China at crossroads

We expect that the Chinese authorities’ policy easing bias will turn a bit more defensive in 2016. Efforts to moderate the growth downturn will continue but not at the expense of further, and more politically challenging, reforms. This is because the authorities will also want to lower structural headwinds to ensure the effectiveness of their countercyclical policies. In view of this, and in the aftermath of the inclusion of the Chinese yuan (CNY) in the Special Drawing Rights (SDR) Basket, we believe financial liberalization—including a bit more CNY liberalization—will deepen and State Owned Enterprise (SOE) reforms will intensify. The former will limit the misallocation of capital and the latter should begin easing excess capacity in the industrial sector.

We do not believe the authorities will opt for a much quicker adjustment brought on by bold SOE reforms, or an unexpectedly large CNY depreciation—as these would raise the risk of domestic financial and political stability. The silver lining in the 2016 outlook is the continuing rise of services activity which should place a floor beneath growth risks. Secondarily, China’s large FX reserve buffers and fiscal policy activism also provide countercyclical maneuvering room even though multiple structural constraints are becoming headwinds for policy effectiveness.

The International Monetary Fund’s in-principle acceptance of the CNY in the SDR basket is, in our view, an important step in cementing the process of greater medium-term capital account openness. However, it is unlikely to result in large near-term capital inflows. Therefore, in coming months, the authorities’ will likely have to let the economy gradually adjust to a more market determined exchange rate, so as to not strain confidence in the policy framework.