China Macro-US marketing feedback:9questions

Recently we spent two weeks in the US visiting clients. Six months ago, theclients were concerned about deflation, hard landing risks, capital outflows andthe RMB. The sentiment has improved significantly since then and now the focusis on the cyclical turning point, political transition and the US-China relationship.

In this note, we list popular questions and our answers.

Growth: The mainstream view has changed from deflation to reflation sincemid-2016. Investors are overweighting cyclicals now so the key question iswhen the cyclical turning point comes. Our view is that the Chinese economywill likely decelerate from 2Q17, due to the ongoing property down-cycle. Ourforecasts for growth of new home sales, new starts and property investmentare -10%, -5% and +2% in 2017, vs. +22%, +8% and +7% in 2016. That said,the Chinese government would still set this year’s growth target at 6.5% anduse infrastructure spending to offset the headwinds from property.

Inflation: Under the current reflation environment, clients are interested in ourinflation outlook. In our view, 2017 will be a year of modest reflation. Weexpect the CPI inflation to average +2.4% and PPI inflation at +2.6% in 2017,compared with +2.0% and -1.4% in 2016. Meanwhile, we believe thetransmission from PPI to CPI is very limited and 1Q17 would be the peak forPPI inflation, nominal GDP growth as well as the current earnings up-cycle.

As such, monetary policy would remain tight for now but turn moreaccommodative later this year when both growth and inflation moderate.

Capital flows: Investors are less concerned about capital outflows and wenote three things often overlooked by the market. First, the capital outflowsare now all driven by Chinese residents because foreign money has turnedfrom outflows to inflows from 2Q16. Second, the biggest deficit in FXsettlement comes from the service trade as Chinese households are raisingtheir FX exposure on depreciation expectation. Third, China had a surplus ofUS$1.1tn under goods trade over the past two years but only US$140bn wasconverted into the RMB. Looking forward, we believe that the tightened capitalcontrols could reduce the leakage from these channels and the drop of FXreserves could narrow to US$200bn in 2017.

RMB: Most investors expect the RMB to depreciate 5-10% in 2017 and ouryear-end forecast of 6.9 received lots of push backs. In our view, theUSD/CNY exchange rate is mainly driven by two factors: the US dollar andChina’s capital flows. Assuming relatively stable dollar (up/down 5%), whatmatters is capital flows. As mentioned above, tightening capital controls couldreduce capital outflows and change the FX supply/demand in the market.

Therefore, we caution against being too pessimistic on the RMB outlook.

Political transition and Trump: It’s a consensus among investors that thepolitical transition is the most important event this year. We discuss ourunderstanding of the event and why we are more positive about China’sreform outlook than four years ago (details inside). Meanwhile, the impact ofTrump on China is another popular question. Lastly, another topic ofconversation is a series of thematic reports we wrote over the past fewmonths to debunk popular myths on China’s economy (debt, property, capitalflows and emerging trends). However, the interest in these issues issomewhat lower than six months ago. As the macro backdrop has shiftedfrom deflation to reflation, instead of fearing a hard landing, investors are nowfocusing more on economic data and cyclical movements.