Roundtable Discussion on China’s Economy

On October 1, China celebrated the 70th anniversary of the founding of the People’s Republic of China. Over the course of 2019, the country made steady progress in its economic development despite domestic setbacks and a complex global environment. But people are concerned about a number of uncertainties in China’s economy. Those issues include prices, especially for pork, as well as the impact on the real estate market from reforms in domestic interest rates. Additionally, there is much debate about the influence of further opening-up measures in finance and foreign trade on China’s stock market, the trend in the renminbi exchange rate and which types of assets promise the best returns on investment.

Zhong Wei

Zhang Ming

Sino-US trade friction and interest rate liberalization were among the key issues examined at a recent roundtable discussion organized by China Forex. Zhang Ming, researcher at the Institute of World Economics and Politics of the Academy of Social Sciences and chief economist of Ping An Securities, and Zhou Daochuan , former director of the research and strategy department and managing director at Yunfeng Financial Group,gave their views on these and other topics at this roundtable moderated by Zhong Wei, deputy editor at China Forex. The following is an edited version of this discussion.

01

Zhong Wei: First, I’d like to welcome our two guests. Since the beginning of 2019, prices in China have been rising but they have generally remained under control. As far as the Produce Price Index (PPI) is concerned, the prices of nonferrous metals have fluctuated,and international oil priceshave been unsteady. In terms of the Consumer Price Index(CPI), the prices of pork, fruits and vegetables have been volatile. Of particular concern are surging pork prices. In your opinion, how long will it take before pork prices start to edge lower in this hog cycle?Will monetary policy be used to cushion the effects of volatile pork prices?

Zhang Ming:The rise in pork prices appeared in the middle and late stages of this hog cycle. A turning point is unlikely before the end of this year but year-on-year growth in pork prices is expected to ease significantly in the first half of 2020.

Monetary policy is not expected to be used as a tool to halt the unusual climb in pork prices. There are three reasons for this conclusion. Firstly,monetary policy is normally used in response to substantial changes in the core inflation rate, which excludes items such as food and energy. China’s core CPI has seen slower growth since the beginning of 2019. Additionally, the PPI in China has shown negative growth despite the moderate rise in CPI growth.Moreover, China’s CPI and PPI are likely to grow more slowly in 2020.In conclusion, the main issue with China’s economy is not inflation,but insufficient aggregate demand.As such, we are more likely to see tighter monetary policies.

Zhou Daochuan:The current hog cycle will last until the end of 2020 at least. China has experienced four complete hog cycles since 2000,with pork prices taking two to three years to go from trough to peak.The current hog cycle began in June 2018, and it is likely that peak prices will be reached in the second half of 2020. To address rising prices, more than 20 policy measures were taken following the August 21 executive meeting of China’s State Council.Local authorities scrapped bans and restrictions on hog raising. In addition, preferential policies were extended to the transportation of piglets and chilled pork to reduce costs. Also, China will offer more preferential loans and insurance as well as boost subsidies for pig farming in order to ensure stable supplies of pork. In spite of these measures, it is estimated that hog prices will not decline until there is a sharp recovery in the supply of pigs.

Pork has had a weighting of 2.1% to 2.5% in the CPI basket this year - not a high percentage. Other components of the CPI — including beef and mutton, vegetables, fruits and crude oil prices — are expected to remain relatively stable. However,there is a possibility that crude oil and pork prices will fluctuate over the short term and push the CPI above China’s target level of 3%.

Nevertheless, monetary policymakers do not need to respond to pork price fluctuations unless inflation surges. Presently, amid the global interest rate cuts and the Sino-US trade tension, China is expected to focus on its objective of ensuring steady economic growth in setting its monetary policy.

The LPR mechanism is an important

step in the effort to liberalize interest rates.

02

Zhong Wei: The People’s Bank of China (PBOC) has been taking measures to deepen market-oriented reforms of domestic interest rates. It has announced across-the-board and targeted cuts in the reserve requirement ratio (RRR) and launched the Loan Prime Rate(LPR). The combination of measures is aimed at reducing financing costs of the real economy, particularly costs of medium- and small-sized enterprises. In your view,what roles will the merging of interest rates play in deepening the transmission channels for monetary policy? And what effect will this have on the real estate sector?

Zhang Ming:The recent lending rate reform merges deposit and lending rates with money-market rates. In this latest move on the interest rate front, China linked bank lending rates to the LPR, which in turn will be determined by the central bank’s medium-term lending facility(MLF) interest rate. Compared with the benchmark lending rate in the past, the LPR will more closely reflect changes in money-market interest rates. Thus, this will help establish a policy transmission mechanism that functions more smoothly. In view of the fact that price pressures in big cities are not strictly a factor of supply while risks in the property market are not decreasing, the central bank and the China Banking and Insurance Regulatory Commission have set a targeted rule for real estate lending.Neither the lending rate for real estate developers nor the personal mortgage rate can be set below the new mechanism. If this stipulation remains in place, the real estate sector faces a substantial adjustment.

Zhou Daochuan:Under China’s“two track” interest rate system in the past, rates in the money and bond markets were basically determined by market forces, while deposit rates were based upon a benchmark rate set by the central bank. That kept funding costs high for the real economy, even when PBOC policies pushed money market rates lower.

The LPR mechanism is an important step in the effort to liberalize interest rates. It pushes banks to use the LPR as a reference when pricing new loans and apply this as a benchmark for floatingrate loan agreements. It also requires banks to link their LPR quotations to the MLF rate, which reflects the average marginal capital costs of the banks. The LPR is then determined by factors including the cost of capital at each bank as well as credit supply and demand and risk premiums. In this way,the MLF interest rate can be easily transmitted to the credit market.

Currently, the LPR consists of rates with two maturities — one year and five or more years. The personal mortgage loan rate is linked to the five-year LPR. It is expected that in view of the policy objective of discouraging speculative investment,there will be “window guidance” for the five-year LPR. This will result in more flexible adjustments in the mortgage loan rate and could pave the way for a rise in rates on personal housing loans. It is reasonable to say that loans in the real estate sector are unlikely to benefit from the new interest rate mechanism.

03

Zhong Wei: Financial policies in China and abroad have diverged since the beginning of this year. Twenty countries havecut interest rates, and some have even employed negative rates. In China, there is an effort to deepen the opening up of the economy. Measures include a further opening of the financial industry and reforms of the Shanghai and Shenzhen stock markets. In addition,there have been reforms in the capital and financial transaction accounts. This, plus the inclusion of China’s stocks and bonds in major global benchmark indexes has led to unprecedented enthusiasm about the Chinese market among foreign investors.Against this background, what do you see for the Shanghai and Shenzhen stock markets?

Zhang Ming:China has expanded its opening to foreign investors, and this is likely to bring a short-term increase in capital inflows. Yet, as we can see from past experience, domestic and foreign capital flows may not offset each other. That is to say, an opening up of the financial system may result in new investment inflows, but it also may add new volatility.

Zhou Daochuan:Gobal growth was slow in 2019, with obvious signs of recession in some economies.The major central banks have been cutting interest rates, and the total of global debt with negative yields hit a record high. Yet, China has not changed its policy of reform and opening, especially in the financial field. As a result, the attraction of the Shanghai and Shenzhen stock markets has increased. China’s efforts were especially significant in the second half of 2019. The PBOC introduced 11 measures in July to further expand the opening up of the financial industry. This was followed by the China Securities Regulation Commission’s steps to deliberate the overall plan for the reform of the capital market, focusing on marketization, more efficient regulation and a greater opening up to the outside. Furthermore,the qualified foreign institutional investor (QFII) and renminbi qualified foreign institutional investor (RQFII) quota limits were removed by the State Administration of Foreign Exchange in September.

At the same time, global indexes such as the MSCI, FTSE Russell,Standard & Poor’s and Dow Jones have added A-shares or increased their weighting. As a result, China has seen soaring capital inflows, with foreign investors picking up the pace of investment in the A-share market.

Most of the foreign investment is from medium and long-term institutional investors. In the long run, this will gradually change the existing shareholder structure which is currently dominated by retail investors. Valuations and pricing on the A-share market will also change. Greater emphasis will be placed on stable long-term returns,while short-term growth will be less important. All the above factors will help make the A-share market more resilient, and worthy of long-term investment, especially as present valuations are below historical median levels.

04

Zhong Wei: The uncertain international economic situation, especially in view of Sino-US trade friction, has created some volatility in the renminbi exchange rate. Haveyou seen any signs of relaxation in Sino-US trade tensions? A depreciation of the renminbi is often seen as beneficial as far as the current account is concerned. Yet, given the structure of the international balance of payments, what is your assessment of the possible effects of changes in the renminbi exchange rate?

Zhang Ming:There have been some signs of improvement in the Sino-US relationship, but we should not get carried away as there have been too many twists and turns in the past one and a half years.There will be prolonged friction between the two countries, which will certainly expand beyond the realm of trade. Domestically, the structure of China’s international balance of payments is changing.The surplus on the current account is decreasing and is likely to move into deficit in the future. Meanwhile,volatility on the financial account is growing. It means that the risk of“double deficits” on both the current and capital accounts is rising. This could result in downward pressure on the renminbi. The depreciation of the renminbi could affect China’s economy in a number of ways. It will help relieve the downward pressure on the real economy, but it may put selling pressure on China’s financial assets. Also, it may lead to increased pressure from imported inflation.

Zhou Daochuan:Sino-US friction has been the main source of uncertainty in the global economy over the last two years. China and the US, the two biggest economies,are complementary in trade, and they have a symbiotic relationship.Tariff increases have been the main weapon in the dispute and this will ultimately lead to the reshaping of the global industrial chain. In addition, it would cause a major increase in the cost of production and eventually have serious implications for future economic growth.

Both China and the US are in a critical period as far as economic development is concerned. For the US, it is under intensifying pressure after a 10-year economic recovery. Additionally, the country holds its presidential election next year and that could complicate policy decisions. As far as China in concerned, it is a turning point in the nation’s effort to achieve industrial transformation and supply-side reform.

In terms of exchange rates, the renminbi is one of the world’s more stable currencies. But a depreciation of the currency would help offset the impact of higher import duties in overseas markets and thereby help China’s exporters. On the other hand, too much depreciation would alarm the market and lead to capital outflows. This would not be beneficial to China’s economic and financial stability. As long as Sino-US friction does not exceed China’s tolerance level, a relatively stable renminbi is better for the macroeconomy.

05

Zhong Wei: Since the beginning of 2019, both institutional and individual investors have discovered that there are hardly any highyield assets. Nevertheless,global gold prices have risen above $1,500 per ounce,bringing substantial benefits toinvestors. Additionally, digital currencies such as Bitcoin are performing well. What would you say are some “good assets”worth investing in the coming quarters?

Zhang Ming:Uncertainties in the global economy, finance and politics have intensified in recent terms. Investment havens including the US dollar, gold, the Swiss franc and the Japanese yen have helped in hedging amid rising market volatility. As far as Chinese assets are concerned, bonds look promising amid present downward pressure and possibly flat-to-lower inflation. Another “good asset” is the undervalued, higher-yield blue chip shares of the industrial leaders. The Chinese stock market has adjusted appropriately compared to the US market. An increase in foreign investment in China’s shares is expected. Additionally, adjustments in the domestic real estate market may encourage fund outflows from that market to the stock market.

Zhou Daochuan:Central banks have been forced into super monetary easing since the beginning of 2019. As a result, asset bubbles are forming, and the issuance of negative-yield debt has hit a record.“Good assets” are hard to find and the situation may be similar to the asset shortage witnessed in 2015-2016.

It is obvious that the marginal stimulus from monetary policy has weakened substantially, while downward pressure on the economy has intensified and inflation remains relatively steady. All of this signifies that the global economy has fallen into a situation similar to stagflation.Against this background, keeping core assets, including stocks and bonds, in the developed markets of the US and Europe is not very profitable. On the other hand,precious metals represented by gold are worth investing in.

In addition, Chinese bonds are worth including in any portfolio. As the third largest bond market, China has bonds with higher yields than those of equivalent bonds in the US and Europe. The obvious advantage in the valuation of China’s bonds,compared with the negative-yielding bonds in Europe and Japan, makes them attractive to foreign investors.Therefore, China’s bonds can be considered “good assets” as long as credit risk is controlled.

Zhong Wei: Thank you both for your opinions and analysis. Both of you point out that the CPI in China has not peaked yet. Pork prices will not begin to fall until the second half of 2020. Contrary to your optimism about the“MLF+LPR” mechanism and its impact on the lending rate, I personally think that it remains unclear whether the merging of China’s two interest rate tracks will be effective. In terms of the Sino-US trade friction and the renminbi exchange rate, both of you regard present signs as somewhat positive for negotiations between the two countries.Renminbi depreciation will have a multiplier effect on China’s economy, and we can’t really say that the weaker the exchange rate, the better.Lastly, both of you consider gold and China’s debt securities as attractive investments.Both are also optimistic about A-shares.