China
Dissect the Policy Uncertainties: Revisiting Our Four-Season Framework
March 27, 2008

By Qing Wang | Hong Kong

Revisiting Our Four-Season Framework

Late last year, we put forward a four-season framework to describe the potential scenarios in 2008 (see China Economics: Journey into Autumn: An Imported Soft Landing in ’08, December 4, 2007). We believe that it remains a useful framework in explaining the economic and policy developments since early this year and helping to dissect the enormous policy uncertainties going forward. Here we provide a brief recap of the key elements of this framework.

There are two types of uncertainty facing the Chinese economy in 2008: i) whether an external slowdown in the wake of the US subprime crisis will be significant enough to effectively disinflate the Chinese economy; and ii) whether macroeconomic tightening policy launched by the Chinese authorities will be followed through consistently to cool off domestic demand sufficiently and thus effect disinflation.

Along the two dimensions of uncertainty, there are four potential scenarios: i) Autumn features a combination of an external downturn and policy muddling-through, bringing about ‘an imported soft landing’; ii) Summer features a combination of no meaningful external downturn and policy muddling-through, which results in an ‘overheating’; iii) Spring features a combination of no external downturn and a large revaluation of the exchange rate, which helps to achieve a ‘policy-induced soft landing’; and iv) Winter features a combination of an external downturn and aggressive domestic tightening, which leads to ‘an outright hard landing’.

Baseline Scenario: Autumn

Autumn, or an ‘imported soft landing’, is our baseline scenario for 2008. This scenario hinges on two key calls: i) a US-led global downturn that slows the rapid expansion of China’s exports and thereby helps the economy to cool off; and ii) a muddling-through style for macroeconomic management in that as external demand weakens, domestic policy tightening will not be followed through consistently and will even be eased over the course of the year. Our policy call therefore features three “No’s”: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no aggressive interest rate hikes.

There are of course risks to the two key calls on which our ‘imported soft landing’ call hinges. However, we believe that the risk of policy overtightening − where aggressive tightening policy is pursued even when external demand weakens substantially − is quite low.

When the policy tightening was announced back in December last year, we believe that it was predicated on a largely benign external environment. However, the developments in the global economy and market have since made the Chinese authorities recognize the potentially large downside risks and stand ready to adjust their policy stance as external demand weakens (see China Economics: Be Prepared for Potential Policy Shift, February 4, 2008).

In particular, a senior PBoC official was quoted in late February as saying that in 2008, M2 growth would be around 16% and bank credit growth will be lower than the 16.1% in 2007, and that was what PBoC meant by “tight monetary policy”. Obviously, this “lower than 16.1%” credit growth target leaves much upside potential to market consensus of 13-14% bank credit growth in 2008 as envisaged under the authorities’ original tightening plan announced last December. In fact, the strong money and credit growth in January-February is an indication of the flexibility on the authorities’ part in implementing their ‘tight’ monetary policy.

While the authorities are unlikely to make an official announcement for a policy shift and the rapid pace of money and credit growth in January-February (17.5% and 15.7%, respectively) is unlikely to be sustained throughout the year, we do not believe that the authorities would stubbornly stick to the aggressive targets for money and credit growth (i.e., 13-14% credit growth) originally set at the end of last year, if substantially weak external demand were to materialize.

Risk Scenario: Pendulum Between Winter and Summer

Against the backdrop of a broad-based global market sell-off, investors’ sentiment toward China has been generally negative as well. Many investors appear to have attached a high probability to the risk scenarios instead of our baseline scenario, with sentiment swinging between Winter (i.e., an outright hard landing) and Summer (i.e., overheating).

In January, as the US subprime prime crisis started to take its toll on much of the rest of the global markets, especially in emerging Asia, investors’ primary concern was whether the Chinese economy had the ability to cope with a global downturn, led by a severe US economic recession, through stimulating domestic demand and thus avoiding a hard landing. This concern was exacerbated by the Chinese authorities’ high-profile announcement late last year to pursue aggressive tightening policies to prevent the economy from overheating. Many investors fear that the Winter scenario may materialize, where a double-whammy impact stemming from a combination of external downturn and domestic policy tightening would lead to a hard landing of the economy.

However, entering February and March, market sentiment appears to have shifted diagonally from concerns about the hard landing risk (i.e., Winter) to concerns about the overheating risk in China (i.e., Summer) and the potential harsh anti-inflation policy responses. This shift appears to have reflected two important recent developments: i) China’s export growth in January-February (averaging 17%Y) remained quite robust, showing no clear signs of being negatively impacted by the external downturn; and ii) CPI inflation in January-February posted record highs.

Against this backdrop, and in view of the authorities’ renewed pledge made at the NPC meeting (second week of March) to make controlling inflation a top policy priority, some investors started to wonder whether inflation in China is not out of control and China would not repeat its costly anti-inflation experiences in 1987/88 and 1994/95.

The Likely Alternative Scenario: Spring

If the Autumn scenario − ‘imported soft landing’ − fails to materialize, we think that the most likely alternative scenario will be Spring − a ‘policy-induced soft landing’ – and so we would caution against excessive pessimism right now.

We are still of the view that inflation is not out of control in China. The record-high CPI inflation in January-February in part reflected some one-off supply-side factors (e.g., snowstorms) that sharply pushed up the prices for some food items (see China Economics: Higher Inflation for Longer, March 11, 2008). And the latest high-frequency data indicate that food prices in March will likely drop below the February peak, pointing to a lower (year-on-year) headline CPI reading in March (see China Economics: Food Price Inflation Monitor: Average Prices for Raw Food Continued to Edge Down, March 23, 2008). A lower reading of headline CPI inflation in March will diminish the probability that authorities will make a strong anti-inflation policy response, in our view.

But if headline CPI inflation in March were to register a higher reading than in February by defying seasonality and despite the tapering-off of the snowstorm-related one-off factors, it would indicate that the underlying inflation expectations may have been so strong that higher inflation due to one-off factors could easily carry on its own life. If this were to be the case, we are afraid that inflation could indeed be at a high risk of running out of control. The risk that our call for an ‘imported soft landing’ may not materialize would be on the rise.

Should we then expect heavy-handed tightening policy measures in the form of consecutive rate hikes and much tighter administrative controls over bank lending and fixed-asset investment? Will China repeat the costly anti-inflation experiences in 1987/88 and 1994/95, as some investors fear?

We attach a low probability (less than 20%) to this pessimistic scenario. If, contrary to our expectations, the much-anticipated external slowdown is not deep enough or takes too long to have a disinflationary impact on China and, at the same time, the authorities are eager to take pre-emptive action to nip the inflation expectations in the bud, we believe that a much faster or even a large one-off revaluation of the exchange rate instead of heavy-handed domestic tightening (e.g., aggressive interest rate hikes) will play a primary role in the authorities’ anti-inflation effort.

We have been making the argument that for the Chinese authorities to be willing to make a large one-off revaluation of the exchange rate, at least one of the following two conditions would need to be met: i) domestic CPI inflation moves out of control; or ii) such a sizeable revaluation would produce an international political gain vis-à-vis China’s major trading partners (e.g., the US and EU) that would be sufficient to make the currency move worthwhile (see China Economics: Fasten the Seatbelt, October 22, 2007; China Economics: Fasten the Seatbelt: An Update, November 12, 2007).

In fact, this is what we envisage under the Spring scenario: a combination of no external downturn and a large revaluation of the exchange rate helps to achieve a ‘policy-induced soft landing’. We think this is the most likely alternative scenario, if our baseline scenario fails to materialize. Here’s why.

Why Currency Appreciation Instead of Rate Hikes?

To bring inflation under control, especially when inflation expectations are high, a price in the form of slower output growth will have to be paid. Moreover, to effectively turn inflation expectations around would require that the magnitude of a policy move be large enough and/or its frequency high, in our view. Determining which anti-inflation policy tools − interest rate hikes or exchange rate appreciation/revaluation − to use boils down to deciding on which sector − domestic demand-oriented or export-oriented − assumes the bulk of the adjustment costs.

In this context, we believe that there is no room for large and frequent interest rate hikes (or domestic tightening) and much room for currency appreciation/revaluation (or external tightening). First, large and frequent rate hikes will not only weaken domestic investment, but also impinge on domestic stock and property markets. While preventing too rapid investment growth has always been one of the key policy objectives, the authorities are unlikely to be willing to see domestic asset markets subject to further downward pressures, given the current fragile market sentiment.

Second, interest rate hikes will only serve to worsen the external imbalances (e.g., persistently wide trade surpluses and rapid FX reserve accumulation). This is because: i) higher interest rates weaken domestic demand and thus imports, further widening China’s trade surpluses; and ii) consecutive rate hikes in China − while the Fed is cutting rates aggressively − further widen the already large and positive China-US interest rate spread, making it even more difficult to reduce net capital inflows and also adding to the operating costs of the PBoC’s sterilized intervention. And it is the persistent external imbalances (i.e., FX reserve accumulation) that constitute the source of liquidity creation and strong money supply growth.

On the other hand, much faster currency appreciation or even a large one-off revaluation helps rein in inflation. Specifically, a strong currency: i) reduces exports (which are part of aggregate demand pressures) and increases imports (and therefore diverts some of the demand pressures toward goods/services made in other countries); ii) can help stem ‘imported inflation’ by reducing the domestic currency-denominated prices of imported goods; and iii) helps improve external imbalances by narrowing trade surpluses and discouraging capital inflows when a faster appreciation or a large one-off revaluation dampens the expectation of more appreciation in the future.

A much faster or large one-off revaluation of the exchange rate will likely have a negative impact on the domestic asset markets to the extent that inflows into these markets are from foreign sources and thus sensitive to exchange rate movement, and these investors may take profits from the currency gains and exit the markets. However, since foreign participation in both the domestic property and stock markets has been very insignificant compared to the vast presence of local investors, the negative impact on the asset market of a currency appreciation or one-off revaluation will likely be much more modest than that of consecutive interest rate hikes.

Moreover, the current external environment − the US Fed cutting interest rates aggressively and the USD plunging − substantially limits the room for the PBoC to hike rates while leaving much upside for the renminbi to appreciate against the USD to effect a meaningful nominal effective appreciation (i.e., appreciation against the underlying currency basket).

As discussed above, large appreciation of the exchange rate has obvious advantages over consecutive rate hikes as an anti-inflation policy tool at the current juncture. One important downside of large appreciation is the potentially greater job losses, when some less competitive exporters go out of business due to a strong currency. This underscores the importance of avoiding aggressive domestic tightening so that jobs lost in the export sector can be created in the domestic demand-oriented sector, as the overall economic growth is still robust. At the same time, the availability of unemployed workers should help ease the tightness in the current labor market and prevent sustained upward wage growth − which is the ultimate source of persistently high inflation.

Different Situation from the 1987/88 and 1993/94 Anti-Inflation Experiences

Many investors are concerned that China may repeat its costly anti-inflation experiences in 1987/88 and 1993/94. Since inflation is always a monetary phenomenon, in this regard the previous two episodes of inflation indeed look similar to the current one; however, the underlying mechanism is different. Specifically, in both 1987/88 and 1993/94, the high CPI inflation was attributable to proactive loosening of monetary and fiscal policies; however, the current inflation reflects primarily a passive loosening of monetary policy due to persistently large external imbalances and the desire for very gradual appreciation of a substantially undervalued exchange rate. The anti-inflation policy mix this time should be different from those in the previous episodes, in our view.

The 1987/88 inflation began with an early relaxation of monetary and fiscal policies due to concerns that stringent policies, adopted during the previous cycle, were causing problems for state-owned enterprises. Inflation rose to 19% in 1988, and the authorities responded with a heavy reliance on administrative measures, complemented with interest rate hikes. But to contain the resulting output loss, the government made 18% and 8% devaluation of the exchange rate in 1986 and 1987, respectively. Inflation was quickly brought under control, but the economy suffered a hard landing, with GDP growth dropping from 11.3% in 1988 to 4.1% in 1989.

The 1993/94 inflation was preceded by a rise in central and local government spending and an easing in bank credit policies. By 1992, an investment boom was underway, with real GDP growth exceeding 14%. Demand pressures led to a pick-up of inflation, boosted by liberalization of food prices and public sector wage hikes. The authorities responded in mid-1993 with a ‘16-point’ plan to cool the economy. The measures included raising interest rates, tightening credit controls and limiting investment approvals. At the same time, also to minimize the resulting output loss, the renminbi exchange rate was devalued by about 50% in 1994.

The authorities eventually achieved a soft landing, with inflation in single-digits by 1996 and only a modest slowdown in growth. While a soft landing was achieved, the rapid pace of credit growth and the subsequent strong policy tightening in 1992-96 contributed to a build-up of NPLs in the banking system. In fact, the bulk of the NPLs that had paralyzed the banking system until a few years ago date from this period.

The policy responses in these two previous episodes of inflation share one common element: a combination of domestic tightening (i.e., interest rate hikes, administrative money and credit controls) and external easing (i.e., devaluation of the exchange rates). This policy approach is broadly appropriate, since inflation was after all mainly caused by a proactive loosening of monetary and fiscal policies.

However, the current situation is different and thus requires a different policy mix. Since the current inflation mainly reflects passive monetary easing due to external imbalances, the optimal policy mix should feature external tightening (e.g., currency appreciation/revaluation), to be complemented with modest domestic tightening or even a neutral policy stance.

Our Policy Call

Our policy call under the baseline ‘imported soft landing’ scenario features three “No’s”: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate and no aggressive interest rate hikes. In fact, in view of the aggressive rate cuts by the US Fed, we have changed our call from “two rate hikes in 1H08” to “no rate hikes throughout the year”. We continue to believe that this is the most likely scenario.

If, however, headline CPI inflation in March were to register a higher reading than in February, it would indicate a high risk of inflation running out of control, in our view. In this event, we suggest that clients be prepared for a much faster appreciation or even a large one-off revaluation of the renminbi exchange rate. While we cannot completely rule out a token rate hike in this context, we see little chance for aggressive interest rate hikes (e.g., more than two 27bp hikes). In our four-season framework, this will essentially be the Spring scenario: a policy-induced soft landing.

As the renminbi appreciation pace accelerates, we expect the government to further tighten controls over inflows under the capital account (both foreign direct and financial portfolio investments). And we do not rule out that the government may even tighten its controls over inflows under the current account (e.g., inbound remittances, transfers).

In view of the very rapid loan expansion in January-February, it is highly likely that loan growth will be aggressively curtailed in the next couple of months. However, we believe that it is impossible to achieve the authorities’ ambitious target of 13-14% loan growth per annum − which was originally set at the end of last year − and expect actual loan growth in 2008 to be no less than 16%.

Besides these price-based measures, we expect that the nine policy measures aimed at boosting supply − which were laid out by Premier Wen in his government work report − will be implemented and the attendant negative financial implications to companies impacted (e.g., refinery and power-generating companies) will be addressed with fiscal support (see China Economics: Key Statements by Premier Wen on Inflation and Housing Policy, March 5, 2008).

Implications

Under either the baseline scenario of an ‘imported soft landing’ scenario or the most likely alternative scenario of a ‘policy-induced soft landing’, we think that the policy environment will likely be characterized as ‘domestic demand-friendly’. With sustained robust domestic demand, China’s imports are unlikely to slow significantly despite a potential decline in China’s export growth. This should be constructive for the global commodity market, in our opinion.

Since we see substantial upside to the renminbi exchange rate and limited upside for interest rates, we suggest that long domestic demand-oriented sectors that have a large content of imported inputs and/or benefit from a broadly stable interest rate environment, and short external demand-oriented or imports-competing sectors that are vulnerable to a strong currency should make a sensible investment strategy.

Risks

We see little risk of an economic hard landing. The biggest risk to our call is not the ultimate outcome (i.e., soft versus hard) but rather how we get there. A lack of effective communication strategy on economic policy on the authorities’ part may constantly create confusion and exacerbate the uncertainties, resulting in unwarranted and significant volatility in the market.

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