Recent developments in China

 

Warning signs are emerging in the Chinese economy: equity prices have fallen significantly from the start of the year; the yuan has devalued sharply against the USD over June and July (and has also fallen on a trade weighted basis); growth in industrial production and urban fixed asset investment (particularly infrastructure investment) has fallen notably in recent months and manufacturing PMIs have softened; real retail sales growth has weakened; and credit growth has slowed over the course of the year. What’s been driving the softening in these data?

Trade tensions between the US and China have escalated over recent months, and this has likely weighed on sentiment, particularly in equity markets. However, much of the slowing more likely reflects intentional and expected policy tightening as authorities seek to contain risks in the financial system. The first half of the year saw authorities continue with deleveraging efforts such as tighter regulation of financial products and local government financing, which had seen higher interest rates and defaults and slowing of credit growth (including local government borrowing). Has this changed our outlook for China?

Movements in equities and the currency have drawn parallels with 2015, when there was concern over the outlook for the Chinese economy. But underlying conditions are different this time: industrial profits are still growing (rather than falling in 2015); external demand was weaker and trade was falling in 2015, whereas both are now positive. In 2015 there were significant capital outflows, putting more pressure on the currency, whereas now there are few signs of a surge in capital outflows reigniting. The PBoC raised short-term interest rates by 5bps in December and March alongside Fed hikes to avoid too much pressure on the currency, while refraining from tightening too aggressively given the backdrop of tightening financial regulations and credit conditions and the benign inflationary environment. However, the PBoC refrained from tightening monetary conditions further after the US Fed’s June rate hike and have subsequently allowed the currency to depreciate.

In addition, Chinese authorities have shown a willingness to take steps to provide support. This has included increased fiscal stimulus and injections of liquidity and an easing of credit conditions (including softening financial regulations and RRR cuts, which have helped lower interbank interest rates). While these policy tweaks are aimed at supporting economic growth, they do not signify an intention by authorities to move away from their policies of deleveraging and containing financial risks, but rather a moderation in these policies given the escalating trade tensions, tighter credit conditions and evidence of slowing momentum in the real economy.

We continue to expect growth to average 6.6% in 2018, easing slightly to 6.3% in 2019. However, risks to the downside are rising and growth will depend on how trade issues evolve. We expect policy adjustments to support growth in the near term, with infrastructure investment likely to rebound in the second half of the year. Fiscal spending and local government special bond issuance are currently well below their targets, and have headroom to increase in H2. However, we don’t anticipate large-scale direct fiscal stimulus (a la 2008) in the absence of a more severe escalation in the US-China trade war. Over the medium term, momentum in the Chinese economy will continue to ease as authorities implement structural reforms, including debt deleveraging and the containment of credit growth (particularly in the shadow banking sector). The transition from investment and export driven growth to growth driven more by consumption and services is also likely to weigh on growth in the short term, but boost medium-term growth prospects.

While our baseline forecast remains for an orderly rebalancing in the Chinese economy, medium-term risks around corporate debt, financial stability and a trade war could delay structural reform efforts, complicating the deleveraging process and raising the risks of a hard-landing in the Chinese economy. In our view, the imposed US tariffs on aluminium and steel, and on $50b of imports from China (with China’s tit-for-tat response on $50b of imports from the US), is only expected to have a modest impact on Chinese growth (around -20bps), and shouldn’t disrupt China’s deleveraging process too much. However, our modelling suggests that the more recently proposed tariffs between the US and China could wipe off around 60bps from US and China GDP by the end of 2021. Further escalation, to tariffs on all trade between the two countries, would see an even greater impact. In our view, Chinese authorities would respond to the threat to economic growth, under a full-trade-tariff scenario, with further fiscal stimulus and an easing of credit conditions. The risk to China and, indeed, the global economy is that greater stimulus and faster credit creation (and hence debt accumulation) in the short term leads to greater financial risks and potentially a more severe adjustment down the track.

Table 1: Financial market movements, 2 - 9 August 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,853.6

0.9%

US

2.93%

-6.0 bps

US Dollar Index (DXY)

95.50

0.4%

Nikkei 225

22,598.4

0.4%

Japan

0.12%

-1.1 bps

USD-JPY

111.08

-0.5%

FTSE 100

7,741.8

2.2%

UK

1.30%

-8.1 bps

GBP-USD

1.282

-1.5%

DAX

12,676.1

1.0%

Germany

0.38%

-8.5 bps

EUR-USD

1.153

-0.5%

S&P/ASX 200

6,297.7

0.9%

Australia

2.66%

-7.3 bps

AUD-USD

0.737

0.2%

Source: Bloomberg

 

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