- The lack of budget consolidation and the Bank of Japan’s continued quantitative easing policy should weaken the yen, in line with our expectations
In Japan, Prime Minister S. Abe’s gamble paid off, leading his Liberal Democratic Party (LDP) to victory in the early elections for the lower house of parliament on 22 October. Announced as the LDP and its ally - the Komeito party - already held a two-thirds majority in the Japanese House of Representatives, this election aimed to further strengthen S. Abe’s legitimacy, enabling him to roll out his programme of economic and political reforms. The LDP has maintained its two-thirds majority, winning 313 of the 465 seats, and S. Abe should thus remain Prime Minister until 2021.
From a political perspective, S. Abe’s electoral victory will give him the legitimacy needed to present his plans to Parliament to amend the constitution in order to recognise the legality of Japan’s armed forces. For the moment, Article 9 forbids the creation of any permanent military force, but it has been interpreted up until now as allowing an army to be created exclusively for defence. However, any amendment to the constitution will also need to be approved with a national referendum, and the latest polls show that the majority of Japanese people are against changing Japan’s pacifist status.
From an economic perspective, S. Abe’s main proposal aims to use part of the revenues generated by raising VAT from 8% to 10%, planned for October 2019, to support the creation of childcare centres and the social security system, rather than using these funds to help repay its high levels of debt. The country is therefore not expected to return to a primary budget surplus for the 2020 tax year, despite the government’s commitment to achieving this.
The yen’s exchange rate is expected to be weakened by the Bank of Japan maintaining its quantitative easing policy for the long term and the lack of any fiscal consolidation, in line with our forecasts. We are maintaining our forecast for a USD-JPY rate of 116 in 2018.
Matthias van den Heuvel, Economist
Focus on China : First insights from the Congress
- While the 19th Communist Party Congress kicked off on 18 October, Chinese GDP growth remains solid at 6.8% for the third quarter, down slightly from the first half of the year
- The Congress will be accompanied by a major political reshuffle, which could further strengthen the powers of the current General Secretary and President, Xi Jinping
- His inaugural speech included few comments concerning economic aspects, but, by referring to more qualitative growth, could leave the door open for a lower rate of growth
- We expect China’s reforms to move forward at a moderate pace and to be primarily focused on managing financial risks, particularly informal credit. This could be ramped up post Congress
- Nevertheless, we forecast authorities to ensure that these reforms do not weaken growth by too much
18 October marked the start of the 19th Chinese Communist Party Congress. This week-long event will map out the leadership and policy priorities for the next five years. It will be accompanied by an extensive reshuffle across the Party’s three main levels (see table, p.7). Five of the seven members of the Politburo Standing Committee – the Party’s structure with the highest executive power – are expected to be replaced, with just the General Secretary and current President Xi Jinping and Prime Minister Li Keqiang to keep their seats. Between 10 and 13 of the Politburo’s 25 seats and almost 50% of the Central Committee’s permanent positions are expected to be reallocated. In total, nearly 70% of the positions will be renewed, compared with 60% previously.
This Congress, which marks the transition between Xi Jinping’s first and second terms, is expected to provide insights into the strengthening of his political powers. One illustration would be the reduction of the Politburo Standing Committee from seven to five members. Alongside this, although the Constitution does not allow presidents to serve more than two terms, Xi Jinping may not appoint a clear successor for after 2022, opening up the possibility for a third term. The strengthening of Xi’s powers seems to indicate a transition from collective leadership – where decisions are taken on a collegial basis – to a presidential model where he will have increased executive powers. Nevertheless, the Party’s influence on the Chinese economy is expected to remain strong, with Xi Jinping reinforcing its legitimacy since 2012 by embarking on a major anticorruption programme and increasing the supervision of local government budgets. During his inaugural speech for this Congress, he ruled out the possibility of liberalising the Party.
Although quantitative targets have not been provided, insights can be gained concerning China’s economic priorities. Xi Jinping has reaffirmed the ambition to “build a moderately prosperous China by 2020”, probably in line with the 2002 target to double GDP between 2010 and 2020. This means that growth would remain high for the next few years, probably between 6.3% and 6.5%, while this third quarter saw GDP growth of 6.8%, slightly lower than the first half of the year (6.9%). However, this element would need to be confirmed at December’s Central Economic Work Conference or the National People’s Congress in March 2018. Xi has announced that the country would strive for growth that is focused more on quality – based more on high value-added industry, entrepreneurship, services and innovation technologies – and more socially inclusive, which could imply more tolerance for a lower rate of growth than in the past. This approach would even be further strengthened with the increased focus on managing financial imbalances, as announced at July’s National Financial Work Conference and reconfirmed by Xi. With this more qualitative approach, Beijing may not give formal growth targets for the coming years.
The results of the reforms adopted at the 18th Congress in 2012 have been mixed, particularly with regard to state enterprises. Xi highlighted that China’s model is unique, which points to a conservative reduction in domestic imbalances, quite far removed from market economy practices and with a significant role played by the State. The reforms that are underway therefore look set to continue moving forward, or even be ramped up, but any significant increase in their intensity seems relatively unlikely. In our opinion, three reform initiatives warrant particular attention: the management of financial risks, the reform of state-owned enterprises and the country’s internationalisation.
Financial risk management
The country’s credit rating was downgraded in 2017, highlighting the significant debt burden (see left-hand chart). However, China has various specific features that tend to reduce the probability of a systemic debt crisis, such as the fact that debt is held primarily domestically, which restricts the dependence on foreign financing (foreign investors hold just 4% of sovereign bond debt), the State’s involvement, which makes it possible to reallocate non-performing loans and debt to other accounting entities, as well as the high level of domestic savings. In this environment, Beijing does not need to urgently reduce the imbalances in terms of debt and it is relatively unlikely that we will see any significant monetary tightening within the next few months aimed at reining in credit growth. The current approach – characterised by maintaining higher interest rates and a stricter regulatory framework for the financial sector – looks set to be maintained, while being partially mitigated through more accommodating, targeted measures aimed at directing “classic” bank credit towards the real economy. From the start of 2018, the lower required reserve ratios introduced for banks lending to SMEs or startups is in line with this approach. Informal credit is expected to face increased regulatory constraints following the Congress. Overall credit conditions are therefore expected to be more restrictive, which is likely to weigh on domestic growth. This approach is likely to push up default rates for more fragile businesses – operating in more vulnerable sectors such as heavy industry or with restricted access to bank credit – but would limit the risks of a systemic crisis.
State-owned enterprise reforms
The state enterprise reforms are focused on reducing surplus production capacity, improving operational efficiency and deleveraging. Xi has once again highlighted their crucial role within China’s economy, confirming a state capitalism approach. This does not indicate that the inefficiencies facing these businesses are likely to disappear any time soon through privatisations or debt restructuring plans. The maximisation of profits and allocation of resources in line with a market approach are therefore not expected to be the norm. Instead, the aim will be to consolidate this network of state-owned enterprises and encourage higher value-added activities. In the short term, the reduction in surplus production capacity and the stricter environmental standards introduced are expected to support the industrial profit cycle, improving debt ratios.
Lastly, the One Belt, One Road infrastructure project was singled out by Xi to illustrate the progress made with China’s international integration. His inaugural speech included few comments concerning financial integration, i.e. the inclusion of domestic equities in international indices, the opening up of the financial balance or the yuan’s increased flexibility.
- Xi Jinping’s opening speech focused more on political than economic aspects. Few concrete measures and figures were provided, which calls for a cautious approach for any analysis.
- The emphasis on the search for more qualitative and inclusive growth could mean greater tolerance for a lower rate of growth than previously.
- The Chinese model’s specific features and the state capitalism approach indicate a conservative reformist approach. Financial risk management is expected to be ramped up following the Congress, with the authorities supporting bank credit, while increasing the regulatory pressure on informal credit and credit not intended for the real economy. The good GDP figures, which are expected to confirm the growth target of 6.5% for 2017, mean that Beijing has some flexibility to step up the management of financial risks.
- China is therefore expected to target a compromise between economic growth and progress with reforms, particularly in terms of financial risk management. Economic growth is likely to be given priority if credit conditions are tightened up by too much and this affects the business environment, job market, real estate or private consumption.
- The seemingly progressive nature of the reforms does not suggest that the current growth drivers, including investment in fixed assets by state-owned enterprises and the use of credit, are likely to be abandoned any time soon.
François Léonet, Economist, Emerging Markets