In recent years, the big question for China watchers was whether the authorities can pull off a smooth rebalancing away from an investment-led economic model, which created an immense industrial supply glut. Though policymakers officially remain committed to rebalancing, monitoring developments in this area looks to be a relatively dull exercise this year. This is because much of the needed structural reforms to steer China onto a more sustainable, consumption-led growth path will arguably have to wait until late in the year, after the Party Congress, a major political gathering held only every five years to install new leadership. In the meantime, authorities will place a large weight on stability with GDP likely to grow at around 6.5% in 2017. In short, we see no big policy changes this year.
Instead, the focus has shifted to the rising tide of capital outflows from China that re-emerged towards the end of 2016. Importantly, previous spikes in outflows were mostly driven by investor perceptions of domestic factors, including growth sustainability, gradual portfolio rebalancing by onshore residents, and confusion about China's exchange rate regime. This time around, external pressures are playing a lead role in a strong dollar environment, driven by expectations of higher U.S. growth and interest rates.
Chinese policymakers are clearly concerned. They have three unpleasant policy options to counter the outflow pressure: (1) let the currency depreciate at a (much) faster pace, (2) deplete the country's foreign exchange reserves further, or (3) intensify capital controls.
At the moment, it appears that policymakers are doing a little bit of everything, but each of these options comes at a cost.
- Capital outflows will likely supplant China's growth trajectory as the key focus of markets and analysts in 2017.
- Periods of capital outflow pressure are likely to continue or recur--suggesting that the market feels that the Chinese renminbi is overvalued.
- Policymakers can (1) let the currency depreciate, (2) deplete foreign reserves, or (3) intensify capital controls. It appears they are doing all three, but each has a cost.