How is China positioned for growth in 2014? There are reasons to be optimistic, and reasons to be cautious. Household consumption, exports and the bottoming out of the industrial cycle will be positive drivers. Drags on growth include tighter monetary policy, a slower property market, a cash crunch in local government infrastructure space, and a mild rise in inflationary pressures.

The dividends from economic reforms will likely only appear during 2015-16, though if administrative reform and the opening up of services to the private sector can be front-loaded, there is a chance of a small growth windfall in the second half of 2014. In sum, we think real GDP growth is likely to slow a little in 2014, to 7.4 percent from 7.6 percent in 2013, with momentum slowing moderately throughout the year. We think the official growth target will come in near this level too.

Counting the positives

At least three developments in recent months should support economic growth in 2014.

First, household income growth has stabilized. Urban households’ disposable income rose 7.2 percent year-on-year in real terms in the third quarter, after growth slowed to 6.4 percent in the second quarter. This appears to have already led to a mild pick-up in urban household consumption, which grew by 5.6 percent year-on-year in the third quarter, up from 4.6 percent in the second quarter. Real growth in rural households’ cash income also accelerated, to 10.2 percent in the third quarter from 8.9 percent prior. The pace of income growth is now lower and consistent with overall growth. This, plus a robust labor market, indicates that household income growth is entering 2014 with reasonable momentum.

Second is better external demand on the back of a continued global recovery. We are global bulls for 2014. US growth is likely to improve to 2.4 percent (from 1.7 percent in 2013), and Europe’s to 1.3 percent (from -0.3 percent). Despite tapering beginning in the second quarter, we think the Federal Reserve will keep rates at zero until early 2016. The European Central Bank will also conduct a zero interest rate policy for several more years. China’s exports to the EU and US have already picked up, and our colleagues in Europe believe they should grow faster in 2014. Moreover, our leading indicator, a weighted average of manufacturing PMIs in China’s key export markets, suggests this positive momentum is likely to continue into 2014.

Third, the industrial cycle has bottomed. Better consumption and external demand have helped China’s industrial cycle turn. Industrial production growth picked up to 10 percent year-on-year in November after bottoming out at 9 percent in the second quarter. If one thinks the electricity production data provides a more accurate picture of activity, the rebound was stronger. Our forward-looking indicators — producers’ confidence and the inventory cycle — are still rising. This suggests to us that the industrial recovery is likely to continue into the first half of 2014.

Now we turn to the list of negatives for 2014.

First, we face slowing credit growth. There is no doubt that some senior policymakers are seriously concerned about the rapid debt build-up over the past five years. The total debt level, as of end-2012, was about 215 percent of GDP, by our calculation, up by a significant 65 percentage points since 2008.

And now the negatives

Of most concern is corporate leverage in the heavy industrial sector and local government debt. Although the absolute leverage levels are manageable, we believe, the speed of increase and apparent lack of growth dividend have made policymakers cautious about allowing leverage to rise more.

Indeed, even when slower growth became a concern in the second quarter of 2013, the response was targeted at several specific sectors, and did not involve reaccelerating credit growth. Then, shortly after growth had stabilized, in the fourth quarter the People’s Bank of China (PBoC) was let off the leash again and began quietly tightening monetary policy. The result has been that interbank/bond market rates have risen toward benchmark loan rates. This has an immediate impact on firms reliant upon discounting bankers’ accepted drafts for financing. Over time, as they face higher funding costs, many banks will likely have to increase standard loan rates, pushing out marginal borrowers and delaying some corporate investment. This will compound the trend of decelerating total social financing growth.

Second, there is slower fixed asset investment growth, particularly in the infrastructure space. Despite our reservations about the overwhelming dominance of investment in China’s economy, it is still the major growth driver. The outlook for investment growth in 2014 is mixed. We believe there is good reason to expect a slower pace in the infrastructure space, as external financing for local government platforms is squeezed, again.

The Ministry of Finance will, we hope, roll out its local debt management framework in 2014, which will throw considerable grit into the wheels of leveraged cities and counties.

Last, housing market faces more difficulties in 2014. We are not negative on China’s housing sector in 2014 — it will do fine. But after the clear turnaround year of 2013, we expect a more mundane 2014. Property investment growth has slowed since the second half of 2012. Developers seem confident of a continued recovery — growth in floor-space starts looks especially solid. But sales growth has slowed since the peak.

There appear be still significant risks in China’s smaller cities — which make up some 80 percent of the national market. The data we do have still looks solid, but there are hints of weakness. First, land-sales growth in hundreds of smaller cities slowed in the third quarter. The average floor space of available-for-sale apartments in 13 small cities for which we have numbers remains high — meaning another year of stress for local developers. Developers in the lower-tier cities will also likely experience tougher financing conditions in 2014, as trust companies and other shadow banks concentrate their funds in the higher-tier cities. Our baseline scenario is that a large majority of small cities will struggle through, prices will remain flat and developers will gradually sell their stocks. The national housing-starts numbers, however, suggest that nationally the construction market will be relatively healthy.

What about inflation?

Overall, we are not concerned about inflation in 2014, either in China or globally. With 3.5 percent growth, the world economy will still be running below potential, unemployment remains a drag in many economies, and it is hard to see commodity prices shocking. That said, food inflation has been picking up in China, and we expect it to rise further in the first half of 2014. We will see some strong base effects take effect during the first half, thanks to the outbreak of H7-N9 bird flu in the first half of 2013. Pork prices fell by 8 percent in the first half of 2013, chicken prices by 6 percent. Those prices have since recovered, but the year-on-year CPI rates will be affected in the first half. Accelerating food inflation should push CPI moderately higher in 2014. This will help the central bank continue with its tighter monetary policy and deleveraging agenda.

Conclusion

Demand drivers are finely balanced, we believe, for 2014. Slower credit growth, however, is key and will, in our view, ultimately drag on 2014 growth momentum. So far, policymakers appear content with the growth outlook. But if we are right about slowing momentum, by the summer the slower macro numbers should induce a mild loosening of monetary policy. As was the case in the second half of 2013, this loosening will occur via lower interbank rates, rather than cuts in benchmark interest rates. Some analysts will inevitably write this policy shift off as ripping up the reform agenda and pump-priming, as they did in the summer of 2013, but we expect they will be wrong again. Reform needs a certain level of growth to ease its implementation. The dividends from structural reforms will likely not show up quickly enough to impact 2014’s growth.

China still has not released an official growth target for 2014, though we expect a figure of 7.5 percent. The central government has sent a reassuring message to the provinces: “Yes, we want to implement deep, often painful, structural reform, but we also recognize the need to maintain a healthy pace of growth, so do not panic.” We are entering a year in which deleveraging will be a big theme.