Supply-Side Constraints Mounting Pressure to Chinese Economy

- The main constraints to Chinese economy come from the supply side according to President Xi.

- Chinese economy follows an L-style path and enters the flat stage of that trend.

- Yuan devaluation against the dollar is to designed to maintain yuan’s stability against a basket of currencies.

Xinhua News

(Chinese government's official news agency)

Chinese President Xi Jinping said on January 6 that in the current and the following stages, the Chinese economy is and will continue to be constrained by issues from both supply and demand. Yet, the main issues currently proving vexing for the Chinese economy come from the supply side, especially the overcapacity issue. As a result, the government needs to further promote the structural reforms on the supply side, reducing excess production, and helping businesses to cut costs.

In an article published early yesterday on People’s Daily, the official newspaper of the Chinese communist Party, an authority’s comments on the development of Chinese economy were quoted: The economy will move forward in an L-style path. This is different from the market expectation of a V-style path that the Chinese economy will quickly pick up after the decline. The authority also pointed out four major declines in China: economic growth, industrial prices, corporate profits and fiscal income. At the same time, economic risks are rising. These issues are more structural than cyclical.

The L-style expectation gives us an outlook of China’s economy moving forward. After the economic growth dropped to below 7%, almost half of the growth rate seen at its peak level, China is now entering a flat stage of growth. The Chinese economy will stay in this stage for quite a while before it can solve its major problems and find new momentum to stimulate the economy.

One of the major issues is excess production. In yesterday’s article, we discussed that Chinese coal firms are facing shutdown with record debt-to-asset ratio (overleverage). After President Xi Jinping emphasized the government’s focus on solving the overcapacity issue, and stock prices of energy companies, especially coal companies and steel firms, rose significantly. Some of these issues even reached their daily limit-up band.

In order to solve the overcapacity issue, China is putting considerable resources behind the “One-Belt-One-Road” initiative, which is an effort to export the excess production currently being seen in the Chinese economy. And it combines this strategy with the yuan globalization process by issuing an OBOR Yuan Index.

New initiatives that China is developing include “Internet Plus” and the promotion of energy-saving industries. Another top news item on January 6 shows us how China is promoting the Internet Plus industry:

The State Council announced a list of new pilot zones for cross-border E-commerce business. At these new pilot zones, a six-division system will be created and tested. Private companies, financial institutions, regulators will all participated and cooperate in creating the new system.

Sina News

(China’s most important online media, similar as CNN in the US. Also, it owns a Chinese version of twitter, called Weibo, with around 200 million active usersmonthly)

PBOC set yuan’s reference rate to be the lowest since 2011, at 6.5314on Tuesday.

An analyst at China Merchant Bank (CMB) said that yuan’s devaluation is designed primarily to maintain the stability of CFETS Yuan Index. As the dollar strengthened significantly after the New Year against the Euro and other major currencies included in the CFETS Index, in order to keep the index stable, the Yuan needs to continue shedding value against USD.

The PBOC did not make any official comments on why it guided the yuan lower at such an aggressive pace.

The CFETS Yuan Index is a new index created by the PBOC after it announced the de-pegging of the yuan from the US dollar and refers to a broader basket of currencies. As the CFETS Yuan Index is fairly new, there are only five available readings (it’s a weekly index). From the below readings, we can easily see how the weekly change of the yuan index is roughly 1%. This means that the yuan is relatively stable against a basket of currencies despite the heavy volatility being seen in the Yuan against US Dollars.

Written by Renee Mu, DailyFX Research Team