China 2018/19 outlook: The age of the strongman
- Gradual slowdown in growth to continue; a gradual approach to deleveraging will also persist
- 2018 will mark the very first year of a new era under Xi’s tight control; challenges are immense
- Gold-backed Petro-yuan will likely bring profound institutional change; RMB is becoming more stable
- Modestly higher rates ahead amid firmer inflation and tighter liquidity
- Domestic liquidity and confidence of international investors to drive the Hang Seng towards 33,000
The likelihood of state-driven investment becoming the prime economic growth driver in 2018 and beyond is high. The orthodoxy of developing a consumption-led economy is unlikely the sacred goal for China at this juncture. Improving the livelihood of the Chinese people requires per-capita income to rise sustainably over the long run. This requires investment in the right places now to generate decent returns in the future. Consumption rises only when incomes do. That is indeed the path of development followed by many Asian economies. China clearly does not want to be cursed by the “middle income trap”. The authorities know well that artificial wealth creation via inflation of the property bubble is a precarious route.
Industrial policies will intensify to sharpen the export competitiveness of the following strategic sectors: railway equipment, electric vehicles, manufacturing control systems, maritime engineering, and biomedicine etc. China will continue to embrace free trade that suits her mercantilist favour. Trade conflict with the US is set to rise. Against this backdrop, 2018 growth, buoyed by a new phase of urbanisation and state-driven investment in strategic sectors, may surprise on the upside, conditional upon the magnitude of deleveraging.
Fiscal canons should be more effective in boosting short-term growth. However, effective expansionary fiscal policy is about meticulous planning and execution. Coherence of policy execution should be substantially improved in the next five years as key provincial leaders supporting Xi are already in place. That should buy China more time to deleverage to restrain the proliferation of WMPs. As far as the exchange rate is concerned, the key tactic is to maintain “the stability of the CNY with a slight depreciation bias”. Doing so fits the purposes of multiple agendas.
From now on, attention must be paid to foreign policies, especially those pertaining to Belt and Road Initiative projects. In 2018, China will speed up these projects: (1) the building of the Jakarta-Bandung high-speed railway, (2) the China-Laos railway, (3) the Addis Ababa-Djibouti railway, (4) the Hungary-Serbia railway, (5) the Melaka Gateway project in Malaysia, and the upgrading of (6) the Gwadar port in Pakistan. The goal is to elevate the global influence of China via the EURASIA integration strategy. China will likely put extra effort in Pakistan and Malaysia because those projects are the easiest to execute, given the countries’ strong diplomatic relationships.
In line with this, efforts will be made to increase the yuan’s global acceptance. Yet maintaining financial security is equally important from policymakers’ perspective. Striking the right balance is a challenge under the upcoming US rate-hike cycle.
Turning to regional usage, direct investment, rather than portfolio investment, would be the focal point. The BRI will play a pivotal role. To curb capital flight, regulators have this year stepped up scrutiny on overseas investment and debt-fuelled acquisitions.
Another highlight would be yuan use in commodity trading. Under BRI, the “belt” is a series of overland corridors connecting China with oil-abundant countries in Europe, Central Asia, and the Middle East.
Should Saudi Arabia follow in Russia’s footsteps with yuan settlement for oil transactions, this would mean a paradigm change for the whole industry. Propelling the development are RMB-denominated gold contracts traded in the Hong Kong and Dubai exchanges, which allow oil exporters to invest their yuan proceeds. Alongside the recent Panda bond issuance plans for Saudi Arabia and the Emirate of Sharjah, this suggests that the “Petro-yuan” story may not be too far-stretched.
The Chinese yuan is, after two tumultuous years of depreciation pressures, set to become a more stable currency in 2018. Since mid-2016, the yuan has been increasingly aligned, in varying degrees, with global and regional currency trends.
As for rates, with growth trending below 7% and trend CPI probably marginally above 2%, we suspect that 10Y yields should be in the 3.5-4.0% range under normal circumstances. With the People’s Bank of China still focused on deleveraging, it is likely that short-term onshore rates would be elevated, spilling over into longer-term swaps and yields. The open market operation weighted-average rate has climbed by about 25bps to 3% since the start of the year. With this guidance, the 7D repo has generally been staying above 3% this year.
The investment case for China-related equities listed in Hong Kong remains strong as Xi embarks on his second term. There should be more confidence in the new administration as observers witness China’s new dominance in world affairs, while having a strong grip on domestic issues.
Meanwhile, on-going reforms in the financial sector and capital markets, as well as economic restructuring should present investment opportunities in sectors such as SOEs, banks, e-commerce, and new technology.
We forecast the Hong Kong market to ride its current momentum that’s driven by positive earnings. Economic reforms are expected to follow through with greater authority, removing uncertainty for the market. Valuation of the Hong Kong market is still not excessive compared to other markets and considering its growth prospects. We expect domestic and international fund flows to provide support to the market. The HSI is expected to trade between 30,000-33,000, translating into the price-earnings multiples that are still below long-term averages.
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