tougher balancing act in 2016, as it cuts capacity and leverage while ensuring minimum growth of 6.5% to achieve a well-off society by 2020, says a new research report by Standard Chartered.

The bank believes that the government is unlikely to tolerate a growth rate lower than 6.5% for the next five years.

The key theme for China’s economy in the next few years is a cautious approach to capacity reduction and deleveraging, while trying to maintain growth of above 6.5%.

In order to achieve that in 2016, China needs to use fiscal policy, perhaps by widening the budget deficit to 3.3% of GDP, or RMB2.4 trillion, this year from an estimated 2.7% in 2015.

At the same time, the People’s Bank of China is likely to cut the reserve requirement ratio (RRR) four or five times by a total of 200 to 250 basis points to ensure adequate liquidity.

On the RMB front, the trade-weighted onshore RMB index is likely to maintain certain degree of consistency. It will be close to the current level of about 100 by year end 2016, although deviation is likely during the year.

In order to keep the RMB’s exchange rate on a manageable level, the authorities will likely keep annual onshore RMB depreciation against the U.S. dollar below 5% to prevent a panic shift to U.S. dollar deposits by households.

As a result, capital account liberalization is likely to be put on hold if large capital outflows continue.

China’s current account surplus continues to support the Yuan’s strength, but depreciation expectations have intensified capital outflows and taken a toll on foreign exchange reserves.

Standard Chartered estimates that China needs about US$3 trillion of foreign reserves to deal with potential adverse external shocks. The reserves of US$3.3 trillion at the end of December will soon fall below this level at the current pace of loss.

Existing capital controls will be tightly enforced as the authorities deem that a growing share of foreign exchange purchases are not supported by real business needs.

The key downside risks for the Chinese economy this year will be from larger-than-expected capital outflows, the combination of abrupt capacity reduction and rising non-performing assets, and policy missteps.

Conversely, property investment and exports may provide positive surprises, the bank says.