This year has been a period of stimulus for China’s economy. 2016 will be the same as well.
The central bank has cut interest rates multiple times. It has injected liquidity to offset capital outflows and deployed new instruments to cap money market rates and guide longer term lending costs down.
The Ministry of Finance has accelerated public spending and rolled out a 3.2 trillion yuan (US$495 billion) debt swap for in-the-red local governments. Most recently the yuan has fallen, dropping 2.4 percent to 6.4726 in mid-December from 6.3174 at the end of October.
All of that has succeeded in putting a floor under falling growth. Bloomberg Intelligence Economics’ monthly GDP tracker came in at 6.8 percent year on year in November, up slightly from a steady reading of about 6.6 percent since July. That reduces the urgency in rolling out further stimulus.
That said, with risks to growth still tilted firmly to the downside, the outlook for 2016 is for a steady ratcheting up of policy support.
On monetary policy, the central bank faces two main challenges. First, high costs from servicing existing debt are crimping demand for credit. According to BI Economics’ calculations, the cost of servicing existing borrowing is already equal to about 30 percent of GDP.
With such high costs from existing loans, China’s businesses are understandably reluctant to borrow more. Addressing that problem likely means further rate cuts to allow refinancing at a lower cost.
Second, the return on investment has fallen perilously close to the cost of credit, denting incentives to borrow. Back in 2007, businesses could borrow for about 7 percent and nominal growth (a proxy for return on investment) was above 20 percent. Businesses had every incentive to borrow and invest.
Fast forward to 2015, and the benchmark loan rate has come down toward 4 percent, but nominal growth has collapsed to 6 percent. The incentive to borrow is much weaker. That, too, makes a case for rate cuts.
BI Economics is penciling in two 25 basis point cuts in the first half of 2016 and probably more in the second half. The reserve requirement ratio, a blunt instrument used by the central bank to manage liquidity, is set to come down from the current 17.5 percent level.
The PBoC uses the timing of RRR cuts to signal stimulus support. The main impact, though, is to offset the impact of capital outflows as the yuan depreciates.
Shifts in the policy position will take place against the backdrop of an evolving tool set. Interest rates have been liberalized, with no cap or floor on banks’ loan or deposit rates. Even so, the PBoC will likely continue to signal shifts in policy by announcing movements in benchmark rates. Benchmark rates will retain a guiding influence on the market.
Monetary policy will be more efficient and market based. Still, against a background of high debt and falling prices, it is losing some of its traction. Control of the yuan continues to lurch from the government to the market and back again. That makes the outlook for China’s currency difficult to predict. That said, multiple signs point to depreciation.
The consensus forecast is for the yuan to end 2016 at 6.60 to the dollar. The forecast range is from 6.24 to 7.65. A critical variable in determining the outlook is what happens to the dollar.
A sharp rise in the US currency would force an aggressive decoupling of the yuan as China attempts to maintain the real effective exchange rate on an even keel - supporting export competitiveness.
The views expressed in this article are those of Tom Orlik and Fielding Chen, economists at Bloomberg Intelligence.
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