18 June 2018
Time for policy adjustments: Macro 2H18 outlook

 

Financial conditions have tightened more aggressively since Nov. 2017 than we previously expected, as a result of overlapping policies targeting at “deleveraging”. We have observed softer investment growth, declining inflation, & early signs of stress in corporate & local govt. cash flow. The ongoing pace of tightening may deem unsustainable, esp. given rising external demand uncertainties. Empirically, over-tightening will lead to lower growth & inflation with a lag, esp. when it pushed GDP growth below trend. Faster decline of nominal GDP growth may soon work against the goal of “deleveraging & risk prevention”. On the micro level, deteriorating cash flow will likely only force the corporate sector to borrow more.

In light of the recent macro developments, we expect monetary policy to loosen incrementally in 2H18 & revert to a more “neutral” stance. We no longer expect any benchmark rate hikes in 2018, nor do we see the PBoC raising OMO rates any further. Meanwhile, we expect 2 more 100bp RRR cut in the rest of 2018 (“targeted” or otherwise), part of which may be used to swap out some of the maturing OMO instruments outstanding. We see further steepening of the yield curve in 2H18, with 10Y treasury yield at 3.70–3.80% by year-end, while short term rates have more room to fall.

We adjust our 2018 year-end USD/CNY exchange rate forecast to 6.38 from 6.18, on the back of the upward revision for the year-end USD index forecast (to 93 from 87) and lower risk-free rate forecast in China.

Fiscal policy may become more expansionary than in 1H. Govt. income growth may moderate as the VAT cut & import tax cuts materialize in 2H, while govt. expenditure growth will likely pick up as it has lagged the fiscal budget YTD. Thereby, we may see slower growth of fiscal reserves.

We lower our 2018 real GDP growth forecast to 6.8% YoY from 7.0% YoY, vs. the current consensus of 6.6%. Meanwhile, we revise down our 2019 real GDP forecast to 6.7% YoY from 6.9% YoY. The downward adjustment was driven by the visible tightening of financial conditions YTD.

We also tune down our 2018–19 CPI forecasts to 2.0% & 2.2% from 2.6% & 2.8%. By the same token, we now expect PPI to average at 3.0% & 1.9% for 2018 & 2019. Consequently, we tune down our 2018–19 nominal GDP forecast to 9.7% YoY and 9.4% YoY, from 10.9% for both years previously.

On the reform front, we see room for acceleration in 2H18–2019 as we fast approach the 2020 “deadline” for a number of planned reform “milestones”, and little progress was made in the first half of 2018. More efforts are expected in the reforms regarding China’s fiscal regime, financial mkt, SSF, & the L-T mechanism for sustainable property mkt development.

We see the risks to our 2018–19 growth forecast as balanced and largely policy-dependent. If policy adjusts more timely & decisively than expected, growth may rebound earlier & more forcefully than our current forecast. However, if the necessarily policy adjustments continue to be lagging or inadequate, there may be downside to our growth inflation outlook.