Despite the 53 percent rise in the Shanghai A-share index last year, with the bulk of the increase coming in the last two months of 2014, there is one big factor that will drive the market further this year: liquidity. What is important for investors to note is that bad news for the economy is actually good news for the stock market.
While China’s 2014 GDP growth only missed the official target marginally, its CPI inflation (which averaged less than 2 percent in 2014) undershot Beijing’s target of 3.5 percent significantly. In the meantime, the PPI has been stuck in deflation for almost three years now. The property market correction, if not managed properly, could convert CPI disinflation into outright deflation by inflicting a systemic shock. Those who think all this sounds bad for Chinese stocks should probably think again.
The key to China’s market outlook is the threat of deflation and its policy implications. The size of the “output gap”, or the difference between actual and potential output growth, determines the rate of inflation. A positive output gap (i.e. actual growth higher than potential growth) generally leads to rising inflation, while a negative output gap leads to falling inflation or even deflation.
The IMF estimated that China’s potential growth rate had fallen from more than 10 percent a year between 2003 and 2010 to 8.5 percent between 2011 and 2013. However, its inflation rate has fallen even faster, implying a negative output gap in recent years.
China’s declining growth rate is the result of a policy choice by Beijing, which is focusing on structural reforms rather than chasing growth number. Intensifying reforms under President Xi Jinping have forced GDP growth down to 7.0-7.5 percent a year recently, widening the negative output gap and raising the risk of deflation.
The output gap is widening because both domestic and external demand are weak. One could argue that commodity price weakness had also exerted significant deflationary pressure on China. This is only half right because weak Chinese demand has had a negative feedback effect on commodity prices (especially oil), with China being the world’s largest oil importer and one of the largest commodity users.
The policy implication would be for monetary easing to close the output gap and boost inflation back to normal levels consistent with potential growth. China is still a long way from zero interest rates. Beijing has the firepower to address the mounting deflation risk. So far it has refused to engage in significant easing as it is wary of throwing more good money after bad. But this also makes it hard to break the disinflationary/deflationary trends decisively.
The inflation outlook depends on whether China’s output gap narrows or widens. Beijing cannot affect the potential growth rate in the short-term, but it can set a GDP growth target that influences market expectations and actual output.
If it cuts the growth target to 7.0 percent or less, as some observers speculate, growth expectations would fall and that creates a self-fulfilling prophesy that would not help close the output gap and fight deflation. Setting a growth target range of 7.0-7.5 percent seems a better choice, as that would allow Beijing some flexibility to maneuver policy while having 7.0 percent as the bottom line for the balance between growth and reform.
Since monetary policy affects the economy with long and variable time lags, the People’s Bank of China will have to keep a policy-easing bias for longer to ensure there is no “growth mistake”. What would prompt it to ease more aggressively?
Not inflation because there is none; nor a credit event in the system since Beijing still has a selective “implicit guarantee” policy in place to contain any systemic fallout. It will not be growth either, as slow growth is a policy choice. A possible trigger would be a sharp deterioration in the labor market, which would affect the Communist Party’s power base.
The liquidity implications of this macroeconomic backdrop bode well for Chinese stock prices. When bad news for the economy is good news for the market, the stock price recovery should have a long way to go in China.
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