Thu 21 Sep 2017


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In Portfolioticker today

read_this Hey Jarvis, how did we go today?

Today at the stock market

bull/bearU.S. stock indexes slipped on Thursday as investors braced for a third interest rate hike this year and the United States ordered new sanctions against North Korea. The S&P and the Dow snapped a run of record closing highs and Apple was the biggest drag on the three major indexes with a 1.7% drop on worries about demand for its latest smartphone.

  • The S&P 500 lost 7.64 points, or 0.30%, to 2,500.6.
  • The Dow Jones Industrial Average fell 53.36 points, or 0.24%, to 22,359.23
  • The Nasdaq Composite dropped 33.35 points, or 0.52%, to 6,422.69.
  • Declining issues outnumbered advancing ones on the NYSE by a 1.35-to-1 ratio; on Nasdaq, a 1.24-to-1 ratio favored decliners.
  • About 5.54 billion shares changed hands on U.S. exchanges on ,compared with the 6.03 billion average for the last 20 sessions.

Investors increased bets the U.S. Federal Reserve would raise rates again this year after the central bank’s statement on Wednesday and were also assessing its decision to start reducing its roughly $4.2 trillion in U.S. Treasury bonds and mortgage-backed securities.

U.S. President Donald Trump opened the door to blacklisting people and entities doing business with North Korea, further tightening the screws on Pyongyang’s nuclear and missile programs.

“The Fed had investors on edge already. Ratcheting up of North Korea tensions can put investors in a little more of a risk-off mode,” said Chris Zaccarelli, chief investment officer at Cornerstone Financial Partners, in Huntersville, NC.

Fed Chair Janet Yellen said the fall in inflation this year remained a mystery, adding that the central bank was ready to change the interest rate outlook if needed.

Investors were pricing in about a 70% chance of a Dec 2016 hike, according to CME’s FedWatch tool, up from about 51% just prior to the Fed statement.

Only two of the 11 major S&P sectors – financials and industrials – were higher, with gains of 0.2% and 0.3%. The consumer staples index was the biggest decliner, down 0.97%.

Financial stocks have been on a tear in recent days as investors anticipated and then reacted to Fed commentary on rate hikes, which tend to help bank profits.

The S&P has risen about 11.7% so far this year, helped by strong corporate profits and lingering optimism among some investors that Trump will cut taxes for businesses. This has boosted valuations. The S&P is trading at roughly 17.6 times expected earnings, well above its 10-year average of 14.3, according to Thomson Reuters Datastream.

“It’s very hard for me to see a tremendous catalyst for the upside, although I also don’t see that massive catalyst to create a crack to the downside,” said Cantor’s Cecchini.Bloomberg

Market indices

Market indices
^ Market indices today (mouseover for 12 month view) Chart: Google Finance

Index Ticker Today Change 31 Dec 16 YTD
S&P 500 SPX (INX) 2,500.60 -0.31% 2,238.83 +11.69%
DJIA INDU 22,359.23 -0.24% 19,762.60 +13.13%
NASDAQ IXIC 6,422.69 -0.52% 5,383.12 +19.31%

Portfolio Indices

USD and AUD denominated indices over the past 52 weeks (Chart: Bunting)
^ USD and AUD denominated indices over the past 52 weeks Chart: Bunting

Index values

Index Currency Today Change 31 Dec 16 YTD
USD-denominated Index USD 2.761 -1.27% 2.105 +31.18%
Valuation Rate USD/AUD 0.79771 -1.18% 0.72663 +9.78%
AUD-denominated Index AUD 3.464 -0.11% 2.895 +19.66%

Portfolio stock prices

Stock Ticker Today Change 31 Dec 16 YTD
Alphabet A GOOGL $947.55 +0.00% $792.45 +19.57%
Alphabet C GOOG $932.45 +0.09% $771.82 +20.81%
Apple AAPL $153.39 -1.72% $115.82 +32.43%
Amazon AMZN $964.65 -0.88% $749.87 +28.64%
Ebay EBAY $38.25 -0.75% $29.69 +28.83%
Facebook FB $171.11 -0.62% $115.05 +48.72%
PayPal PYPL $64.63 -0.17% $39.47 +63.74%
Twitter TWTR $17.58 -0.23% $16.30 +7.85%
Visa V $105.31 +0.32% $78.02 +34.97%
VMware VMW $109.07 -0.96% $78.73 +38.53%

FX: USD/AUD

USD

DXY movements
^ Bloomberg Dollar Spot Index (DXY) movements today (mouseover for 12 month view) Chart: Bloomberg

The Bloomberg Dollar Spot Index (DXY) fell 0.1% after earlier touching the highest in more than 2 weeks.
The EUR climbed 0.5% to USD 1.1950.
Japan’s JPY fell 0.1% to 112.334 per USD, hitting the weakest in more than 2 months.
Bloomberg

AUD

AUD movements
^ AUD movements against the USD today (mouseover for 12 month view) Chart: xe.com

Oil and Gas Futures

Futures prices

Prices are as at 15:48 EDT

  • NYMEX West Texas Intermediate (WTI): $50.67/barrel -0.04% Chart
  • ICE (London) Brent North Sea Crude: $56.46/barrel +0.30% Chart
  • NYMEX Natural gas futures: $2.95/MMBTU -4.52% Chart

flag_australia AU: RBA Governor Lowe’s Speech

This is a time when one chapter in Australia’s economic history is drawing to a close and another is about to start. A main theme in the chapter that is about to come to an end is the mining investment boom. That boom, and its unwinding, has been central to the story of the Australian and Western Australian economies for more than a decade now. The new chapter will, almost certainly, have a different central theme.

Today, I would like to provide a sketch of some of the likely plot lines of the next chapter. Before doing that, though, I will reflect on the current chapter.

THE CURRENT CHAPTER

The storyline of the current chapter is well known. It has had two main plot lines.

The first was a troubled global economy. A decade ago we had the global financial crisis and the worst recession in many advanced economies since the 1930s. A gradual recovery then took place, but it was painfully slow. Recently, things have improved noticeably and unemployment rates in some advanced economies are now at the lowest levels in many decades. Throughout this chapter, central banks have mostly worried that inflation rates might turn out to be too low, not too high. Interest rates have been at record lows. And workers in advanced economies have experienced low growth in their nominal wages. So it’s been a challenging international backdrop.

The second plot line was the resources boom. Strong growth in China saw strong growth in demand for resources. Prices rose in response, with Australia’s terms of trade reaching the highest level in at least 150 years. Then an investment boom took place in response to the higher prices, with investment in the resources sector reaching its highest level as a share of GDP in over a century. And now we are seeing the dividends of this, with large increases in Australia’s resource exports.

au_lowe_graph1_20170921

Overall, it has been a reasonably successful chapter in Australia’s economic history. Real income per person is around 20 per cent higher than it was in the mid 2000s and real wealth per person is 40 per cent higher. Australia is one of the few advanced economies that avoided a recession in 2008. And the biggest mining boom in a century did not end in a crash, as previous booms did. Our interest rates remained positive, unlike those in many other advanced economies. Since the mid 2000s, the unemployment rate has averaged 5¼ per cent, a better outcome than in the previous three decades. Inflation has averaged 2½ per cent. And over this period, GDP growth has averaged 2¾ per cent, higher than in most other advanced economies.

So, taking the period as a whole, it is a positive picture.

At the same time, though, as the chapter draws to a close, we do face some issues. I would like to highlight three of these.

The first is the recent slow growth in real per capita income. For much of the past two decades, real national income per person grew very strongly in Australia . We benefited from strong productivity growth, higher commodity prices and more of the population working. In contrast, since 2011 there has been little net growth in real per capita incomes. This change in trend is proving to be a difficult adjustment. The solutions are strong productivity growth and increased labour force participation.

au_lowe_graph2_20170921

A second issue is the unusually slow growth in nominal and real wages. Over the past four years, the increase in average hourly earnings has been the slowest since at least the mid 1960s. This is partly a consequence of the unwinding of the mining boom but there are structural factors at work as well. The slow growth in wages is putting a strain on household budgets and contributing to low rates of inflation.

au_lowe_graph3_20170921

A third issue is the high level of household debt and housing prices. Over recent times, Australians have borrowed a lot to purchase housing. This has added to the upward pressure on housing prices, especially in our two largest cities, where structural factors are also at work. Australians are coping well with the higher level of debt, but as debt levels have increased relative to our incomes so too have the medium-term risks. The very high levels of housing prices in our largest cities are also making it difficult for those on low and middle incomes to buy their own home.

So as we turn the final pages of this chapter, these are some of the issues we face. But as we turn these pages, we also see improvements on a number of fronts.

Business conditions, as reported in surveys, are at the highest level in almost 10 years. There are also growing signs that private investment outside the resources sector is picking up. We have been waiting for this for some time. For a number of years, animal spirits had been missing, with many firms preferring to put off making decisions about capital spending. It appears that some of this reluctance to invest is now passing. According to the June quarter national accounts, private non-mining business investment increased strongly over the first half 2017, to be around 10 per cent above the level at the start of 2016. Non-residential building approvals have increased to be above the levels of recent years and there is a large pipeline of public infrastructure investment to be completed. The decline in mining investment has also largely run its course.

au_lowe_graph4_20170921

There has also been positive news on the employment front. Over the past year, the number of people with jobs has increased by more than 2½ per cent, a positive outcome given that the working-age population is increasing at around 1½ per cent a year. Growth in full time employment has been particularly strong. The various forward-looking indicators suggest that labour market conditions will remain positive in the period immediately ahead.

Here in Western Australia, there are also some signs of improvement after what has been a difficult few years. The drag from declining mining investment is diminishing. Businesses are feeling more positive than they were a year ago and employment has been rising after a period of decline. At the same time though, conditions in the housing market remain difficult, with housing prices and rents continuing to fall in Perth. Weak residential construction has also weighed on aggregate demand over the first half of this year, although building approvals and liaison reports point to some stabilisation in the period ahead.

au_lowe_graph5_20170921

For Australia as a whole, the recent national accounts – which showed a healthy increase in output of 0.8 per cent in the June quarter – were in line with the Bank’s expectations. These, and other recent data, are consistent with the Reserve Bank’s central scenario for GDP growth averaging around the 3 per cent mark over the next couple of years. This is a bit faster than our current estimate of trend growth in the Australian economy, so we expect to see a gradual decline in the unemployment rate. This should lead to some pick-up in wage growth, although we expect this to be a gradual process given the structural factors at work that I have spoken about on previous occasions. We can also expect to see a gradual increase in inflation back towards the middle of the 2 to 3 per cent medium-term target range.

There are clearly risks around this central scenario. We would like to see the improvement in business investment consolidate and a continuation of job growth at a rate at least sufficient to absorb the increase in Australia’s workforce. Some pick-up in wage growth in response to the tighter labour market would also be a welcome development. So these are some areas to watch. But as things stand, the economy does look to be improving.

THE NEXT CHAPTER

I would now like to lift my gaze a little and turn to the next chapter in our economic story. I would like to sketch out four of the possible plot lines, acknowledging that, as in all good stories, there are likely to be plenty of surprises along the way.

Shifts in the global economy

A first likely plot line, as it has been in previous chapters, is the ongoing shift in the global economy. Here, changes in technology and further growth in Asia are likely to be prominent themes.

In some quarters there is pessimism about future prospects for the global economy. The pessimists cite demographic trends, high debt levels, increasing regulatory burdens that stifle innovation and political issues. They see a future of low productivity growth and only modest increases in average living standards.

It’s right to be concerned about the issues that the pessimists focus on, but I am more optimistic about the ability of technological progress to propel growth in the global economy, just as it has done in the past. We are still learning how to take advantage of recent advances in technology, including the advances in the tools of science. In time we will do this and new industries and methods of production will evolve, some of which are hard to even imagine today. So there is still plenty of upside. The challenge we face is to make sure that the benefits of technological progress are widely shared. How well we do this could have a major bearing on the next chapter.

Beyond this broad theme, it is appropriate to recognise the important leadership role that the United States plays in the global economy. If the US economy does well, so does most of the rest of the world. The United States has long been a strong supporter of open markets and a rules-based international system. It has been the breeding ground for much of the progress in technology. And it has been a safe place for people to invest and an important source of financial capital for other countries. It is in our interests that the United States continues to play this important role. A retreat would make our lives more complicated.

Another important influence on the next chapter is how things play out in China. While growth in China is trending lower, the share of global output produced in China will continue to rise, as per capita incomes converge towards those in the more advanced economies. As this convergence takes place, the structure of the Chinese economy will change and so too will China’s economic relationship with Australia. Exports of resources will continue to be an important part of that relationship, but increasingly trade in services and other high value-added activities, including food, will become more important. Notwithstanding this, there are risks on the horizon, with the Chinese economy going through some difficult adjustments. One of these is the switch from a growth model based on industrial expansion to one based more on services. Another is managing an increasingly large and complex financial system. Australia has a strong interest in China successfully managing these challenges.

au_lowe_graph6_20170921

Another shift in the global economy that could shape the next chapter is the growth of other economies in Asia. Developments in India and Indonesia bear especially close watching. Both of these countries, especially India, have very large populations, and per capita incomes are still quite low. In time, the effects of economic progress in these countries and others in the region could be expected to have a substantial effect on the Australian economy, just as the development of China has.

Normalisation of monetary conditions

A second likely plot line of the next chapter is a return to more normal monetary conditions globally. Since the financial crisis we have been through an extraordinary period in monetary history. Interest rates have been very low and even negative in some countries. Central banks have greatly expanded their balance sheets in order to buy assets from the private sector. This period of monetary expansion is now drawing to a close.

au_lowe_graph7_20170921

Some normalisation of monetary conditions globally should be seen as a positive development, although it does carry risks. It is a sign that economic growth in the advanced economies has become self-sustaining, rather than just being dependent on monetary stimulus. It would also lift the return to many savers who have been receiving very low returns on interest-bearing assets for a decade now.

On the other side of the ledger, periods of rising interest rates globally have, historically, exposed over-borrowing somewhere in the global system. Investment strategies that looked sensible when interest rates were very low tend not to look so good when interest rates are higher.

We can take some comfort from the major efforts over the past decade to improve the resilience of the global financial system. But at the same time, investors have increasingly been prepared to take more risk in the search for yield. Many continue to expect a continuation of low rates of inflation and low interest rates, despite quite low unemployment rates in a number of countries. So this is an area that is worth watching. If higher interest rates are the result of a surprise increase in inflation, financial markets could be in for a difficult adjustment.

A rise in global interest rates has no automatic implications for us here in Australia. Notwithstanding this, an increase in global interest rates would, over time, be expected to flow through to us, just as the lower interest rates have. Our flexible exchange rate though gives us considerable independence regarding the timing as to when this might happen.

Higher levels of debt

This brings me to a third plot line: that is, how we deal with the higher level of household debt and higher housing prices, especially in a world of more normal interest rates.

It is likely that higher levels of household debt change household spending patterns. Having increased their borrowing, households are less inclined to let consumption growth run ahead of growth in incomes for too long. Higher levels of debt also mean that household spending could be quite sensitive to increases in interest rates, something the Reserve Bank will be paying close attention to.

To date, households have been coping reasonably well with the higher debt levels. The aggregate debt-to-income ratio has trended higher, but the ratio of interest payments to income is not particularly high, given the low level of interest rates. Housing loan arrears remain low, although they have increased a little recently, especially here in Western Australia.

au_lowe_graph8_20170921

Over recent times, one issue that the Reserve Bank has focused on is the build-up of medium-term risks from growth in household debt persistently outpacing that in household income. Our concern has been that, in this environment, a small shock could turn into a more serious correction as households seek to repair their balance sheets. We have been working with APRA through the Council of Financial Regulators to address this risk. The various measures are having a positive impact in improving the resilience of household balance sheets.

A broadening of the drivers of growth

The fourth likely plot line is a broadening of the drivers of growth in the Australian economy. How the next chapter in our economic history turns out depends partly on our ability to lift productivity growth across a wide range of industries. The resources sector will, no doubt, continue to make an important contribution to the Australian economy, but it is unlikely that it will shape the next chapter in our economic history as it did the current chapter. With another major upswing in the terms of trade unlikely and the working-age share of our population having peaked as the population ages, improving productivity will be key to growth in our national income.

The drivers of growth are changing: they increasingly depend on our ability to produce innovative goods and services in a rapidly changing world. In this world, it is difficult to make precise predictions about where the jobs and growth in our economy are going to come from in the future. But it seems clear that we will be best placed to take advantage of whatever possibilities arise if businesses and our workforce are innovative and adaptable.

Australia is fortunate to have a natural resource base that provides an important source of national income, and this will remain the case. But in this next chapter we will need to look more directly to the skills of our workers and our businesses to drive economic growth. If we are to take advantage of the opportunities that are offered by technology and growth in Asia, we need a flexible workforce with strong skills in the areas of problem solving, critical thinking and communication. Investment in human capital will be one of the keys to success. We also need a competitive business environment that encourages innovation. How well the next chapter turns out will depend on how we do in these areas.

So, in summary these are some of the themes we might expect to see in the next chapter – the impact of technology and the growth of Asia; the normalisation of monetary conditions; the effects of higher levels of household debt; and the capability of our workforce and businesses to be flexible, innovative and adaptable.

This is, obviously, not a complete list. There are clearly other factors that could have a major influence on the storyline, including how geopolitical tensions are resolved and how we adjust to climate change. And no doubt there will be surprises as well.

But overall, I remain optimistic about how this next chapter might unfold. While we have our challenges, some of which I have talked about, we also have some advantages. We have a strong institutional and policy framework, a skilled, growing and diverse population and a wealth of mineral and agricultural resources. We have strong links to Asia, the fastest growing part of the global economy. We also have a flexible economy with a demonstrated capacity to adjust to a changing world.

These factors should give us confidence about our future. But we can’t rest on this and there are a number of significant risks. The world is a competitive place and the global economy is continuing to go through some challenging adjustments. If we are to do well in this world, we need to keep investing in both physical and human capital. We also need to keep investing in policy reform.

Finally, I have said relatively little about monetary policy today. This is partly because there are other forces that are likely to be more important in shaping the next chapter of the Australian economy. Monetary policy has an important role to play in supporting the economy as it goes through the current period of adjustment. It can also help stabilise the economy when it is hit by future shocks. Monetary policy can make for a more predictable investment climate by keeping inflation low and stable. Having a competent, analytical, transparent and independent central bank can also be a source of confidence in the country. But beyond these effects, monetary policy has little influence on the economy’s potential growth rate.

Over recent times, the Reserve Bank Board has not sought to overly fine-tune things. We have provided support and allowed time for the economy to adjust to the new circumstances. In its decisions, the Board has been careful to balance the benefit of providing this support with the risks that can come from rising household debt. As things currently stand, we look to be on course to make further progress in reducing unemployment and moving towards the midpoint of the medium-term inflation target. This would be a good outcome.

Philip Lowe, Governor, Reserve Bank of Australia, “Address to the American Chamber of Commerce in Australia (AMCHAM) “, Perth – 21 September 2017 Speech

Market Impact

The AUD fell near 1% against the USD on Thursday after the RBA governor Lowe said rising rates abroad have no automatic implications for Australia and noted that households are highly indebted and higher rates could hurt consumption. The speech was made hours after the Fed signaled another rate hike for 2017. The AUD dollar was down 1% to USD 0.795 around 11:00 AM London time. TradingEconomics

So far the main reason why households haven’t had to worry about their balance sheets, or wealth, is that house prices have gone through the roof.

There’s around AUD 1.6 trillion of debt linked to the residential property market for investors and owner occupiers, but the value of all that property now stands at around AUD 6.7 trillion. When rates rise, however, that debt number stays roughly the same but paying for it all goes up and if Capital Economics is right there will be a fall of 10% in prices. That takes the total value of housing closer to AUD 6 trillion, but if its closer to a 20% fall then it dips to AUD 5.36 trillion.

It shows why the balance sheets of households with a mortgage are so exposed to a drop in house prices. While everyone seems to point to the household debt relative to disposable income, that has reached the record high of 200%, it’s really the ability to service the debt that is the ticking time bomb.AFR

flag_usa EU: Flash Consumer Confidence Indicator. Sep 2017

Comment: TradingEconomics

The consumer confidence index for the Euro Area increased to -1.2 in September of 2017 from -1.5 in August, preliminary estimates showed. It is the highest reading since April of 2001, beating market expectations of -1.5. Consumer Confidence in the Euro Area averaged -12.14 from 1985 until 2017, reaching an all time high of 2.20 in May of 2000 and a record low of -34.60 in March of 2009.TradingEconomics

Press Release Extract [ser_eu_cci]

In September 2017, the DG ECFIN flash estimate of the consumer confidence indicator increased in the EU (+0.8 to -1.5) and, to a lesser extent, in the euro area (+0.3 points to -1.2) compared to August.

eu_cci_20170921

Directorate-General Economic and Financial Affairs (DG ECFIN) of the European Commission, “Flash Consumer Confidence Indicator For EU and Euro Area. Sep 2017“, 21 Sep 2017 More

flag_usa US: Unemployment Insurance Weekly Claims

Press Release Extract [ser_4]

insurance

In the week ending September 16, the advance figure for seasonally adjusted initial claims was 259,000, a decrease of 23,000 from the previous week’s revised level. The previous week’s level was revised down by 2,000 from 284,000 to 282,000. The 4-week moving average was 268,750, an increase of 6,000 from the previous week’s revised average. This is the highest level for this average since June 4, 2016 when it was 269,500. The previous week’s average was revised down by 500 from 263,250 to 262,750.

Hurricanes Harvey and Irma impacted this week’s claims.

unemployment

The advance seasonally adjusted insured unemployment rate was 1.4 percent for the week ending September 9, unchanged from the previous week’s unrevised rate. The advance number for seasonally adjusted insured unemployment during the week ending September 9 was 1,980,000, an increase of 44,000 from the previous week’s revised level. The previous week’s level was revised down by 8,000 from 1,944,000 to 1,936,000. The 4-week moving average was 1,953,000, an increase of 6,500 from the previous week’s revised average. The previous week’s average was revised down by 2,000 from 1,948,500 to 1,946,500.

Unadjusted data

The total number of people claiming benefits in all programs for the week ending September 2 was 1,729,253, a decrease of 114,202 from the previous week. There were 1,905,531 persons claiming benefits in all programs in the comparable week in 2016.

No state was triggered “on” the Extended Benefits program during the week ending September 2.

Initial claims for UI benefits filed by former Federal civilian employees totaled 658 in the week ending September 9, a decrease of 114 from the prior week. There were 655 initial claims filed by newly discharged veterans, a decrease of 62 from the preceding week.

There were 8,076 former Federal civilian employees claiming UI benefits for the week ending September 2, a decrease of 281 from the previous week. Newly discharged veterans claiming benefits totaled 9,083, a decrease of 684 from the prior week.

The highest insured unemployment rates in the week ending September 2 were in Puerto Rico (2.7), New Jersey (2.6), Alaska (2.0), Connecticut (2.0), Pennsylvania (1.9), California (1.8), Massachusetts (1.7), New York (1.7), Illinois (1.6), Nevada (1.6), and Rhode Island (1.6).

The largest increases in initial claims for the week ending September 9 were in Iowa (+534), Nebraska (+64), Tennessee (+30), Wyoming (+23), and Washington (+22), while the largest decreases were in Texas (-11,764), California (-7,375), Michigan (-4,483), New York (-2,938), and Florida (-2,289).

Employment and Training Administration, “Unemployment Insurance Weekly Claims Report“, 21 Sep 2017 (08:30) More

flag_japan Japan update

Currency: USD/JPY

JPY movements
^ JPY movements against the USD over the past month (mouseover for inverse) Chart: xe.com

Stockmarket: Nikkei 225

N225 movements
^ Nikkei N225 movements over the past week Chart: Google Finance

flag_china China update

S&P Cuts China’s Credit Rating To A+ from AA-

OVERVIEW
China’s prolonged period of strong credit growth has increased its economic and financial risks.

We are therefore lowering our sovereign credit ratings on China to ‘A+/A-1′ from ‘AA-/A-1+’.

The stable outlook reflects our view that China will maintain its robust economic performance and improved fiscal performance in the next three to four years.

RATING ACTION

On Sept. 21, 2017, S&P Global Ratings lowered the long-term sovereign credit ratings on China to ‘A+’ from ‘AA-’ and the short-term rating to ‘A-1′ from ‘A-1+’. The outlook on the long-term rating is stable. We have also revised our transfer and convertibility risk assessment on China to ‘A+’ from ‘AA-’.

The downgrade reflects our assessment that a prolonged period of strong credit growth has increased China’s economic and financial risks. Since 2009, claims by depository institutions on the resident nongovernment sector have increased rapidly. The increases have often been above the rate of income growth. Although this credit growth had contributed to strong real GDP growth and higher asset prices, we believe it has also diminished financial stability to some extent.

The recent intensification of government efforts to rein in corporate leverage could stabilize the trend of financial risk in the medium term. However, we
foresee that credit growth in the next two to three years will remain at levels that will increase financial risks gradually.

OUTLOOK

The stable outlook reflects our view that China will maintain robust economic performance over the next three to four years. We expect per capita real GDP
growth to stay above 4% annually, even as public investment growth slows further. We also expect the stricter implementation of restrictions on subnational government off-budget borrowing to lead to a declining trend in the fiscal deficits, as measured by changes in general government debt in terms of GDP.

We may raise our ratings on China if credit growth slows significantly and is sustained well below the current rates while maintaining real GDP growth at healthy levels. In this scenario, we believe risks to financial stability and medium-term growth prospects will lessen to lift sovereign credit support.

A downgrade could ensue if we see a higher likelihood that China will ease its efforts to stem growing financial risk and allow credit growth to accelerate to support economic growth. We expect such a trend to weaken the Chinese economy’s resilience to shocks, limit the government’s policy options, and increase the likelihood of a sharper decline in the trend growth rate.

RATIONALE

The ratings on China reflect our view of the government’s reform agenda, growth prospects, and strong external metrics. On the other hand, we weigh these strengths against certain credit factors that are weaker than what is typical for similarly rated peers. For example, China has lower average income, less transparency, and a more restricted flow of information.

Institutional and economic profile: Reforms to budgetary framework and financial sector in progress

  • China’s policymaking has helped it to maintain consistently strong economic performances since the late 1970s.
  • We project China’s per capita GDP to rise to above US$10,000 by 2019, from a projected US$8,300 for 2017.

The Chinese government is taking steps to bolster its economic and fiscal resilience. We view the government’s anti-corruption campaign as a significant
move to improve governance at state agencies, local governments, and state-owned enterprises (SOEs). Over time, this could translate into greater confidence in the rule of law, improvements in the private-sector business environment, more efficient resource allocation, and a stronger social contract.

The government continues to make significant reforms to its budgetary framework and the financial sector. These changes could yield long-term benefits for China’s economic development. The government also appears to be signaling that it will allow SOEs with lesser policy importance to exit the market either through merger, closure, or default in order to allocate resources more efficiently. More recently, it has also indicated financial stability as a top policy priority and is acting to rein in growth of public sector borrowing. However, we believe some local government financing vehicles, despite their diminishing importance, continue to fund public
investment with borrowings that could require government resources to repay in the future.

China’s policymaking has helped it to maintain consistently strong economic performances since the late 1970s. However, coordination issues between the line ministries and the State Council sometimes lead to unpredictable and abrupt policy implementation. The authorities also have yet to develop an effective communication channel with the market to convey policy intent, heightening financial volatility at times. Moreover, China does not benefit from the checks and balances usually coming from the free flow of information. These characteristics can lead to the misallocation of resources and foster discontent over time.

We expect China’s economic growth to remain strong at close to 5.8% or more annually through at least 2020, corresponding to per capita real GDP growth of above 5.4% each year. We also expect credit growth in China to outpace that of nominal GDP over much of this period.

We project China’s per capita GDP to rise to above US$10,000 by 2019, from a projected US$8,300 for 2017, given our assumptions about growth and the continued strength of the renminbi’s real effective exchange rate. Over the next three years, we expect final consumption’s contribution to economic growth to increase. However, we believe the gross domestic investment rate is likely to remain above 40% of GDP.

Flexibility and performance profile: External profile remains key strength

  • We expect financial assets held by the public and financial sectors to exceed total external debt by more than 90% of current account receipts (CAR) at the end of 2017. At the same time, we estimate China’s total external assets will exceed its external liabilities by 65% of its CAR.
  • In 2017-2020, we project the increase in general government debt in each of these years at 2.8%-4.9% of GDP. We project net general government debt will fall toward 46% of GDP in the period to 2020 and interest cost to government revenue will remain below 5% throughout the forecast horizon.
  • We believe China’s monetary policy is largely credible and effective. We believe the liberalization of deposit rates at banks in recent years is an important reform that could further improve monetary transmission in China.

China’s external profile remains a key credit strength despite the recent decline of its foreign exchange reserves. We partly attribute the fall in reserves in 2016 to increased expectations of renminbi depreciation. Consequently, some private sector firms reduced or hedged their dollar debt and exporters kept a greater share of their proceeds in foreign exchange. We also attribute the accommodation of SOE and private-sector demand for foreign exchange as a willingness of officials to diversify China’s external assets away from holdings of U.S. government debt to other investments of the financial and private sectors.

China remains a large external creditor. We expect financial assets held by the public and financial sectors to exceed total external debt by more than 90% of current account receipts (CAR) at the end of 2017. At the same time, we estimate that China’s total external assets will exceed its external liabilities by 65% of its CAR. China’s external liquidity position is equally robust. We expect the country to sustain its current account surplus at more than 2% of GDP in 2017-2020. We project annual gross external financing needs in 2017-2020 to total less than 60% of CAR plus usable reserves.

The increasing global use of the renminbi (RMB) also bolsters China’s external financial resilience. According to the Bank for International Settlements’ (BIS) “Triennial Central Bank Survey,” published 2016, the renminbi was traded in 4% of foreign exchange transactions globally. We therefore assess the RMB as an actively traded currency. Demand for renminbi-denominated assets from both official and private-sector creditors could rise with the inclusion of the renminbi in the IMF’s Special Drawing Rights basket of currencies.

We expect the share of renminbi-denominated official reserves to rise over time. If the renminbi achieves reserve currency status (which we define as more than 3% of aggregated allocated international foreign exchange reserves), it could strengthen external and monetary support for the sovereign ratings. Although the People’s Bank of China (the central bank) does not operate a fully floating foreign exchange regime, it has allowed greater flexibility in the nominal exchange rate over the past decade. Based on estimates from the BIS, the real effective exchange rate has appreciated by close to 10% since the end of 2011. Any future weakness of the renminbi needs to be analyzed in this light.

China is gradually implementing an ambitious fiscal reform to improve fiscal transparency, budgetary planning and execution, and subnational debt management. These reforms could help the government to manage slower growth of fiscal revenue and lower its reliance on revenue from land sales.

In 2017-2020, we expect the Chinese government to keep the reported general government deficit close to, or below, 2.5% of GDP. However, off-balance-sheet borrowing could continue for the next two to three years. This reflects both the financing needs of public works started before 2015 as well as some new projects that the central government is willing to authorize to support growth. Consequently, we project the increase in general government debt in each of these years at 2.8%-4.9% of GDP.

We now include the entire sum of nearly RMB25 trillion (US$3.9 trillion, or approximately 36% of 2015 GDP) of government-related debt from local government financing vehicles in general government debt. We have also included the debts of China Railway Corp. in general government debt. The company was previously the Ministry of Rail but was incorporated as a special industrial enterprise. Bonds issued by the company are held on China banks’ books at a lower capital charge compared with other corporate debt.

We offset these debts to compute net general government debt with fiscal deposits held by the government, net assets of the China Investment Corp. and net assets of the National Council of Social Security Funds. Using this method, we project net general government debt will fall toward 46% of GDP in the period to 2020 and interest cost to government revenue will remain below 5% throughout the forecast horizon. These forecasts in turn follow from our assumptions regarding real growth and ample domestic liquidity keeping financing cost low for the government.

Although the fiscalization of the local government financing vehicles and China Rail Corp. has raised our figure for general government debt, it has simultaneously decreased our estimates for contingent liabilities to the government from this sector. Entities with weak financial metrics owe much of the financing vehicle loans that are being redeemed through government bond issuance. By putting these loans on the government’s balance sheet, the government has significantly reduced the banks’ credit risks, in our view.

We believe China’s monetary policy is largely credible and effective, as demonstrated by its track record of low inflation and its pursuit of financial sector reform. Consumer price index inflation is likely to remain below 3% annually over 2017-2020. Although the central government–through the State Council–has the final say in setting interest rates, we find that the central bank has significant operational independence, especially regarding open-market operations. These operations affect the economy through a largely responsive interbank market and a sizable and fast-expanding domestic bond market. The liberalization of deposit rates at banks in recent years is an important reform that could further improve monetary transmission in China.

S&P Global Ratings, “People’s Republic Of China Ratings Lowered To ‘A+/A-1′; Outlook Stable“, 21 Sep 2017 More

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