China 2019 outlook
China: walking a tightrope
- The changing impact of the Sino-US trade war – from a market shock to a growth shock – is set to create strong headwinds for the Chinese economy in 2019
- Beijing is under pressure to steer policy towards growth preservation, but its desire not to reverse structural reforms will limit the vigour of stimulus
- Without a full policy offset, economic growth is expected to slow to 6.1% in 2019 and 2020, with waning inflation
- The changing macro environment will force Beijing to accelerate reforms on multiple fronts
A rocky path turns rockier in 2019
2018 has been a challenging year for the Chinese economy and financial markets. What got off to a positive start, following the strong momentum of 2017, quickly gave way to a rapid deterioration in economic fundamentals and investor sentiment. A sudden turn for the worse in Sino-US trade relations dealt a heavy blow to Chinese equities and currency. Domestic policies, particularly those centred on deleveraging and shadow-bank controls, also contributed to the negative sentiment by pulling down domestic demand. While macro policies have now been adjusted, we think these changes will be inadequate to reverse the negative growth trend. We expect the economy to end 2018 at 6.6%, the lowest rate of growth since the global financial crisis.
Turning to 2019, the Year of the Pig will unlikely get any easier. Externally, the Sino-US trade war has not yet impacted the real economy, as exports have been front-loaded ahead of the tariff implementations. However, these “pre-emptive” purchases will not last forever and we expect the real shock of the trade conflict to hit home from early 2019. Besides the growth impact, the trade war will also accelerate the turning of China’s current account balance, from surplus to deficit, with important implications for both China and the world.
China’s domestic conditions will, as usual, be buffeted by the ebb and flow of official policies. Beijing’s supply-side reforms (2015-2016) and deleveraging (2017-2018) have perpetuated profound changes in the macro landscape over the past few years. The macro environment has now changed again and will require Beijing to steer its policy towards striking a better balance between growth stability and risk management. However, the desire not to reverse reform progress will limit Beijing’s ability to stimulate the economy as quickly and aggressively as in previous easing cycles. Without a full policy offset, we expect the economy to slow further to 6.1% in 2019 and 2020. By our calculations, this should be sufficient to achieve the official target of doubling 2010 GDP by 2020, making the slowdown less susceptible to political objections (Exhibit 1).
Source: CEIC and AXA IM R&IS calculations – As of 20 November 2018
Real impact of trade war to hit home
Delving into the details, 2018 has been an eventful year for China’s external environment. The lack of follow-up actions in 2017 from Trump’s anti-trade election promises had led to a popular belief that the “business-minded” President was more interested in doing deals than engaging in confrontations. However, such a sanguine view was proven wrong by the events of 2018, with trade sanctions, tariffs, and plenty of protectionist threats propagating major shocks across the global markets.
Compared to other countries, China commands a unique position in Trump’s protectionist plot. Despite tentative deals with traditional allies, Trump has maintained pressure on China by repeatedly threatening to put all Chinese products under punitive tariffs. On the surface, the protectionist measures implemented so far are justified as necessary moves to punish China for its “unfair” trade practices and restore the bilateral trade balance. However, the on-going escalation of tensions – in trade, but also other areas – suggests that a deeper malaise has set in, one that has shaken the very foundation of US-China relations and which cannot be easily repaired under the current political setup. This underscores our view that the trade conflict is likely to get worse before it gets better, and there are risks that the competitive landscape between the world’s two largest powers could spread to other fields in the coming years.
Given the likely protracted nature of the trade conflict, China needs to be prepared for its consequences. In our base case of a 25% tariff on $250bn of goods, China’s GDP growth will be lower by around 0.9ppt after accounting for the direct and indirect impacts (Exhibit 2). Combined with slower global demand, the ongoing trade tension will create a tough environment for Chinese exports, which we expect growth to grind to a halt in 2019 after a solid year in 2018.
Source: AXA IM R&IS calculations – As of 20 November 2018
The adverse impact of the trade war will also be felt in China’s current account (CA), which registered its first quarterly deficit in nearly twenty years in Q1-2018. Barring any surprises, we expect the CA to record its first annual deficit since 1994 next year (Exhibit 3). While the timing is clearly exacerbated by the trade war, the overall evolution of the CA is a result of China’s own domestic factors, such as the rebalancing towards consumption-driven growth. We think this structural shift in China’s current account will have important implications for the world:
- First, the erosion of CA surplus means that China will no longer export capital to the rest of the world, dampening its demand for global assets, such as US treasuries.
- Second, as the CA turns to deficit, China will have to borrow from offshore to finance its domestic investment and debt. This will put pressure on domestic interest rates and subject China to volatile global capital flows.
- Finally, the disappearance of the CA surplus will remove a structural support for the RMB, creating more volatility for the exchange rate.
The above developments will in turn have policy implications for Beijing. The need to import foreign capital will require the authorities to further liberalise and open up their domestic markets to attract global savings. In addition, China needs to manage its leverage problem carefully and expedite reforms to keep investors’ faith in its assets. Finally, the RMB exchange rate needs to become more flexible if it is to act as an effective buffer for the economy by adjusting for export competitiveness. In short, the turning of China’s CA could represent an important catalyst for Beijing to accelerate reforms on multiple fronts over the coming years.
Source: CEIC and AXA IM R&IS calculations – As of 20 November 2018
Domestic policy requires a delicate balance
These growth external challenges will spill over to the domestic economy, and in turn, affect overall GDP growth (Exhibit 2). But the bigger impact, in our view, lies in the official policy adjustments needed to partially offset the effects of the Sino-US trade war.
Seasoned China observers will know the importance of official policies, not headline GDP, in driving the Chinese markets. One only needs to go back to 2015-16 to see the drastic changes prompted by Beijing’s supply-side reforms on the PPI and corporate profitability, which sowed the seeds of a massive equity rally in 2017. The recent policy shift towards deleveraging also generated profound changes in the financial system by forcing banks to cut their shadow-banking exposure and normalise off-balance-sheet activities. Together with a successful reflation in the economy, the deleveraging campaign helped to halt the rising trend in China’s debt ratio last year, at 256% of GDP.
We expect a further shift in China’s official policies in 2019. The worsening macro environment has closed the door on Beijing’s singular approach to reform that takes little account of short-term impacts. Instead, a more balanced policy mix that preserves both short-term growth and long-term structural progress is needed in the new environment.
Making stimulus more sustainable
Recent developments suggest that such a policy shift is already underway. To counteract rising growth pressure, Beijing has started to relax controls on local government debt, public-private-partnership (PPP) projects, and non-bank credit intermediation. In addition, the PBoC has cut the RRR three times to boost domestic liquidity and the government has lowered tax burdens for households and small businesses.
Notwithstanding the pro-growth policy shift, there are important differences between the current stimulus and past ones. To start with, China has less room to implement large-scale monetary stimulus, given the risk of exacerbating structural imbalances. The tepid liquidity injection and the lack of a significant easing of shadow-banking controls suggest that the authorities are wary of the pitfalls of such tools and are using them with caution.
Instead, fiscal stimulus is implemented with more prominence. Besides its lower risk of side-effects, fiscal policy can also be deployed more selectively, allowing Beijing to target specific sectors of the economy. The latter has enabled the authorities to direct policy supports to the household sector and private-owned enterprises (POEs) via tax cuts, subsidies and deregulation. For the former, the recent personal tax cuts could unleash up to RMB500bn worth of tax savings, or 0.6% of GDP, helping to support consumption growth and further the economic rebalancing in 2019.
The POEs have also received value-added tax reductions, along with other rebates and subsidies, with senior officials vowing more stimulus to come. By making the POEs the centre of policy supports, Beijing can achieve two objectives. First, the POEs, on aggregate, are less indebted, but more productive and profitable than their state-owned counterparts (SOEs). This will give the government more bang for the buck for its stimulus. But more importantly, by pledging “unwavering” support to the POEs, Beijing is reasserting the importance of private businesses in China’s economic development. Should these be followed by tangible actions that lead to a reallocation of resources to the private sector, away from the state sector, the net impact will be similar to a SOE reform.
But a “constrained” policy easing has costs
Compared to households and POEs, we expect Beijing to be more cautious with policy easing for the housing market and infrastructure investment. Even though some unwinding of the local government debt control should spur renewed growth in infrastructure investment, the scale of the recovery will be shallower than during past stimulus. We also do not expect a wholesale reversal in housing market policy any time soon. Even though some scaling back of the recent tightening is possible beyond Q1, we still expect the property sector to be a drag on economic growth in 2019.
In short, we think the mix of “proactive” fiscal policy and “prudent” monetary policy will remain intact. The former will lead to a rise in the fiscal deficit to 3%, from 2.5% this year, with the expansion potentially amplified by local governments’ off-budget operations. The PBoC will also cut the RRR three to four times to supplement fiscal operations and maintain liquidity as other central-bank lending facilities, such as the Medium-Term Lending Facility (MLF), run off.
Overall, Beijing’s attempt to strike a balance between short-term growth and long-term sustainability is laudable. But this “cautious” policy easing will come at the cost of a less vigorous economic response. We think the accumulative stimulus – even with more to come in 2019 – will not be enough to prevent a further growth slowdown to 6.1% in 2019 (Exhibit 4). This growth backdrop will, in turn, put downward pressure on domestic inflation, which we expect to moderate to 2%, from 2.3% this year.
Source: AXA IM R&IS calculations – As of 20 November 2018
Risks lie in policy uncertainties
The biggest risks to our baseline outlook lie with the policy uncertainties from both Washington and Beijing. The former, particularly with regard to trade policies, has proven extremely difficult to predict, and we do not expect the clarity in Trump’s decision-making to improve in 2019. In a situation of greater US-China conflicts, we expect a more aggressive policy response from Beijing to hold growth above 6%. In that environment, the PBoC will not be able to maintain a neutral policy stance, and may have to reverse deleveraging by relinquishing control of the shadow banking system. Beijing may also have to give up its curb on local government debt and the housing market to extract growth, even at the expense of economic sustainability. However, these aggressive moves to boost the economy may only extract a temporary positive response in the market, as investors quickly turn to long-run consequences of such stimulus.
On the flipside, a “cease fire” in the trade war would calm investor sentiment and alleviate pressure on the economy. The authorities, in that case, will not have to ease policy as aggressively, and may continue to deleverage the economy. This would be a positive scenario for the equity and currency markets, which appear to have already priced in significant disruptions of a protracted Sino-US trade conflict.
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