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What will the economy be like next year

By MARK WILLIAMS/JULIAN EVANS-PRITCHARD (China Daily) Updated: 2014-12-08 13:09

China's leaders will gather in Beijing shortly to discuss priorities for 2015. They use the year-end Economic Work Conference to set out priorities for the year ahead.

Fiscal policy has been "proactive" in 11 of the last 15 years, including in the past few years in which the (cyclically adjusted) fiscal deficit was first reduced and then rebounded. And monetary policy has been "prudent" since 2011 and will probably remain that way in 2015.

The People's Bank of China recently cut benchmark interest rates and we (at Capital Economics) expect further cuts next year. But changes in policy and in how policy is described don't go hand in hand. For example, the shift from "prudent" to "tight" policy at the end of 2007 only happened when the tightening cycle had almost come to an end.

Despite the economic slowdown this year, the labor market has proved remarkably resilient. And as China's economy shifts towards the more labor-intensive service sector, lower growth rates will be sufficient to maintain healthy employment growth. With the labor market now their primary concern, policymakers should therefore feel comfortable lowering their growth target for next year, most likely to "about 7.0 percent".

Turning to the outlook for the main expenditure components, consumption growth has been broadly stable this year and should hold up reasonably well in 2015 given the recent strength of wage growth. Also, export growth, which has picked up this year, should remain healthy given that we expect global growth to be slightly stronger in 2015.

However, support from consumption and exports is unlikely to fully offset downward pressure on growth because of overcapacity in many industries, most notably property, which will weigh on investment.

While recent policy measures are likely to provide some support to sales, a large glut of unsold properties means developers will remain cautious about launching new projects and we therefore don't foresee a marked recover in construction activity next year.

More positively, the recent sharp fall in oil prices should give a boost to spending. In 2013, China's net imports of oil cost the equivalent of 2.5 percent of GDP. If the 30 percent fall in global oil prices is sustained, the economy as a whole will be better off to the tune of 0.8 percent of GDP.

In principle, this windfall could boost GDP by a similar margin if it was all spent. The boost is unlikely to be quite so big because companies and households in China typically save a large share of their income. Nonetheless, for a large oil consumer like China, the fall in prices reduces the downside risks to growth.

We expect inflation to continue falling next year. That said, we think deflation fears are overdone; we are not expecting consumer price inflation to turn negative. In any case, the fall in inflation is largely being driven by falls in global commodity prices which should actually benefit most firms and households.

Besides, wage growth and profit margins remain healthy.

The focus here is likely to remain on keeping financing costs low. The recent rate cut has not been fully passed on by banks and is unlikely to help smaller companies so policymakers may have to do more. We expect two more cuts to benchmark lending rates by the middle of next year, as well as liquidity injections, including in the form of reserve requirement ratio (RRR) cuts, in order to bring down market interest rates.

But we shouldn't read too much into any given move. Tougher banking regulation will have a tightening effect over the months ahead. A slowdown in foreign exchange purchases would be felt in a similar way. To some extent, liquidity injections and RRR cuts will be needed to offset these shifts.

Crucially, we don't see the recent benchmark rate cut as the start of a new easing cycle similar to that in 2008. Interest rates are likely to fall but we believe that the PBoC will stop short of driving a sustained rebound in credit growth, unless the economy and labor market deteriorate markedly.

How policymakers respond to the revision to China's budget law, which will come into effect on Jan 1, will be key in determining the fiscal stance for next year. The new law requires that the two-thirds of government spending that currently takes place outside the formal budget, either by branches of government or notionally independent local government financing vehicles, be included in the budget.

While this is a welcome step toward boosting transparency, it will force officials to either drastically tighten the effective fiscal stance or see the budget deficit soar.

As expected, financial reforms are progressing the fastest. The recently announced deposit insurance scheme should come into force early next year and lay the foundations for the launch of more private banks and further steps toward interest rate liberalization. In that regard, while we expect the benchmark deposit rates to be cut again, we think the PBoC will keep the ceiling on deposit rates unchanged next year by increasing the margin by which retail deposit rates can exceed the benchmark.

The result would be to give banks more flexibility in setting interest rates and to support greater competition.

Other areas to watch include the hukou (household registration) system, where liberalization is inching forward, and State-owned enterprises where more pilot programs for mixed ownership schemes could be launched.

We also expect further efforts to reduce the regulatory burden, particularly on smaller companies, and encourage more private sector investment in currently protected parts of the economy. Also, a nationwide property registry could be launched, paving the way for the eventual expansion of the much-touted property tax.

In some other areas reforms may make slower progress. The strength of the US dollar and rapid appreciation of the renminbi in trade-weighted terms looks to be pushing the PBoC to resume foreign exchange intervention, setting back hopes within the PBoC that the renminbi could soon be allowed to float freely. In turn, this implies that full opening-up the capital account remains some way off.

The authors are economists with Capital Economics, a London-based independent macroeconomic research consultancy.

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