China: Cooling economy induces policymakers to fire up the stimulus engine (again)

The growth of China’s gross domestic product (GDP) continued to decline in the fourth quarter of 2018. Real GDP increased by 6.4 percent compared to the fourth quarter of 2017. In the third quarter the economy grew by 6.5 percent compared to 2017Q3. As a result, the annual figure for 2018 as a whole came in at 6.6%. This was exactly in line with our expectations. In 2017, the economy grew by 6.8%.

As in the previous three quarters, net trade once again contributed negatively to growth (Figure 1). Apart from this quarterly figure, the most recent monthly data already confirmed that the Chinese economy continues to cool down (Table 1). For example, retail sales and industrial production have been lower compared to 2018H1. And in December 2018 both exports and imports shrank in nominal USD terms. Exports partly declined on the back of a slowdown in world trade, but also due to less demand from the United States, probably because the frontloading effect vanished compared the preceding months as an anticipation of trade tensions. The decrease in imports is a clear signal of the cooling domestic demand.

Corresponding with weak figures from end 2018, sentiment has also become more negative, especially on the side of manufacturing. In December 2018 both the official Purchasing Managers' Index (PMI) and the Caixin manufacturing PMI fell below the so-called 'neutral level' of 50. A level below 50 usually indicates a contraction in the period thereafter. The services PMI index remained at the same level for the time being (Figure 2). Despite this negative sentiment, some recovery has been visible in Chinese financial markets over the past period. For example, the Chinese currency (CNY) strengthened against the US dollar (USD) and the Shanghai stock exchange recovered slightly since the beginning of 2019 (Figure 3). This is mainly related to positive signals about the trade tensions with the United States. We expect, however, that this positive sentiment will not be sustainable (see below).

On balance, we expect Chinese GDP growth to decline further this year compared to 2018. For 2019, we assume GDP growth of 6.3% before declining further to 5.8% in 2020. We expect that the challenges for Chinese policymakers will pile up further over time, which leads to a strong case for higher downward pressure on growth in 2020. For the time being, 2019 will again be a year of stimulus to prevent a significant slowdown or hard landing.

In March 2018 policymakers indicated that they would shift their focus to so-called quality of economic growth. As a result, more attention would be paid to reducing environmental pollution and income inequality, and restoring financial stability. Despite these announcements, we asked ourselves what would happen if the domestic growth slowdown would be faster than anticipated, for example due to increasing financial instability or a further escalation of trade tensions with the US. That turned out to be a valid question and the answer followed quickly in 2018Q3. Due to the rapidly cooling economy and the escalating trade war, stimulus measures were introduced again. It should however be noted that this set of stimulus measures is more limited compared to the large-scale packages that have been implemented regularly since 2008. Regardless of the size, the focus has also changed. Previous rounds were mainly focused on investments in the construction of factories, housing and infrastructure. This time there is more room for consumption.

On the monetary side, the Chinese central bank (PBoC) has reduced the reserve requirements for banks four times in 2018 and increased the liquidity in the financial system through targeted actions. During China's Economic Work Conference of December 2018, it became clear that these measures will be continued through 2019. In addition to the already announced and introduced monetary measures, more government investments and fiscal stimulus measures have been announced as well. For example, the requirements for bond issuance for local governments were reduced in order to facilitate investments in infrastructure. In addition, a broad tax reduction was announced for households and companies. This will reduce corporate tax, income tax and VAT with the aim of boosting investments and consumption. During the National People's Congress in March 2019, the expected economic goals of 2019 will be confirmed, but it is already clear that a further slowdown in economic growth is taken into account in combination with a higher deficit of the central government (Table 2). The question here is whether the combination of these measures will have the desired effect on the real economy.

Although these measures are understandable in terms of preventing a hard landing, the effect of this so far is still limited. For example, credit growth has not yet taken off despite all monetary measures (Figure 4). An important point of attention here is related to credit to the private sector. Many of the companies in this sector finance a lot of their investments through the so-called shadow banking sector. This is because they are less able to obtain credit through traditional bank channels. The contraction of activities in this shadow sector therefore puts a brake on the growth of lending to the private sector. Domestic cooling in general will additionally reduce the attractiveness of stepping up investments. As far as the tax measures are concerned, a higher real disposable income does not always have to lead to a direct real economic impact. After all, part of the tax benefit can also be used as precautionary savings.

Next to domestic uncertainty, we consider the tensions with the United States as the biggest external risk for the Chinese economy despite the current 90 days truce till the beginning of March.

Since the G20 meeting in Argentina on December 1, 2018 between Trump and Xi Jinping, there is a so-called trade war ceasefire of 90 days. Although there were some mixed signals at first due to different interpretations of the results after the meeting, new negotiations were started on 7 January. At the end of January, these will be continued on a higher diplomatic level. It should be noted that the US economy currently is performing much better than the Chinese economy. Exports still are a key contributor to Chinese GDP growth compared to the US. Based on that, the pressure to reach a deal for China seems to be higher than for the US. In December, we already saw that China's nominal exports to the US contracted for the first time since the start of the trade war (Figure 5). Our current baseline scenario for the bilateral trade war is that aside of the already introduced packages in 2018, the US will increase their 10 percent tariff to 25 percent on imports of 200 billion dollars from China. We expect China to respond to this by increasing the tariffs they have applied to imports from the US to 25% as well.

Although there is a real chance that the truce will be extended after 1 March to continue negotiations, we consider it very unlikely that this will ultimately lead to a fundamental breakthrough in the relationship between the two countries. This is because there is more to play than trade tensions alone. Positive voices are expected to be primarily concerned with Chinese commitments to buy more US agriculture, energy and industrial goods, some measures to expand market access for US companies, and modest announcements that signal willingness to take action with regard to the structural problems as identified by the US. The latter mainly concerns the forced transfer of technology, protection of intellectual property, non-tariff barriers, cyber theft and espionage. We consider it very unlikely that China will be able to meet the requirements of the US in this area in the short term. As a result, (trade) tensions are set to continue for a while.