China's slowing investment trumps trade talks

Trade talks are off the table. The stance in Beijing can be captured by Vice Minister of Commerce Wang Shouwen saying yesterday that "it's difficult to proceed with the US posing tariffs like holding a knife to someone's throat". China's leadership has now abandoned views about this being a trade war.

Indeed, we have said for some time that it is not about deficit or surplus. Rather, the logjam is about the US and China’s political and economic models, and this is unlikely to be resolved soon. In any case, Chinese policymakers now digging in their heels would make any trade de-escalation unlikely, considering that anti-American sentiment in Beijing is rising.

Still, the negative impact of the trade war is yet to show up in the data because both parties have been bringing forward sales to pre-empt tariffs. Nevertheless, these front-loaded purchases will eventually become purchases forgone. Perhaps as soon as Q4:18, Chinese exports will show this.

Far more pressing than trade though, is lackluster local infrastructure investment. Simply put, the Chinese economy is slowing because infrastructure and property peaked a few years ago, and no new growth drivers have emerged that are sufficiently sizable to replace them.

In response, many analysts argue that Chinese policymakers have shifted into growth-support mode. However, we believe that regulators wouldn’t want to sacrifice their financial de-risking successes. As such, targeted adjustments are likely, but not blanket support for the economy. Indeed, last week Premier Li Keqiang spoke of the importance of “giving more attention to pre-emptive measures and fine-tuning”. Promisingly, Chinese economic policy is typically at its best when regulators are on the front foot, as in the financial de-risking campaign, instead of reactively fighting fires, as in the trade war. In terms of macro policy, China is somewhere in between reactive and proactive.

The most concerning now is that insufficient infrastructure investment weighs on overall investment and therefore on economic growth. YTD growth has slowed from 5.5% y/y in July, to 5.3% y/y in August. Despite some improvement in manufacturing investment, infrastructure investment fell further into negative territory, contracting by 4.3% y/y (after contracting 1.9% in July). And, the forward-looking data points imply worse still. According to the National Development and Reform Commission (NDRC), intended infrastructure investment contracted by a staggering 35% y/y in the first seven months of 2018.

Since August, the government has been encouraging local governments to spend, specifically by having local governments accelerate their bond issuance. A few weeks ago, the banking regulator (CBIRC) provided banks’ investment arms more leeway to purchase bonds that the bank itself is underwriting, by removing a 20% cap on such purchases. Unfortunately, local governments will have largely hit their annual quotas by the end of September, and so bond issuance will likely slow dramatically in October. However, a more important question: are these bonds financing viable projects? Right now, there are few projects worth investing in.

Another challenge is that after many months of being told to reduce risk and control debt, local governments are wary of putting money into big projects. Recall that the Party issued two policy documents earlier this year – one on thoroughly identifying off-balance-sheet debt, and one imposing lifetime accountability for debt on officials. Hence, local governments are understandably not clear about current policy priorities.

Until investment has turned the corner, the economy would be unlikely to recover meaningfully.

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