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While recent signs point to the Chinese economy and currency stabilizing in the near future, a major market think tank has warned that it may be too early to cheer as there are also indications that growth may slow down and the yuan to come under pressure yet again.
"Evidence of a sharp turnaround in growth and policymakers' success in preventing a destabilizing slide in the renminbi have underpinned a dramatic shift in sentiment toward China," Julian Evans-Pritchard and Mark Williams, analysts for the London-based Capital Economics, said in a recent research report.
The main driver of the turnaround in sentiment has been a stronger Chinese economy, with key indicators pointing to a sharp rise in power consumption, fixed asset investment, services sector activity, and trade growth for the first two months of the year.
According to Capital Economics' China Activity Proxy, the mainland economy is now growing at approximately 6.5 percent year on year, an increase from 4.8 percent at the start of last year.
Meanwhile, market worries about protectionism have subsided as U.S. President Donald Trump has softened his stance on China, Evans-Pritchard and Williams said, adding that concerns over the yuan's depreciation and capital outflows have also faded.
So far this year, the offshore Chinese yuan has risen 1.4 percent against the U.S. dollar. The onshore rate also went up 0.8 percent.
China's foreign exchange reserves rebounded earlier in February--the first time in eight months--at above $3 trillion, increasing by $6.9 billion during the month.
Even debt fears are slowly abating, with profit growth in China's industrial sector surging 32 percent in the first two months of this year to 1.91 trillion yuan.
"A jump in corporate profits has granted struggling borrowers a reprieve," the analysts said.
However, the report warns that this state of affairs will only be temporary.
Capital outflows are likely to pick up and the yuan could come under pressure once the U.S. dollar strengthens again. Trump may also adopt a harsher stance against China later in his term, both analysts said.
"Most important, the current strength of the Chinese economy is unlikely to last, even absent any external shock," they added.
The sharp rebound in China's economic activities has been attributed to a loosening of economic policies, but the growth is well above the sustainable rate.
"As cyclical spare capacity diminishes, growth will inevitably slow, a process that will be sped up by recent moves to tighten monetary and fiscal policy, and property market controls," Evans-Pritchard and Williams said, noting that, in the long run, China's outlook hinges on structural reforms.
"If policymakers move quickly to tackle the debt build-up and resulting resource misallocation by allowing state firms to go bust, then growth could feasibly stabilize at around 4 to 5 percent during the coming decade," they said.
The Capital Economics report notes that China's policymakers have the tools to prevent problems at individual banks from snowballing into a major crisis.
But as balance sheets deteriorate, managing financial risks may become more challenging.
"And even if a financial crisis is avoided, the continued misallocation of resources will result in a deeper economic slowdown, with growth as slow as 2 percent during the decade ahead," the report said.
