Growth in conflict with reform

The stakes are high as leaders signal that GDP growth for the year can fall below target

All year long, Chinese policymakers have been walking a fine line between stimulating growth and pushing forward reform and restructuring. China's third quarter economic data suggests this battle will rage on for at least another quarter.

China has given itself room to fall below the official 2014 GDP target of 7.5 percent by saying that growth of "around 7.5 percent" is acceptable. Premier Li Keqiang later quantified this, saying that China needed growth of 7.2 percent to ensure stability. As the economy clearly still faces downward pressure, quick decisions are needed.

Two important questions are raised in the current environment. First, what are the pressures on growth and how will they play out? Second, how firm is this 7.2 percent floor?

First, at a big picture level, China is seeing a major slowdown in domestic fixed asset investment that is being partially offset by rising exports. GDP can be broken down into three components: gross capital formation (or fixed asset investment), consumption, and net exports (exports less imports). GCF accounted for 41.3 percent of GDP growth in the third quarter of this year, down from 55.8 percent in the third quarter of 2013.

The slowdown in investment is led by the property sector. Residential property sales fell 10.3 percent year-on-year in the first nine months of the year, impacting property developer cash flows. To make matters worse, developer funding has dried up as shadow banking is tightened and lending rates are high. New funds available for real estate investment fell 0.6 percent year-on-year in September after falling 0.5 percent in August. Bank loans fell 3.6 percent year-on-year and mortgages fell 8.2 percent, the fourth straight month of decline, owing to high borrowing costs.

Unable to borrow and with fewer people buying houses, developers are refraining from new investment. New floor space construction fell 12 percent year-on-year in September and is down 10.3 percent year-on-year for the first nine months of the year. Total real estate investment increased by just 8.6 percent year-on-year in September, the slowest growth rate since December 2009, when China was emerging from the global recession.

The major concern here is that new construction starts have historically lagged sales by five to six months as developers wait for funds to come in before reinvesting. Therefore, the continued decline in nationwide housing sales suggests that investment will slow further in the fourth quarter.

Offsetting this slowdown in the third quarter was the surprising strength of exports. Net exports accounted for 10.2 percent of GDP growth in Q3, their largest share since the quarterly data series began in 2009 if you exclude Q1 2013, when China's trade data was artificially inflated due to significant overstatement of exports to Hong Kong.

Looking forward, it is difficult to predict where exports will go. On the upside, the US economy continues to strengthen. Exports to the US rose 11.5 percent in Q3, reporting double-digit growth for three consecutive months for the first time since the end of 2012 and early 2013. On the downside, the European economy is slowing, a fact yet to show up in China's export data but which could appear in the future. Exports to the European Union rose 14.8 percent year-on-year in Q3 and have been firmly in double digits since April.

A further negative for China's exports is the strong renminbi. Since June, the renminbi has gained more than 2 percent against the dollar. At the same time, the dollar has also been very strong, rising by nearly 7 percent against a basket of global currencies since the end of June. This has pushed the renminbi close to a five-year high against the euro and to highs against the yen that have not been seen since the 1990s.

While there are certainly pressures that could bring down export growth, China has a major tool at its disposal to offset this - the ability to depreciate the renminbi. While it is unlikely to do this ahead of the Asia-Pacific Economic Cooperation forum as it normally likes to maintain a certain degree of appreciation before meetings with the United States to head off criticism, the depreciation of more than 3 percent against the dollar from February through April shows that the possibility cannot be ruled out.

Despite this, the fact remains that China's property market should continue to drag on growth, even if exports remain strong. This then gets us to question 2: What do we think about the 7.2 percent GDP target?

On the face of it, China can just expand its stimulus to support the property sector. Many measures have already been taken this year, including the removal of purchase restrictions in most cities, adjustments to how mortgages are classified to lower down-payment ratios and significant monetary easing, including central bank loans of 800 billion yuan ($130 billion, 103 billion euros) in the past two months. However, major easing conflicts with the current reform direction and certain factors underpinning the 7.2 percent GDP floor.

Previously, Li said that 7.2 percent GDP growth was needed to ensure full employment. Yet the spokesman for the National Bureau of Statistics recently said that China has created over 10 million new jobs in the first nine months of the year, already surpassing the annual target. It puts China on pace to create around 13.5 million jobs this year, higher than last year's total.

Such a positive result for employment, the key indicator monitored by the government, should give policymakers comfort in the reform direction and pause on the prospect of future stimulus.

The author is head of the Beijing research office of London-based investment bank NSBO.