A profound long-term economic transition

China’s economic growth seems on track to breach 6.0% y/y in Q4:19. Promisingly, our inhouse China Activity Index is moderating at a much slower pace than a few quarters ago, slipping only fractionally, from 5.87% in August to 5.80% in October. The data implies a near-term cyclical bottom in early Q2:20 – probably in April, once year-on-year data points factor in the lofty base effects of March when, for instance, industrial production jumped by 4pps to a 5-year high of 8.5% y/y.

So far, the cyclical slowdown driven by domestic forces and policy priorities – specifically tight financial conditions, de-risking the financial sector, weak local government investment, and soft domestic demand. There’s little evidence here to call for any substantial policy change.

In recent quarters, China’s economy has been supported by reasonably solid infrastructure investment which has accelerated from just 3.8% y/y in July to 4.5% y/y in September as well as construction activity. Real estate construction has also accelerated steadily, from 4.7% y/y in March to 6.4% y/y in September, prompting the much-watched excavator production and sales growth to rebound in June and July respectively. However, with regard to the latter, real estate construction looks toppish: residential sales growth has been contracting all year; developers’ purchases of land have contracted by 28% YTD y/y, and regulators continue to scrutinize developers’ financial affairs.

For now, though, the US-China trade war seems to be easing, with both sides looking to roll back tariffs on each other’s goods in phases as they work towards at least a partial deal. China seems keen to offer as much possible on trade to build up goodwill, and punting the ongoing opening-up of China’s financial markets, perhaps to avoid the inevitable log-jam around the deeper structural issues. Still, we’d eventually foresee a further breakdown in relations as more likely than a genuine resolution.

The renminbi has appreciated a fraction in recent weeks but remains on the back foot. Worryingly, capital outflows are already building back up towards 2015/2016 levels.

Policymakers seem confident though that they can manage through the cyclical downswing and therefore remain focused on their medium- to long-term goals.

What some frustratingly interpret as easing, monetary policy remains focused on strengthening the position of small banks, replacing interbank liquidity via RRR adjustments and the medium-term lending facility (MLF). Liquidity crunches and runs – most recently at Yichuan Rural Bank in Henan and Yingkou Coastal Bank in Liaoning – have cast doubt over the health of some lenders. We’d therefore expect restructuring, mergers and acquisitions, takeovers and bankruptcies in the next 18 months.

It is also true that policy is trying to support for the real economy and boost market confidence. Talk of better use of counter-cyclical adjustment tools for macro policy has ramped up in the past few weeks. Nevertheless, for now though the goal remains to merely ameliorate some of the most challenged parts of the economy, not reverse the slowdown. Any substantial change to the status quo would be communicated at the China Economic Work Conference next month.

The issue is straightforward: it’s not possible to boost overall lending while staying tough on bad lending. Until June, targeted loosening was enough to keep credit growth gently accelerating. However, over the past four months, credit growth has slipped from 10.8% y/y in September to 10.7% in October, which can only delay any economic stabilization further.

Focus will remain on supporting private sector investment, ensuring that SMEs have access to finance, and cutting taxes and red-tape, and ameliorating any slowdown in consumption. According to the World Bank’s Ease of Doing Business, China has implemented the largest number of reforms in the East Asia and Pacific region and has streaked to a global ranking of 46 this year, from 78 last year. The policy tilt though has proven to be less effective in placing a floor under growth than traditional levers but remains the core policy anchors at this time.

China is clearly in a profound long-term economic transition that could see it at a growth rate of around 3-4% in 2025. Its economic performance should therefore be seen in the context of cyclical movements around a decelerating trend. Upswings will be shorter than before, and downswings longer. As China’s economy matures, economic reform will become ever more important, in order to unlock productivity gains that can propel economic growth. Promisingly, economic reformers are harnessing the slowdown to push reforms, especially to create a pro-business environment for SOEs, private business, and foreign-owned business.

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