The trade winds of war

Pervasive global trade winds have been unleashed by callous tariffs; the storms to follow are sure to be severe.

The US-China trade war comes with a great many uncertainties and ramifications. For Chinese policymakers, this comes as the Chinese economy is decelerating. The frigid air from Beijing’s multi-year deleveraging drive has inflated corporate borrowing costs, delayed projects, and depressed the private sector. Weakening economic data was always going to test regulators’ mettle to continue focusing on de-risking the financial system and getting gearing under control.

The entrenched trends indicate that the cyclical path will likely depend on policy choices: will deleveraging efforts be paused; will stimulus be forthcoming? We see the economy growing 6.5% in 2018 and 6.1% in 2019. That would imply GDP growth slipping from 6.7% in Q2:18 to 6.0% in Q4:18, then staying there for some time.

The US-China trade war is the main downside risk to China’s economy. Rates are still a domestic story but inflation may prove the biggest short-term risk, rising from 2% in 2018 towards the 3% target in 2019. Our previous expectation for the CNY/USD to trend towards 6.0 by end 2019 now seems off target. The CNY has fallen by almost 10% from its peak in April. The PBoC is unlikely to defend the CNY at a time that other major currencies are also depreciating against the greenback. Also, market participants are wary of the PBoC, choosing not to short the red-back too aggressively. Thus, the PBoC is letting markets determine the price of the currency by now choosing not targeting a specific exchange rate. Most likely, when the dollar’s path changes, the CNY will strengthen again.

Because both the US and China seem confident of “winning” a trade war, tariffs and retaliatory measures have flown thick and fast. Nevertheless, China seems persuaded that domestic growth will merely crimp to what it deems an acceptable 6% in Q4:18, from 6.8% in Q1:18. In fact, Beijing can achieve its 2020 target of doubling GDP per capita with a growth rate of 5% in the next 2.5 years.

China nevertheless does not desire a trade war. Retaliatory actions result in self-inflicted pain at a time when the economy needs all the help it can get from productive areas. Therefore, China will likely remain restrained, with each move merely matching that of the US. It will decline being cast as villain in this story. In fact, China’s biggest long-term risk is that the US eases tensions with other countries, and that what is a US/China war becomes “China against the rest of the world”. We foresee a three- to six-month trade war that stays in the range of USD100 billion worth of tariffs, with China likely capitulating on trade, because to China trade is the least crucial aspect of this dispute. In fact, China has already made many conciliatory offers to the US to reduce its trade surplus. Chinese leaders will likely stay this course by way of offering an off-ramp to the Trump administration.

Regarding the policy outlook, the State Council’s most recent meeting favoured a pro-growth tilt. Consensus seems to be that the deleveraging programme will stall a while. Regulators will likely use the trade war as an excuse to go easier than they said they would; however, the policy goal of “de-risking” cannot be abandoned. Reversing course would undermine the administration’s laudable progress to date – like regulators’ handling of the stock market collapse of 2015.

Markets nevertheless expect credit growth to accelerate in H2:18. The PBoC has cut the required reserve ratio (RRR) twice since April. More cuts are likely assured. However, such moves would not qualify as outright easing. The PBoC is trying to adjust the structure of liquidity in the banking system, not accelerate credit or economic growth; it is intent on extending a lifeline to smaller banks and directing credit to smaller companies. To this end, the PBoC has also broadened the types of collateral that it will take for loans made through the Medium-Term Lending Facility. Previously, the central bank had only accepted higher-quality bonds from borrowers, such as policy banks, but will now accept rural, green and SME bonds as collateral — in an effort to change who gets liquidity, incentivizing banks to buy bonds issued by smaller companies, which should help shift financing toward previously underfunded entities. The rub: the central bank is taking on riskier collateral.

The central bank still seems committed to deleveraging and keeping financing conditions relatively tight. However, the deleveraging drive is now starting to tighten credit conditions and restrain financing. For many, the growth in overall credit (total social financing) in May was a wake-up call, declining to an all-time low of10.3% y/y, from 10.5% in April. Indeed, the flow of new loans and new total credit sped up in June. However, the stock of these indicators tells the real story: new overall credit grew by less than 10% in June, the slowest in a decade, and bank loan growth has flat-lined since April. Put plainly, regulators are not stimulating, but rather simply stabilizing the pace of credit creation.

But now that banks have largely unwound their more speculative assets, further de-risking – or outright deleveraging – is starting to be a drag. Already, interest rates for non-financial corporations are on the rise. Interestingly, this is happening even as observable market rates – i.e. bond yields and money market rates – were low in H1:18. In fact, most companies still rely on bank lending. This is a clear sign that financial de-risking – which saw funding for banks get tighter throughout 2017 – is forcing banks to pass on the higher cost of funding. Though the initial round of financial de-risking did not have an adverse effect on growth, the next 18 months could prove differently.

There have been rumours that China might invest more in infrastructure projects to soften the blow to the economy. But such stimulus would not reverse the deceleration in investment. YTD, China’s infrastructure investment growth has tumbled to 7.3% y/y, from 21.1% y/y this time last year. Of course, this slowdown has dragged fixed-asset investment growth to a record low. Cement output has crawled through the first five months of the year – a leading indicator of more investment weakness to come. Having cut off financing sources has jeopardized going projects, which could leave them unfinished, with no chance of ever seeing a return, and also leaving local governments unable to roll over the financing debts. We reiterate that regulators are not stimulating, but rather simply stabilizing credit.

On the fiscal side, the Chinese government has promised to make its fiscal policy “more” proactive. This has translated into permitting more companies to claim deductions for R&D and supporting local governments to issue CNY1.35 trillion in bonds thus far. This is more about sentiment, showing that the government is supportive, but Beijing would be loath to sacrifice the progress it has made on encouraging fiscal responsibility. Beijing has nevertheless undertaken several measures to ameliorate the burden on consumers, such as cutting import duties on almost 1,500 goods, tax cuts, and reducing the administrative burdens for businesses; and, fiscal expenditure on education, healthcare and poverty alleviation has gained greater momentum.

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