When It Comes to Growth, In China We Trust
Since the beginning of the trade dispute, concerns over a sharp slowdown in China have been making headlines again. Should we be worried?

The answer is ‘yes’ but with qualifications. While we do not expect the trade dispute to cause a hard landing in China, the country’s sheer size keeps us highly attuned to anything that goes on there. After all, China contributes around one-third of global economic growth, and its linkages to the rest of the world are highly consequential for both manufacturing tigers and the commodity exporters in the emerging market (EM) world.  

The slowdown we have seen so far in China is mostly a self-inflicted one, and it is not dramatic. There is always a degree of uncertainty about the level of official growth numbers but, leaving aside the unknowable, China’s growth has been on a broad, gradually declining trend since the global financial crisis (GFC), and the latest figure for 2018 confirms that this trend is intact.  What has been changing since March 2018 is the direction from tightening to easing of what I call the Chinese “policy tanker” as policy shifts work their way through the system, slowly. As easing takes hold, we expect growth in China to stabilize by the second half of 2019 and provide a cushion for EMs globally.  

A Brief History of the Slowdown

The credit high. China allowed excessive leverage to build up in the corporate and non-bank financial sectors with its post-GFC stimulus. They followed the same playbook to a lesser degree in 2013 and 2015. When one adds to this combination the recent build up in household debt,  all balance sheets in China (perhaps with the exception of the central government balance sheet) start looking stretched (Exhibit 1). At the macroeconomic level, high levels of leverage translate to a high reliance on credit for any incremental growth, and this is clearly not sustainable.

Exhibit 1: An Unsustainable Rise in Debt

The hangover. The Chinese government put the brakes on these excesses through a series of policies such as its anti-corruption campaign, pressure on local governments to deleverage, closer scrutiny of infrastructure projects, tighter property sector policies and, more recently, tighter regulations on shadow banking. The government’s new motto became “quality of growth” rather than “quantity of growth.”

These policies helped arrest the fast increase in leverage and contain off-balance sheet fiscal risks, but they also slowed fixed investment growth, especially in the infrastructure and property sectors (Exhibit 2). The private sector was hit hardest as new lending growth slowed from about 20% in 2015 to 7% in 2017 because the state-owned banks that dominate the financial sector usually prefer lending to government-backed state-owned enterprises (SOEs). The message from Beijing emphasizing Communist Party control at all levels of life certainly did not help the animal spirits of the Chinese private sector either. Against this backdrop, the uncertainty surrounding the U.S.-China trade dispute is just another addition to a long list of domestic concerns.

Exhibit 2: Fixed Investment Growth Has Slowed

The Tanker Is Turning

In China, where feedback mechanisms are stunted because price signals are not fully market-determined, the policy tanker tends to turn slowly. Since the first quarter of 2018, the Chinese government has taken several steps to stabilize growth, but we don’t think the tanker is making a 180-degree turn: An anti-corruption agenda, a political dislike of speculative housing investment, and tight financial regulations to control excessive leverage are here to stay, but they are not likely to get any tighter anytime soon. So what is changing?  

Drip Therapy Will Keep China’s Growth on Target

First, monetary and credit policies are easing. You haven’t heard about any interest rate cuts from the People’s Bank of China (PBOC) lately, but stealth easing has occurred through several other venues. First, PBOC stopped following the Fed hikes in March 2018; since then, it cut the reserve requirement ratio by a cumulative 350 basis points (bps), and introduced a new targeted medium- to long-term lending facility to funnel lower cost credit to the private sector. Add to this the high-level moral suasion in the form of publicized official visits to banks to encourage lending to the private sector, and markets took note. The short-term money market rates declined by about 140 bps since March 2018.

Is this enough monetary easing? We think not. Clearly, none of this easing so far is comparable in magnitude with the stimulus blitzes we saw in 2009 or 2015. Credit impulse (the change in new credit issued as a percent of GDP) is still in negative territory, but it has started recovering and we expect it to turn positive in the second quarter.

We expect more reserve requirement ratio cuts and more active liquidity policies from PBOC. China accumulated massive foreign currency reserves until 2014 as a counterpart to its large current account (CA) surpluses under a tightly controlled exchange rate and capital account regime. In this environment, high reserve requirements imposed by the PBOC on banks act as dam to block part of this liquidity from overflowing into the real economy.  Now, with declining CA surpluses, further reductions in the reserve requirement ratios in 2019 and beyond are needed just to make up for the ebbing tide.

We should also see more active credit policies to direct credit where the government thinks it should go. This may not be the most efficient way to conduct monetary policy. The little bang for the buck in terms of the economic growth that China got for the excessive credit growth it generated in the past is a good reminder of this inefficiency (Exhibit 3). We assume China has learned this lesson, and that’s why we don’t expect credit impulse to reach double digits again. Hence, short of a reliance on a key policy interest rate and a well-functioning market mechanism that can properly price risk for its transmission to the real economy, PBOC will be left to doing the heavy lifting through additional micro-management of it various quantitative and regulatory tools.

Exhibit 3: Little Bang for the Buck

Fiscal policy is looser too. There is also a very long list of tax measures since 2018 that target both households and corporations. The most important ones were a cut in VAT rates, a reduction in personal income taxes that targeted middle-income households, and import tariff cuts. These are estimated to add up to about 1.5% of GDP in the second half of 2018 and 2019.  

Will they be enough? Fiscal multipliers are tricky numbers to predict in any country, especially with a population used to saving excessively due to lack of an adequate safety net. Nonetheless, we are betting especially on the younger urban middle classes to spend a lot of their tax cuts. After all, consumption accounts for more than half of GDP and the new generation of Chinese have lived in more prosperous times than their parents, developing a taste for cars, travel, and urban services.  However, with broader concerns about trade relations and increasing soft survey evidence that global supply chains have started to adjust, the private corporates are not likely to go on an investment spree, even if they aren’t concerned about the expanding role of the Communist party in the economy.  Overall, the estimated GDP impact of these policies is around 0.4% to 0.5%, a sizable cushion.

Can the government engineer a much bigger tax cut? We think at most cuts amounting to another 1% to 1.5 % of GDP are possible because, at 9.15%, China’s tax revenue-to-GDP ratio is already low compared to other countries.1 Furthermore, the central government balance sheet, along with SOEs, underwrites the economic strength of the Communist Party, something that the leadership will not want to risk. Should growth not stabilize by March, we think it’s more likely that China will seek to boost consumption through the quick and dirty method of providing temporary incentives for car buying and upgrading to new cell phones before a bigger round of tax cuts later in the year.

So what else is left? We think China will emphasize infrastructure again, returning to an old and tested tool of government spending.  The government has already increased the special bond quotas for infrastructure development projects and expedited the timeline to issue them. Spending should follow once spring arrives and construction can begin. There is likely to be a further increase in infrastructure-related borrowing in 2019. Although one could debate whether China needs more infrastructure, its ambitions to become a developed economy and its ongoing urbanization suggest that the Chinese authorities will not find it difficult to find useful places to pour more concrete.  The master plans to connect the northeast and southern economic centers are a good example of this. Moreover, upgrading the country’s environmental management and building out its 5G network and internet-of-things capabilities provide ample venues for investment.

Will housing policies be eased? So far we have not seen conclusive signs that there is an appetite for it. The success in reducing excess inventory in Tier 2 and Tier 3 cities, the ongoing urbanization, and the structural demand for upgrading housing quality may be giving the authorities comfort for now that property investment, though much slower already, will not decline further. However, should these expectations disappoint, we expect to see shantytown redevelopment projects as a first course of action before a much broader easing of housing policies.

Addressing the elephant in the room: the trade dispute. Our baseline expectation calls for an agreement that will extend the current lull in tariff wars along with more Chinese imports from the United States. We don’t view a reduction in tariffs as highly likely at this stage before the two countries establish an understanding about how to deal with structural issues such as technology transfer requirements, Chinese government subsidies to SOEs, and intellectual property protection. These are thorny issues to put in an agreement in 90 days. The Chinese government has already signaled significant progress in several of these areas, but it would be naïve to think that these promises would be enough to secure a comprehensive deal. If “a deal” is indeed what the U.S. administration desires at this stage, agreeing on a framework to make progress on these structural issues could be the best outcome. After all, the strategic competition between the United States and China is not just about the bilateral trade deficit, and will be the defining theme of the rest of this century.

Until a new framework that addresses China’s gigantic role in the world as a non-market economy sees the light of day, we expect the drip therapy to continue. Not too much, not too little. Just enough to deliver the growth targets promised by the Communist Party by 2020. That is the China in which we trust.

  1. ^Source: IMF Government Finance Statistics, as of 2016.