Credit driven slowdown in 2018

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1 Credit driven slowdown in 218 Tighter credit conditions will slow growth in GDP to 5% in 218 from around.2-.3% in 217 Housing market has already turned, with home sales and starts falling in annual terms Consumer demand has disappointed recently, but is expected to pick up in 218 Economic growth to slow in 218 on credit tightening The Chinese economy has been through a strong cyclical rebound since late 2. The housing market has boomed, infrastructure investments have continued to rise at an impressive pace, and the industrial sector has seen a healthy improvement in earnings due to rising commodity prices. In addition, consumer spending has remained strong, supported by rising wages and a healthy labour market. In recent months, however, we have received information indicating that the cyclical rebound has come to an end, and that the pace of growth has fallen. Our expectation is that this will continue well into 218, and that a new rebound only will emerge if and when the government start to ease policies again. To be clear, a slowdown has been in the cards for some time already. In early 217 the central bank began to tighten policies, after its target was changed from reducing borrowing costs for non-financial enterprises to reducing risks to financial stability. This was done by raising market based interest rates which pushed up borrowing costs for corporates and households and by draining in liquidity in the interbank market, which amplified the effect of rising interest rates. On top of this, regulators tightened restrictions on home purchases in several large cities, in part by limiting household s reselling opportunities, in part by raising down-payment requirements, and in part by requiring banks to raise mortgage rates on loans in cities where the authorities had become vary of a bubble China: Interest rates Percent PBoC reverse repo (7d) 7 day repo 1y govt. bond yield Avg. actual lending rate China: PBoC Open Market Operations Net injection (+) or drain (-) in bn yuan *4 months rolling sum As in previous years, it took some time before the economy reacted. However, the impact of the changes in monetary policy in H1-217 is now leaving its footprint on the economy. Our MacroScore for China, which is a broad-based index that tracks growth relative to its potential, has fallen in the last two months, and is now negative for the first time since January 217, thereby indicating that GDP growth is somewhat below its potential. Historically the credit impulse, which measures the change in credit in the last months in % of GDP, has been a leading indicator for the China MacroScore with the former leading the latter by about months. Currently the credit impulse is consistent with a decline in the MacroScore to around -.5. If materialises it will be consistent with a slowdown in GDP growth of around 1%-points to roughly 5% y/y (we estimate that GDP growth has been slightly above % y/y so far in 217). -1-

2 China: Credit impulse and DNB MacroScore China Credit Impulse* DNB China MacroScore, m lag (right) *m change in new credit ex, central govt., in % of GDP Source: Bloomberg/Thomson Datastream/DNB Markets China: DNB MacroScore and metal prices DNB China MacroScore Bloomberg Industrial Metals Index, y/y in % (righ) Source: Bloomberg/Thomson Datastream/DNB Markets Correction in housing market has started The most important factor behind the slowdown is the weakening of the housing market. Housing investments increased from around 1% of GDP in 2 to % in 21, and further up to an estimated.5% in 217. This makes housing investments one of the largest components of GDP, especially when taking into account indirect effects via interconnected sectors. With new home sales declining, both in the big cities and on a nationwide level, housing investments are set for a decline in 218. Home starts have already started to fall, and the increase in land purchases seen earlier in 217 seems to have faded, with land purchases being more or less stable in Q2 and Q China: Gross fixed capital formation Housing investments, in percent of GDP *217 is estimated by DNB Markets China: Home starts Sqm, percent change from year before China: Home sales Percent change from year before T1 and T2 cities Nation China: Land space purchases Million square meters, m rolling sum

3 We expect new home starts to decline by around 4-5% in 218 after increasing by an estimated % in 217. This is much more moderate than in 214-, when home starts fell by 14-% per year. Still, given the importance of real estate investments in GDP, the shifts from growth to contraction should have a material impact on domestic demand. To be clear, we expect home sales to remain well above housing starts in 218, lifted by the government s home purchases under its slum redevelopment project. These purchases are expected to run until 22 and will have a positive impact on inventories but limited effect on construction of new homes. 25 China: Housing market Million units 14 China: Home sales Million units Inventories Starts Sales Private Govt. purchases Source: Gavekal/Thomson Datastream/DNB Markets The impact of weaker development in the real estate sector is already visible. The Caixin Manufacturing PMI fell in November to its lowest in five months, driven primarily by weaker domestic orders and rising inventories. Historically the PMI has lagged growth in home sales by about 3 months, and we expect the PMI to fall further in Q Elsewhere, production of cement has declined for some time already, with growth slowing to -3.5% y/y in October, the weakest development since Q1 21. Meanwhile, output steel and glass is still expanding, but growth has weakened markedly in recent months, and is likely to turn negative in early 218. Admittedly, apparent steel demand is holding up better, but that is entirely due to statistical changes as demand is now entirely satisfied by mainstream steel producers compared to previously when a significant share was satisfied by outdated induction furnaces which were not counted by the National Bureau of Statistics. Adjusting for these changes steel demand will increase by 3% in 217 according to estimates by World Steel, significantly below what we get by looking at the figures for apparent steel demand derived from the data from National Bureau of Statistics China: Housing sales and Caixin Manuf. PMI Housing sales, y/y in %, 3m mav (left) PMI (3m lag, right) China: Real estate related products Percent change from year before Cement Steel Plate glass prod. -3-

4 The upshot is that the construction cycle in China is about to weaken, but that the decline in activity will remain moderate. Still, with real estate investments accounting for.5% of GDP, even a modest decline will have a material impact on the rest of the economy. The manufacturing sector will see weaker growth, which is likely to weigh companies willingness to invest. Fixed asset investments is therefore set to slow further from already low growth rates. Growth in imports is also likely to abate, but the impact from weaker investments will be offset by increased efforts by the government to improve the environment. Consequently, we remain relatively upbeat about trade volumes in 218 despite the slowdown in investment growth China: Fixed asset investments Percent changefrom year before -1 Oct-9 Oct-11 Oct-13 Oct- Oct-17 SOEs Private All China: Trade volumes Percent change from year before, 3mma Exports Imports Increased downside risk for household demand Household demand has in recent years been one of the most important drivers to economic growth. Not just because of its strong growth, but also because of its stability relative to other components of GDP. To measure consumer demand we rely mostly on NBS quarterly survey, which asks households about their income and spending patterns. The survey has shown some volatility on a quarterly basis, but the trend for growth in personal spending has been fairly stable in the last decade, showing only a moderate slowdown. Moreover, spending growth has more or less been in tact with income growth, thereby indicating that households propensity to consume has been fairly stable over the period. 9 3 China: Urban households Percent change from the year before Q3 27 Q3 29 Q3 211 Q3 213 Q3 2 Q3 217 Income (CPI-deflated) Consumption (CPI-deflated with trend) China: Private cons. expenditure Percent change from year before, current prices Food & clothes Housing Transport & comm. Medical & medic. Educ. & ent. Misc. *217 is based on data for Q1-Q3 and DNB estimates for Q4. However, the pace of growth has weakened markedly in the last two quarters, with Q3 ending at 3.7% y/y in real terms, the weakest growth rate recorded since Q1 28. Retail sales volumes have been growing at a faster pace, but also here growth has fallen in recent months, thereby confirming the recent softness in consumer demand. -4-

5 The slowdown has been surprising given that growth in households disposable income has accelerated to its highest since 2. This owes partly to a positive development in the labour market, but also that wage growth has remained strong. Consumer confidence has also improved, rising to its highest since 1993 in November and nearly three standard deviations above its long-term average. We believe the recent slowdown primarily is a consequence of the rapid rise in household debt, which has forced households to save more. Household debt increased to 7% of disposable income in Q3 217, nearly 1%-points higher than in 21. The level is still low compared to in advanced economies, but high relative to other emerging markets. Consequently we calculate that the debt service burden, which measures interest payments and amortizations in percent of disposable income, has increased to.8% in Q3, up 1.7%-points from 21. The level is fairly high relative to other economies. For example, BIS calculates that the debt service ratio for US households to be around 1%, while Japanese households spends around 8% of disposable income to service their debts. The high ratio for Chinese households should be seen against higher interest rates and a shorter repayment time. 8 China: Household debt % of disposable income 14 China: Debt service burden Households, % of disposable income The rise in debt is largely linked to the housing market. With home sales declining and home price growth slowing down, we expect the rise in household debt to slow going forward, which should lead to a stabilization of the debt service burden. We therefore expect growth in consumer demand to pick up to around % in 218, up from around 4.5-5% in 217. However, there is a clear risk that household demand remains weak also in 218. We still see very rapid growth in household debt, despite the recent slowdown in home sales. If this continues the debt service burden will continue to rise, which will have a negative impact on household spending. Cyclical slowdown in 218, household demand main downside risk To summarize, we expect GDP growth to decline to around 5% in 218, down from.2-.3% in 217. The slowdown is driven by tighter credit conditions, which will have a negative impact on investment growth, especially in the housing sector. Consumer demand has disappointed recently due to the rise in household debt. But with home sales declining, households debt service burden is expected to stabilize, which will lift growth in consumer spending in 218. However, if households continue to increase their debts at the same pace as in 217, consumption growth is set for another disappointing year, which is likely to push GDP growth further below 5% in 218. Ole A. Kjennerud, DNB Markets -5-

6 DNB Markets Macro Analysis Kjersti Haugland Chief Economist, Euro area / kjersti.haugland@dnb.no Jeanette Strøm Fjære Economist, Norway and Sweden / jeanette.strom.fjare@dnb.no Ole A. Kjennerud Economist, China and Japan / ole.kjennerud@dnb.no Knut A. Magnussen Senior Economist, USA, UK and Brazil / knut.magnussen@dnb.no Magne Østnor FX Strategist / magne.ostnor@dnb.no Marit Øwre-Johnsen FX Analyst / marit.owre-johnsen@dnb.no Kyrre Aamdal Senior Economist, Norway, Sweden, interest rates / kyrre.aamdal@dnb.no --

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