Growth could decline below 6% in 2019

Arguably, investors may be too complacent about China. Growth may even fall below 6.0% y/y in 2019. The confluence of the pressure on trade, investment and consumption growth is unique, unflinching, and creates a complex challenge to top-down policy approaches.

Right now, macroeconomic policy is somewhere between proactive and reactive. Rightly, Beijing is reluctant to relinquish the positive momentum made in de-risking the financial sector and reducing leverage over the past 18 months.

On the fiscal side, investors should lower their expectations on Beijing launching further stimulus sufficiently sizeable to reverse the sharp slowdown in infrastructure investment (which has slumped from 20% y/y growth to below 5% y/y in the past 8 months). We expect more bond issuance, and faster fiscal expenditure (which has expanded at an average pace of just 8.5% y/y this year). The deficit will likely widen this year and next but we don’t expect a significant fiscal response.    

Given that Beijing faces constraints in its credit-fueled investment-led option, tax cuts would be a likely path. For one, it would support the private sector firms – that dominate in sectors such as manufacturing, wholesale and retail trade, scientific research, mining, and so on – accounting for two-thirds of investment in the Chinese economy. So far, private investment has held up reasonably well this year but the trade war looms over such investment.

We expect a further escalation of the US-China tensions. A hardening of positions on each side has become the baseline scenario. China is trying to de-couple the trade part of the dispute from the intellectual property, investment, and technology parts. China is also seeking to keep the trade and economic issues separate from military and geopolitical discussions around Taiwan and the South China Sea. However, the US seems to be shifting focus to a broader arc of issues. Should broader geopolitics get wrapped up in the economic tensions, China will also become much more aggressive.

China’s economic policy support will likely be domestically focused, and aimed at consumption. So far, auto sales have dragged down the headline number, but elevated mortgage debt (and concomitant repayments), sluggish wage growth, fragile stock markets, and the obliteration of P2P platforms put pressure on households, undermining plans to support consumption.

China’s central bank has cut the reserve requirement ratio (RRR) twice in the last three months, and four times this year. The latest cut was the largest, at 100 basis points. We are not convinced that the move aims to stimulate lending. And, even if so, a widespread acceleration in credit is unlikely because of the continued crackdown on non-bank financial institutions and the difficulties facing smaller banks. The most reasonable interpretation is that the central bank rightly recognizes that the real risk facing the financial system is liquidity due to the ongoing de-risking campaign. Therefore, the central bank is (i) ensuring ample liquidity via reserve requirement cuts, and (ii) encouraging banks to continue to make use of longer-term funding sources. The coming months will very likely bring further policy moves, including more direct liquidity injections via RRR cuts, the MLF and open market operations.

The RMB will remain under pressure, likely breaching 7.00 in the coming months. The PBoC will take further measures to limit the pace of RMB depreciation and ensure bi-directional moves. Indeed, Chinese authorities are getting creative on exchange rate intervention, issuing treasury bonds in Hong Kong, for example, which soaks up some CNH liquidity and increases CNH borrowing costs. Tightening liquidity and higher CNH borrowing rates makes it more expensive to bet against the currency, and narrows the rate differentials between Chinese bonds and similar duration US treasuries. We’d therefore expect capital controls to resurface.

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