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Macro analysis

Engineering economic stability

China’s economic performance so far this year has matched President Xi Jinping’s 19th Party Congress announcement that the country has entered a new era. 2017 is set to be an impressive year with growth in the upper bounds of the 6.5 to 7 percent growth target, despite a slight slowdown in the third quarter of 2017. At the same time, the government declared that progress was made on reducing debt and overcapacities, implying that all of that was possible while maintaining the current high growth rates. But keep in mind: if it sounds too good to be true, it probably is.

In all fairness, the Chinese economy has many bright spots: consumers are happily spending and China’s dynamic internet economy is contributing to service sector growth. Macroeconomic indicators such as industrial production, investment, and foreign trade are all positive. As a result of capital controls, exchange rate depreciation is no longer a concern. Positive developments in asset markets round off the rosy picture: stock market prices are picking up and real estate price growth has begun to slow down.  The MERICS China Confidence Index (first published here) also reflects these developments. It remained above 100 in Q3, indicating an overall positive mood. The index was largely carried by demand for property and stocks while other components started to weigh it down.    

But the real problem is: China cannot break its reliance on credit.  The government is aware of the problem and has attempted to deleverage by strengthening regulatory oversight of the financial system. But the efforts have not been successful: there has been no real reduction of debt levels. Over the third quarter, total credit kept expanding at a higher pace than GDP growth. There was some success in reducing corporate debt issuance, but these advances were offset by rising shadow banking and consumer loans. Making matters worse, credit’s ability to generate GDP growth has been declining. This suggests that new credit is not making its way into the real economy. It might instead be flowing into the financial system for refinancing and speculative investments. Other than reshuffling the structure of debt, the deleveraging campaign has achieved little.

Credit-fueled growth is here to stay. The government’s efforts to deal with structural problems head on are constrained by the ambitions to keep the economy humming along. Policy makers understand that raising interest rates would hit the economy hard and could potentially cause a crisis. So far they have refrained from tightening monetary policy. Instead, their preferred tool for maintaining financial stability is micro-management. As problems arise, the government tries to contain each by targeted intervention. Meanwhile excessive liquidity shifts to new areas, creating new problems that call for the government’s attention. The latest such trouble spot is the growth of consumer loans, which the government has begun to tackle by unleashing new regulations.

It is becoming evident that achieving deleveraging and maintaining high economic growth simultaneously is not possible. Steps to reduce the Chinese economy’s reliance on credit will remain timid as the government tries to keep GDP growth within a corridor of 6.4 and 6.8 percent in order to reach its target of doubling GDP and income by 2020. This is a narrow band to navigate within and limits the government’s policy flexibility.

The MERICS China Confidence Index measures households and businesses’ confidence in future income and revenues. 
The index is equally weighted between household and business indicators. It includes the following indicators: stock market turnover, future income confidence, international air travel, new manufacturing orders, new business in the service sector, urban households’ house purchase plans, venture capital investments, private fixed asset investments and households’ consumption share of disposable income. All components have been tested for trends and seasonality. 
The MCCI was first developed in Q1 2017.