China's policymakers have had a very busy summer. After very weak growth in early 2015 and significant turmoil in Chinese financial markets this summer, they are working to restore stability and bring real GDP growth back to their “around 7%” target for the year. Their efforts appeared to gain traction with a meaningful improvement in June activity data, but renewed data disappointments in July and early August suggest further policy support is still needed. Alternative indicators of Chinese economic activity have implied a sharper slowdown than the GDP data for some time, particularly in the goods sector and commodity-intensive industries (chart below). More fundamentally, our past research on rapid debt buildups suggests that they result in lower growth, lower inflation, and lower interest rates over a multi-year time frame. All of these consequences are playing out in China's case and we think the story still has several chapters to go.
Chinese growth has slowed, especially by unofficial goods-sector metrics
Source: Haver Analytics, Goldman Sachs Global Investment Research, NBS
2. Several well-intentioned reforms have had the unfortunate side effect of increasing volatility and uncertainty in China’s economy and financial markets this year. Fiscal reform was meant to shine a light on the opaque finances of local governments and encourage more transparent and productive municipal financing, but precipitated a sharp fiscal tightening before policymakers dialed back. The equity market looked like an attractive vehicle for reducing the corporate sector's reliance on debt, but a binge in margin leverage created an unsustainably speedy boom and bust; intervention since then has had the result of reducing rather than increasing free float. The latest reform, to the exchange rate fixing mechanism, was presumably motivated by both market liberalization (SDR) and competitiveness (weaker TWI) concerns, but has de-anchored what was previously the most stable element of China's macrofinancial policies—with outflows and reserve losses apparently accelerating significantly so far in August.
3. The biggest impact to growth from the Chinese equity market and currency moves is probably via this increase in economic and policy uncertainty. Perhaps because of this, policymakers seem to be emphasizing stability and pushing back a little on expectations of further near-term easing in rate and FX markets. That leaves fiscal support (endorsed by the IMF in its just-released Article IV report) as the primary tool for boosting growth in the remainder of 2015. As we have shown in recent research, fiscal policy faces some implementation challenges relative to past years, but should still have a meaningful impact. The urgent task for policymakers is to avoid large spillovers from decelerating investment into labor market conditions and ultimately consumption, which could prove more difficult to reverse. The challenging data so far, and the short-term effects of production shutdowns around major international events in Beijing over the next two weeks, suggest a weak Q3 is unavoidable, but there is still time for policymakers to boost Q4 growth meaningfully.
4. The 3% depreciation in the CNY this month is unlikely to generate a meaningful boost to growth or competitiveness in the near term. However, the apparent intention to decouple from USD could in theory mean a very different USDCNY exchange rate a few years forward. For dollar bulls, the difference between a CNY quasi-pegged to a rising USD, and a CNY that is stable on a trade-weighted basis, could easily be 10-15% or more a couple of years down the road; the cumulative impact of such a "decoupling" would be less tightening pressure on the Chinese economy and more adjustment elsewhere in coming years. Indeed, trade competitiveness was the focus of a State Council paper released a few weeks ago that outlined a number of other policy steps. The key issue for investors is whether Chinese policymakers’ reaction function has fundamentally changed, either to a more hawkish stance or to one more focused on currency depreciation than in the past. At least for now, we think the intention is more to avoid further FX tightening than to use this as the primary easing tool going forward, though statements and actions here will need to be watched even more closely than in the past.
5. Disappointing Chinese growth and the apparent intensification of regional export competition prompted us to revise many of our regional currency forecasts weaker, particularly those for Southeast Asia. Spillovers to commodity markets from weaker Chinese growth, against a backdrop of healthy supply, have already been substantial. Weaker regional exports and lower headline inflation could facilitate another round of monetary policy easing in the region; we expect another cut from the Bank of Thailand, Taiwan's central bank has edged rates a few bp lower in recent days, and further easing in Singapore or Korea is a significant risk in coming months.
Low and potentially falling inflation opens door to more easing
Source: Haver Analytics, Goldman Sachs Global Investment Research
6. Korea is on the sharp edge of the challenges facing the most open economies of the region, with structural challenges (export competitiveness with Japan and China, demographic transition, a debt buildup in the not-too-distant past) exacerbated by short-term blows from the MERS outbreak and now renewed tensions with the North. Policymakers have taken a number of steps, including policy rate cuts, efforts to ease fiscal policy with the passage of a supplementary budget, and measures to address external competitiveness (including proposed legislation to encourage capital outflows). Elsewhere in the region, Taiwan and several Southeast Asian countries, particularly Thailand, Malaysia, and Indonesia, face the difficult combination of a decelerating China, export competitiveness, falling export prices, and/or rising political uncertainty.
7. Japan's multi-year yen depreciation represents the other side of the competitiveness challenge for these smaller open economies. Just as China is advancing technologically from a historical position as a low-cost exporter, Japan is becoming more cost-competitive from a position of high quality. Depreciation has been a key driver of growth and positive inflation readings, with labor market pressures mainly evident in short-term unemployment and not yet broad-based. The BOJ's forecast that 2% inflation can be reached next year looks too optimistic to us; weaker Chinese growth, falling commodity prices, and currency depreciations elsewhere in the region aren't going to help. We continue to expect a step-up in monetary easing in October to bolster the credibility of the 2% target and provide a signal to markets that policymakers are staying the course. A premature “regime shift” back to pre-Abenomics policies would be a major blow to markets but looks very unlikely in the next 12-24 months.
8. Amidst pessimism about EM prospects, it’s worth remembering that there are still credible growth stories in Asia. Though their economies are still small in comparison to China’s, the triumvirate of India, Indonesia, and the Philippines – combined population 1.6 billion – boast potential growth rates above 6% over the next 5-10 years given young populations, more moderate debt loads, and large gaps with developed-market productivity. The challenge is turning that potential into reality against a backdrop of increasing export competition and potentially tightening global financial conditions. In India, where we have been most positive, recent data have been improving but substantial near-term challenges remain, including banking sector stresses and mixed progress on key reforms such as GST and land reform.
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