Proxy indicators for industrial activity such as coal consumption in the major industrial regions have been weak, persuading some observers to believe that growth is actually slowing by even more than the official data shows
As we start thinking about economic prospects for the coming year, it is useful to identify the principal forces that will shape the outlook. It is clear to us that the Chinese economy will be one of the most important of such forces. Certainly, there have been growing concerns about China and these have weighed heavily on financial markets. Our view is that the downside risks have clearly grown:
• First, economic activity has slowed, possibly even more than official data has recorded. The main reason for deceleration seems to be related to domestic factors such as internal imbalances and the loss in confidence among private firms.
• Second, we expect aggressive policy measures to be stepped up, which should support economic growth at around 6% next year. However, the effectiveness of policy tools has weakened while policy interventions could also cause some collateral damage.
Consequently, our main concern about China and its impact on the rest of Asia is not so much a sharply lower pace of economic growth; rather, what we worry about are the unintended consequences stemming from policy actions.
Major headwinds to growth
As we look under the hood of the Chinese economy, a few important dimensions of the slowdown become clearer:
• Investment, which comprises about 40% of the entire economy, has shown a persistent trend of slowing. Indeed, fixed asset investment is now growing at its slowest-ever pace since records began, at 5.3% y-o-y on a year-to-date basis in August, before recovering slightly to 5.4% in September and 5.7% in October.
• The hope has been that consumer spending would take up the slack in investment growth. Yet, strong economic growth and rising household incomes have not translated into strong spending growth by households. In real terms, retail sales are now growing at the slowest pace since data has been available.
• The remaining driver of growth is external demand. But exports held up quite well in recent months despite US tariffs because exports were front-loaded by producers keen to get as much of their goods into the US market before the tariff hikes actually took effect. We expect export vigour to fade soon, taking away one source of growth.
The most recent purchasing manager indices (PMIs) reinforce concerns of slowing growth. The official PMI for the manufacturing sector fell to 50 in November, which means that this key sector was stagnant in November and was at its weakest point since July 2016. The non-manufacturing PMI is in better shape but has also been falling in recent months. Interestingly, proxy indicators for industrial activity such as coal consumption in the major industrial regions have been weak, persuading some observers to believe that growth is actually slowing by even more than the official data shows.
The slowdown in the economy appears to stem from several causes:
First, households are burdened by hefty debt levels. Again, the official data may not have captured the full extent of household borrowing as it may not have captured lending by shadow banks or other sources of informal credit. We suspect that a portion of this borrowing was used for speculation in asset markets, including property, equities and associated wealth management products — which have declined in value — hurting households’ balance sheets and making them more cautious about spending.
Second, investment has slowed as a result of the curbs on lending by shadow banks, which have hit private-sector firms hard as they do not get much credit from state-owned banks that dominate the formal financial sector. However, what is more worrying is the deepening loss of confidence in the private sector, which is troubled by fears that political leaders prefer to see the economy led by state enterprises and distrust private firms that grow too large. The strategy of industrial capacity rationalisation in sectors such as steel and aluminium also produced unintended ill-effects. Many in the private sector feel that the strategy benefited state enterprises that were the predominant producers of these commodities but hurt private-sector manufacturers that used such inputs. There is a growing perception that it is too risky for a private business to grow too large, lest it comes under the notice of a Communist Party leadership that is suspicious of alternative power centres emerging, such as private business lobbies. Finally, our view is that production relocation out of China is accelerating as a result of the trade frictions with the US — this will be yet another drag on private investment.
Third, we also feel that China “borrowed” growth from the future by turbocharging investment growth, especially in infrastructure development. The effect was to telescope what could have been produced over 20 years into an intense 8-to-10-year period. Now, the economy needs time to digest all this massive capacity creation before investment can regain momentum.
Turning to external demand, here, too, there are growing challenges to economic growth. The summit meeting between Chinese President Xi Jinping and US President Donald Trump seemed to have produced a ceasefire rather than a real resolution of their various disputes. We see US pressure on China continuing to exert a drag on China’s growth prospects in the next couple of years:
• First, the agreement between Xi and Trump was vague and devoid of much detail, allowing each side to claim victory and offer contradictory views on what was achieved. One example was in how Trump claimed that China had agreed to eliminate tariffs on US-made cars exported
to China, something that the Chinese did not mention in their statements. In fact, with China appearing to give concessions to the US, Trump may feel that his pressure tactics have worked and that China can be squeezed even harder. There will be a lot more frictions in trade before the two powers agree on how to resolve their trade disputes.
• Second, the differences between the two big powers go beyond trade — the US and China are now engaged in a grand geo-strategic tussle. There are hawks in the Trump administration who want to contain China’s growing industrial and defence might by curtailing technology exports to it and pressing it to give up its ambitious industrial policies to gain pre-eminence in key technologies of the future, such as artificial intelligence. Even if the argument between the two on tariffs is settled, there will be other disputes that could lead to more US pressures on China.
Policy action likely to speed up the economy, but how effective will policy action be?
China retains the capacity for substantial policy interventions to help the economy regain momentum. A slew of tax cuts, lower
reserve requirements and targeted relief measures are already in place to boost consumption and investment, and help the export sector overcome the US’ trade tariffs. The central bank is also stepping up liquidity injections to boost credit growth while encouraging banks to roll over short-term debt to support borrowing by corporates and local governments. Banks have also been given more incentives to buy local government infrastructure bonds, which will be used to raise infrastructure investments.
There is little doubt in our minds that even more stimulus will be rolled out in coming months. Thus, economic growth in 2019 will not be much slower than in 2018. The question is how effective policy action will be and whether these policies could cause some ill-effects in the longer term. This is where we have some concerns:
• First, China today is a vastly more complex economy than a decade ago, with more than half of it now powered by a range of services that were not prominent before. Yet, policymakers continue to wield the same blunt instruments from a previous era. As a result, policymaking has increasingly been overshooting — as seen in the case of the capacity rationalisation mentioned above.
• Second, the harsh and unrelenting manner in which the anti-corruption crusade was carried out has made local officials scared to approve projects and award contracts because they fear taking responsibility for projects that go wrong later. This gridlock within the bureaucracy has meant that central government policies to boost local government spending have not translated into actual spending on the ground.
• Third, while the central authorities will eventually succeed in getting local government investment programmes off the ground, they may be less successful in boosting private investment. Realising the loss of private-sector confidence, Xi and a whole array of top officials have come out to reassure private entrepreneurs. But the private sector is rife with wariness of the state.
• Fourth, in China’s more complex economy, there are more difficult policy trade-offs than before. One example is the conflict between promoting stability through reforms and spurring growth via more stimuli — easy money would reverse the government’s efforts to contain financial risks by reducing the level of debt in the system. This is seen in statements by The People’s Bank of China, which simultaneously espoused “neutral, moderately tight and moderately loose” monetary policy as it attempted to strike “a comprehensive balance within these multiple objectives”. Conflicting policy objectives have led to unintended consequences and high costs as the government attempts to keep too many policy balls up in the air.
• Fifth, the challenge to policy is also seen in how China’s weaker current account balance constrains monetary policy:
Easier monetary policy to support growth could raise import growth and worsen the current account, which turned into deficit for the first time in decades this year. When China ran massive external surpluses, it had much greater room for policy manoeuvre; now, it has to keep a wary eye on the current account balance since that could inflame concerns about the renminbi and precipitate capital flight. In effect, the current account is no longer able to act as a shock absorber.
The bottom line: Policy response may not be enough to prevent more trouble
Over the past couple of decades, China has consistently confounded the pessimists who expected its economy to crash for one reason or other. In all these cases, the pessimists were often right in identifying the problems, but where they went wrong was in underestimating how effective the policy responses were. Thus, stresses were episodic and did not spiral into outright crises.
Today, the state’s capacity for action remains in place — the policymakers are among the best in the world, they are backed by strong and credible institutions such as the central bank and the central government has massive financial resources as well as control over all the major banks and many of the largest companies.
What has changed, however, is the ability to actually mobilise this bureaucratic capacity and incentivise other key players such as local government officials and private businessmen to do what is necessary to make policy effective. Moreover, policy measures today can cause much more collateral damage than before — be it more excessive debt, a weaker current account deficit or a weaker currency.
In short, China’s economy will continue growing at a decent enough pace but other problems could still mean that it could exert
a drag on Asian economies and financial markets going forward.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy