China: Economy suffers from trade war, cooling global demand and higher uncertainty

• The trade war and overall uncertainty are harming confidence and real GDP growth.
• Fiscal stimuli, increased bank lending and larger RMB depreciation have somewhat limited economic damages so far.
• The deleveraging of the economy will remain a priority despite temporary softening.  
• Heavy yet rising domestic debt will constrain long-term growth.
• China’s ascent faces conflictual competition from the US and protests in Hong Kong.

China is striving to mitigate escalating external shocks

China has been going through turbulent and uncertain times since 2018, particularly when trade tensions led the US to raise import tariffs on a first range of Chinese imports. The current downward trend in real GDP growth is not new, as it began in 2011, and it is a necessary evolution to come out of a debt-driven growth. However, after a break in 2017, the slowdown resumed in 2018 and has accelerated this year. The deleveraging of the economy and tightened banking regulations (which seriously undermined the unregulated shadow banking system) were the major explanatory factors last year whereas the trade war and cooling global demand worsened the economic slowdown this year. When the US began increasing its tariffs, Beijing started to launch a broad but relatively modest expansionist policy through a mix of fiscal stimuli (income, VAT and corporate tax cuts or VAT rebates for exporters) and by urging the acceleration of several infrastructure projects. The US decision to raise import tariffs on all of its Chinese imports further harmed the Chinese economy and caused too fast a slowdown to be tolerated by the authorities. Real GDP growth is expected to go down from 6.6% in 2018 to 6.2% in 2019 and could cross the 6% threshold next year especially if the global economy weakens further. This is still a strong performance in absolute and relative values. But behind this figure, industrial production, private consumption (as highlighted by the drop in car sales) and exports have all been suffering from corporate deleveraging, the trade war and weakening global demand, which all negatively impact confidence.

Until now, all in all, the macroeconomic effect is still manageable not least because of the weak share of net exports driving GDP growth, while the rebalancing towards a higher-quality and service-led economy is moving forward. The overall impact has somewhat been cushioned so far thanks to a more accommodative government policy mix, which includes drawing more money into the banking system through multiple cuts in bank reserve requirements and, recently, through the short-term lending rate and higher bank loans, preferably to state-owned enterprises (SOEs), thanks to the recent rebound in shadow banking and thanks to the RMB depreciation against the USD. Last August, the RMB depreciated by 4%, i.e. the biggest monthly decline since its devaluation in August 2015 (see graph 2 below), which brought the total depreciation to 14% since March 2018.

That does not make China a ‘currency manipulator’, as the Central Bank attempts to stem the RMB depreciation arising from large capital outflows and as China’s current account balance is now flirting with deficit. Given the clouded economic outlook and the probable persistence of the trade war, depreciating pressures triggered by capital outflows might die hard. As history shows, if necessary, the Central Bank could introduce or strengthen capital controls and hinder the opening of China’s capital account for stability reasons. At the same time, Beijing has taken various measures to increase foreign capital inflows by relaxing foreign investment rules in financial, banking and insurance sectors. The investment framework has improved over the past year (e.g. the new FDI law) and is seen as a way to offset the trade war negative impact and ease tensions. More fundamentally, the increased financial liberalisation aims to attract more foreign portfolio investments and direct investments in order to allow the financing of China’s future current account deficit.

Amid the trade war, many Chinese companies have opted for trade diversion by relocating their manufacturing production to neighbouring countries such as Vietnam, Thailand or Malaysia. This allows exports to the US to continue and circumvents disadvantageous import tariffs. Now, the resumption of trade talks and the suspension of tariff hikes until at least mid-October provide cautious optimism that a compromise could eventually be found, as both US and Chinese leaders have a domestic political and economic interest in a deal. However, the extent of US demands probably makes any bold outcome difficult or even impossible to reach. Although a fragile deal is not ruled out in the one-year outlook and regardless of who will be the next US president, trade tensions are likely to persist. This is due to profound disparities in economic models (with dominant SOEs in China) and competition for economic and hi-tech leadership (highlighted by the ongoing ‘Made in China 2025’) which could eventually lead to a gradual economic decoupling between both superpowers.

Credendo sees increasing risks despite China’s financial strengths 

In the current circumstances, as internal stability is central to the communist party and is shaken by a declining labour market, the deleveraging process is temporarily softened. Shifting the balance to a more pro-growth focus by boosting bank lending, leaving bank reserve requirements at low levels and supporting the key housing sector could eventually mitigate the GDP growth decline. This could depend on the global context: if it further deteriorates, extra measures could be needed. Given the swifter economic slowdown, the lack of available financing and increased risk aversion, the private sector is facing a higher risk of debt defaults and bankruptcies in all sectors. To a comparatively lower extent, non-systemic SOEs are also increasingly at risk, with a record number of defaults witnessed since 2018 (albeit from a modest level) and with a high number of them being over-indebted and accumulating financial losses. Besides, many so-called zombie companies continue to be kept alive in overcapacity sectors thanks to the State support.

The government’s debt reduction policy will remain a top priority in the coming years as it is essential to achieve financial sustainability when the economy grows by less than 6% in the MLT. Domestic debt remains indeed huge and worrisome. Although non-financial corporate debt decreased in 2017-2018, it has again been increasing this year (to 155.6% of GDP in Q1) as a result of an eased monetary policy. Moreover, household debt (54% of GDP in Q1) and government debt (51% of GDP in Q1) are both on an upward trajectory. They offset the decline in corporate debt of the past years so that the total debt continues to rise. This unsustainable heavy burden, now estimated to be over 300% of GDP, will inevitably constrain future economic growth. Therefore, Beijing will increasingly revert to fiscal policy to boost the economy when needed in the future. As a result, the general government fiscal deficit is expected to continue its upward trajectory, reach a 25-year peak at 6.1% of GDP this year (from 4.8% in 2018) and remain at an average 5.6% by 2024. It will rapidly lift the government debt to higher levels. Currently, the latter is still acceptable, at 50.5% of GDP in 2018, but it comes from less than 40% in 2014 and is forecasted to rise above 60% as of 2020 and reach 70% by 2023 (see graph 3). Yet, the fact that it is almost essentially a domestic debt denominated in RMB shelters China from the currency risk and a change in foreign investors’ risk aversion.

In the medium to long term, China’s public finances will have to be used in an efficient manner to address the rapidly ageing population as well as climate change (including related environmental degradation such as air and water pollution). These two acute risks for China’s social stability and economic continuity call for reforms and high investments. China can still rely on good macroeconomic fundamentals overall and large financial buffers to face current and future risks: a huge savings rate, a current account in small surplus (although expected to be in deficit in the long term), a strong net external creditor position with stabilised and ample foreign exchange reserves (which explain Credendo’s short-term political risk rating in 1/7), large state assets and a low external debt. For all these reasons, Credendo sticks to a 2/7 rating for MLT political risk.

China’s ascent is hindered by conflictual tensions with the US and in its periphery

The economic and trade turmoil is occurring in a more challenging (geo)political environment. That is not the case in mainland China, where stability is maintained under President Xi Jinping and where the communist party’s undisputed grip has been reinforced by a continued anti-corruption campaign, tighter control on the Chinese society and a rising political presence inside local and foreign companies. The story is different outside mainland China. Hong Kong has seen its biggest, longest and most violent protests since it was retroceded to China in 1997. The protests put Beijing in an awkward position as protesters blamed rising interference in local affairs, among other things. Moreover, defiance to China in Hong Kong could spill over to Taiwan, strengthening re-election prospects for the ruling autonomist President Tsai next year. As a result, regional tensions could remain high and conflictual, particularly as Taiwan’s ties with the US ally have been at their best in years while Beijing is expressing rising impatience about Taiwan’s autonomy. This adds uncertainty to an already instable climate outside China where global order is rebalancing. The relation with the US, whose global power is waning, is fundamental. In a period of trade tensions and with a more assertive and militarised China, risks of clashes and conflicts will increase. Cyberattacks, clashes in the South China Sea, conflicts about Taiwan or proxy wars could occur. Meanwhile, China will continue to cultivate friendly, pragmatic and beneficial relations with emerging and developing countries (e.g. in Africa). China’s soft power has indeed allowed building strong economic and financial links with most of them. The Belt and Road Initiative, the pillar of China’s foreign and geostrategic policies, will further strengthen those links during the next decade.   

Analyst: Raphaël Cecchi – r.cecchi@credendo.com