Optimistic US budget; China’s debt

Macro Highlights - 5/31/2017

The White House's 2018 budget foresees a USD 54 billion increase in defence spending and an equivalent decrease in non-defence spending. The underlying working assumptions of a 3% GDP growth and a neutral impact on tax receipts in order to reach a balanced budget by 2027 seem too optimistic. Congress should come up with a more credible budget proposal before the end of 2017. The downgrade of China’s sovereign credit rating should have a limited short-term effect but is a reminder of the need for a coordinated approach to deleveraging the Chinese economy.

On 23 May, the White House presented its fiscal year 2018 budget to Congress. Its proposal contains a USD 54 billion increase in defence discretionary spending and an equivalent cut in non-defence spending. In its longer-term projections, the White House expects to reduce the deficit by USD 3.6 trillion over the next ten years relative to the projected baseline budget. To achieve this, it proposes:

  • 13 major initiatives aimed at cutting mandatory spending[1] (e.g. retirement benefits for federal employees, Medicaid, disability benefits and farm subsidies);
  • a decrease in non-military discretionary spending through a “two-penny plan” meant to reduce this line item by 2% per year.





The budget proposal also includes an assumption of 3% annual economic growth starting in 2021 – an optimistic figure – which is meant to shrink the deficit by USD 2.1 trillion between 2017 and 2026. According to the White House’s estimates, the spending cuts and strong economic outlook should pave the way to a balanced budget by 2027, going from an estimated deficit of USD 603 billion in 2017 (3.1% of GDP) to a surplus of USD 16 billion in 2027 (0.1% of GDP).

But the White House has provided no new details on the tax cuts. It has noted only that the cuts will not lower government revenues. Yet the few tax proposals that the White House did mention – lower income taxes, higher tax deductions for needy families, the elimination of the surtax on capital gains and dividends enacted as part of Obamacare, and the elimination of the estate tax – should in fact feed the deficit. The nonpartisan Tax Policy Center estimated the cost of the personal and corporate tax-cut plans envisaged by the House of Representatives and Mr Trump’s campaign platform at somewhere between USD 3.1 trillion and USD 6.15 trillion. How these tax cuts will be financed remains an important, unanswered question since the White House projected flat or even slightly higher revenues.

The next phase of the proposed tax reform has two parts. First, the White House will continue working on its tax cut proposal, which it is expected to submit to Congress in the summer. Second, the House and Senate budget committees will work on their own proposals, which will certainly not adopt the White House’s proposals wholesale. Congress’s proposals will include details on both spending and tax cuts. Congress members know the clock is ticking and that they must come up with a credible budget quickly. If the tax cuts are not passed during the 2018 fiscal year, it is very unlikely that they will make it through later on. The Republicans are aware that their majority in Congress could very well switch to Democratic hands following the 2018 mid-term elections. We believe that Congress will do everything in its power to pass a tax-cut bill before the end of 2017, with the cuts to take effect in early 2018. The tax cuts should provide a considerable boost to consumer spending and fixed-capital investments in 2018.

Turning to China, Moody’s recently downgraded that country’s sovereign credit rating from Aa3 to A1. The rating agency cited the erosion of China’s financial strength and the country’s high debt level (close to 260% of GDP), which continues to rise even as GDP growth slows towards the agency’s five-year estimate of 5% on the back of declining productivity and an ageing population. Moody’s also noted the extensive use of debt to spur domestic growth and the limited impact of structural reforms on the country’s debt level. At the same time, corporate issuers including China Mobile, Sinopec and Dongfeng Motor Group also saw their credit ratings cut. 

This downgrade is a reminder of the financial headwinds – including high corporate debt levels and opaque bank balance sheets – that Beijing will have to overcome in the medium term. Corporate debt now stands at close to 170% of GDP. In the short term, this downgrade should not significantly affect China’s borrowing conditions. Foreign investors hold little of the country’s sovereign debt – around 3%, versus 30% for emerging markets as a whole – while external debt is equal to only 12% of GDP. In addition, China's investment-grade status remains intact, and its credit rating is higher than Mexico’s and Italy’s and the same as Japan’s. Moody’s decision is more likely to affect international investors’ general perception of the riskiness of Chinese financial assets. But this perception could take another hit if Standard & Poor’s – which changed its outlook on China to negative in March 2016 – also lowered its rating.

 The ramifications of this downgrade are more likely to be felt in the medium term. It could in fact delay or even jeopardise the inclusion of Chinese debt and equity assets in international benchmark indexes – one of Beijing’s goals. It is worth bearing in mind that the purpose of internationalising China’s financial markets is to diversify the financing sources for domestic companies. Close to 80% of such sources in China are credit-related. Internationalised markets would lead to more efficient capital allocation and improved corporate governance at Chinese companies, which would in turn lower their borrowing costs. MSCI’s decision on whether to include Chinese domestic shares in emerging-market indexes, set to be announced on 20 June, will offer a glimpse at how Chinese assets are viewed by international market observers.

Imbalances associated with the high level of corporate debt need to be remedied before China's domestic financial markets can be successfully internationalised. For now, the debt load is such that the government's measures – like the debt-for-equity swap programme, securitisation operations and the creation of asset management companies – are too limited and uncoordinated to trigger a sustainable period of debt reduction in China. These measures are aimed more at absorbing and recycling a portion of non-performing bank loans – and thus improving banks’ balance sheets – than at reducing the debt burden. It is therefore likely that public debt – now relatively low at close to 45% of GDP – will end up rising in order to finance potential bailouts aimed at recapitalising failing lenders.

The measures that will be put in place to reduce China's debt are likely to be clarified at the Party Congress set to take place in autumn. For now, the relative closure of China’s financial account, the government’s capital controls and the high level of domestic savings should be enough to reduce these imbalances without leading to massive capital outflows and a depreciating yuan. But we expect the country’s economic growth to slow, which means that this equilibrium will not be sustainable over the long term. Barring any real progress and credible reform in this area, the country’s credit rating could be further downgraded – which would surely push down the yuan.

[1] Mandatory spending is automatically renewed from year to year and is enshrined in law. Discretionary spending is set every year by the budget law passed by Congress.