Chinese economic growth is likely to slow from around 7% this year to 6.2% in 2016, dragged lower by a slowdown in the nation’s vast property construction sector and excess capacity in the industrial and mining sectors.
That’s the downbeat assessment offered by UBS’ China economics team, consisting of Tao Wang, Donna Kwok, Harrison Hu, Ning Zhang and Jennifer Zhong, who believe that “slower investment and GDP growth will bring headwinds for employment and consumption, which may not be fully offset by services sector resilience”.
Despite a resilient result from Chinese industrial production and urban fixed asset investment figures for November released over the weekend, UBS believe that the deceleration in both is likely to continue in the year ahead. That suggests “the continued slowdown of property construction and overhang of excess capacity in the industrial and mining sectors will likely lead to further weakening of industrial demand and fixed investment”.
According to the bank, the slowdown in property construction will spread throughout the economy for the the next two years, a response “to the sharp collapse of new starts in 2014 and 2015”. This, in their opinion, is likely to weigh on industrial production, hence commodity demand, in the year ahead.
“As property-related demand for commodities and machinery declines further, mining and manufacturing enterprises (many already saddled with overcapacity) will cut back on production and investment even more,” says the bank.
“Destocking or closure of excess capacity in the mining and industrial sector thus far has progressed very slowly, possibly due to concerns over any resultant impact on growth or employment. Faster restructuring, which we expect for 2016 and 2017, can help to put China’s corporate sector on a sounder footing over time, but should be more negative for short term growth.”
The chart below, supplied by UBS, reveals the direct and indirect effect of Chinese economic growth from a 10% drop in the growth of property and construction output.
In order to minimise the risk of a so-called economic hard landing, they expect the PBOC and government will look to stimulate activity in the sector, although they suggest it will not be as effective as was the case in previous years.
“We expect further monetary policy easing and see infrastructure investment support continuing, but its effectiveness will become increasingly blunt. We see overall gross capital formation decelerating from 5.9% in 2015 to about 4.8% in 2016 in real terms and from 10-11% to 8-9% in nominal FAI terms,” they wrote.
While UBS expect China’s old growth engine of investment and production to slow further, the economy’s new growth engine – consumption and services – is predicted to remain resilient, although it is not expected to be able to fully offset weakness in the industrial and property sectors.
“Consumption growth is likely to moderate slightly due to weaker employment and wage growth but remain resilient, in part helped by policy measures helping to boost employment and strengthen the social safety net.”
In order to assist the economy’s transition, UBS predict that the PBOC will reduce benchmark one year lending rates twice next year while reducing the official reserve ratio requirement for banks by a further 300 basis points in order” to offset capital outflows and keep liquidity conditions accommodative”.
They also expect the Chinese renminbi to weaken further, suggesting the USD/CNY will trade at 6.8 by the end of next year from its current level of 6.454.
Reflecting of the concern expressed by financial markets this year towards the outlook for the Chinese economy, UBS suggests the government faces a difficult balancing act in the year ahead.
“The government faces a difficult trade-off between more aggressive restructuring (which is bad for short-term growth but good for macro risk reduction and long term growth) and more stimulus to achieve its ambitious growth target and avoid the pain of immediate restructuring,” says the bank.
“We think increasing pains in the real economy and the diminishing effect of policy easing will lead to faster corporate restructuring and debt write-offs in 2016-17, assisted by better social safety net provisions and easier monetary conditions.”
They suggest that downside risks to their forecast could stem from “a deeper and more prolonged property destocking process and a greater knock-on effect on the industrial sector, and to a lesser extent, from insufficient policy support to temper the downturn”.
On the flipside, the bank believes stronger external demand, a faster construction recovery and greater investment in services and new industries could lead to an upside surprise to growth.
“On balance, we think the risks are tilted more to the downside, though we still think a financial crisis is highly unlikely in the near term,” says the bank.