China’s 2014 GDP growth of 7.4% only just missed the official target (of 7.5%). While CPI inflation in China in 2014 undershot the 3.5% target significantly, an ill-managed property market correction could result in outright CPI deflation. And China’s PPI has been stuck in deflation territory for almost three years. But those who think none of this sounds encouraging for Chinese asset prices should, in our view, think again.
Growth slowing but inflation slowing faster
The key to China’s market outlook is the threat of deflation and its policy implications. China’s potential growth rate is estimated to have fallen from more than 10% a year between 2003 and 2010 to 8.5% between 2011 and 2013 . However, its inflation rate has fallen even faster, implying a negative output gap in recent years.
Growth pace policy raises risk of deflation
China’s declining growth rate is the result of Beijing focusing on structural reforms rather than outright growth. Intensifying reforms under President Xi Jinping have forced actual GDP growth down to 7.0%-7.5% a year, widening the negative output gap and raising the risk of deflation.
Monetary easing could help break disinflation trend
China’s output gap is widening on weak domestic and external demand. Monetary easing could close the output gap and boost inflation back to normal levels. Beijing could address the mounting deflation risk (China being far from seeing zero interest rates), but so far it has avoided significant easing, being wary of throwing more good money after bad. Yet this makes it hard to break the disinflationary/deflationary trend.
Target growth of 7%-7.5% = policy manoeuvrability
Should Beijing cut its 2015 GDP growth target to 7.0% or less, growth expectations would fall, giving rise to a self-fulfilling prophesy that would neither help close the output gap nor fight deflation. Setting a growth target range of 7.0%-7.5% would allow Beijing some policy manoeuvrability while having 7.0% as the bottom line for the balance between growth and reform.
Sharp employment drop could trigger sharper easing
As monetary policy can have 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 could prompt it to ease more aggressively? Not inflation since there is none; nor a credit event since Beijing still has a selective “implicit guarantee” policy in place to contain any systemic fallout. Nor would it be growth, as slow growth is a policy choice. A possible trigger would be a sharp deterioration in the labour market, which would affect the Communist Party’s power base.
Call to action
The liquidity implications of this macroeconomic backdrop bode well for Chinese asset prices. If we interpret it as bad news for the economy being good news for the market, then the asset price recovery should have a long way to run in China.