China Macro:2017outlook,What could surprise?

Politics to define the year: After the US Presidential inauguration, the mostimportant political event in 2017 is the political transition in China. It’sunsurprising that China’s policy-makers put stability as the top priority for thisyear, so that they could focus on politics. What could surprise is whether andhow the market reassesses China’s growth and reform outlook after thetransition, when the power and the responsibility for China’s top leader couldboth reach the highest point in the past forty years.

RMB – Likely the biggest surprise in 2017: The biggest surprise in 2016came from the commodity market, about which most people felt so negative12 months ago. The biggest surprise in 2017 might come from the RMB,about which most people are feeling so negative now. And both surprisescould be triggered by non-market mechanisms: supply controls the former andcapital controls the latter. Note that foreign debt repayment is done and thedrop in FX reserves narrowed to US$320bn in 2016 (2015: US$510bn).

However, large FX leakage still exists in goods and service trade (Chart 1 onthe left). For instance, China had a goods trade surplus of US$1.1tn over thepast two years, but Chinese banks only saw US$0.1tn net FX inflows throughthe channel. With tighter regulations aiming to reduce such leakage, thedecline in FX reserves could narrow to around US$200bn in 2017. Givenlower capital outflows, we hold the non-consensus view that the Yuan couldsurprise on the strong side in 2017. While the volatility of the USD/CNY willrise in 2017, our end-2017 forecast is 6.9, i.e. no depreciation from end-2016.

The economy to slow in 2017: Amid the hard landing and deflation fearsearly last year, we made the non-consensus call that China would grow ataround 6.7% every quarter in 2016 and corporate earnings growth would risethanks to property and reflation. But we also pointed out then that thesecyclical drivers could not be sustained, and growth would slow to 6.5% in2017. We still maintain these views. The property sector is likely to have adown-cycle in 2017. GFA property sales could drop 10% after rising 22% in2016. National home prices could start falling in 2H17. Nonetheless, the twobright spots in 2017 could be exports and infrastructure FAI.

Liquidity – A year of two halves: Monetary policy has tightened substantiallyin the recent months to deleverage the bond market. After all, the last thingpolicy makers want to see in 2017 is a market crash. At this moment,monetary policy, regulation, inflation and the rising yields globally are allnegative to liquidity. That said, monetary policy could shift around mid-year tosupport growth. At that time, bond yields could reverse on lower economicgrowth and inflation. For the whole year, we expect no change in benchmarkinterest rate but two RRR cuts (total 100bp). What could surprise us moreRRR cuts than expected. After all, the current 17% RRR is still way too high.

Inflation and other risks: 12 months ago, the major concern for China wasprolonged deflation but it has shifted to inflation. We think both are overdone。Our view for 2017 is a modest reflation. CPI inflation could average 2.4% in2017 vs. 2.0% in 2016. PPI inflation would peak in 1Q17 then trend downafterward. As such, the current corporate earnings up-cycle, which is drivenby reflation and property, could also peak in 1H17 (Chart 2 on the left). Forinflation, oil price is a major uncertainty to watch. Other than inflation, a blackswan is the US-China relationship under the new governments on both sides,in various areas such as trade, currency, geopolitics and others.