A year of living dangerously

Policy stimulus significant enough to reverse China’s economic slowdown seems most unlikely. Further support will undoubtedly be forthcoming, and the authorities have taken a pro-growth policy tilt in recent months, confirmed by the latest Central Economic Work Conference. Rightly, Beijing anticipates that 2019 will be a difficult year, and is, constructively, positioned accordingly.

However, market expectations may be overstated. We believe that policy aims to merely cushion the slowdown, not reverse it.

Nevertheless, this year will again test the agility of policymakers. Over the past two years the government has staved off panic, worked diligently to bolster private sector and consumer confidence, whilst remaining steadfast in de-risking the financial sector. Getting this balance right in 2019 will be critical.

Beijing’s true north remains disincentivizing the allocation of resources towards non-productive investment to reduce this proportion as swiftly as possible without causing unemployment to rise, non-performing loans to balloon and destabilize the financial architecture, or batter confidence. However, it is impossible to replace the non-productive investment with productive investment, thereby maintaining past rates of growth in fixed asset investment, which accounts for half of the economy. To wit, investment growth slowed for a tenth consecutive year, slipping from 7.2% in 2017 to the lowest rate on record of 5.9% in 2018.

On this score, it is hard to be optimistic in 2019. Last year, fixed asset investment in the tertiary sector, which accounts for 60% of total investment and includes large sub-components like real estate, infrastructure, water utilities and so on, expanded by just 5.4% y/y – the slowest pace in over two decades. Even with the increase in local bond financing anticipated, for example, which should support infrastructure investment, given the high base it would take time a tremendous fiscal impulse for a sustainable rebound in infrastructure spending. Consider this: railway investment accounts for just 2-3% of China’s total domestic fixed asset investment and would need to increase by 100% in 2019 from 2018 levels, for total fixed asset investment to expand 1-2pps faster, ceteris paribus. Meanwhile, fixed asset investment in the secondary sector, which makes up almost another 40% of total investment, and is dominated by manufacturing, expanded by just 6%. Private-led manufacturing investment held up well last year, and we expect supportive industrial policies to continue to channel funding for investment in technology. However, it is the firms in these external-orientated areas that are the most vulnerable to the trade war.

For stimulus large enough to move the dial, the government would need to reverse course on the housing market and slacken scrutiny over credit flows and the shadow banking sector. But, that would be foolhardy and short-sighted. Thus, fixed asset investment is likely to remain soft in 2019. Rather than tremendous additional fiscal outlays, policymakers will continue to lean on reductions and exemptions in taxes to ameliorate challenges facing the private sector and lift consumption.

The government has, correctly, focused on ensuring that consumption growth holds up, but that too has proven difficult. Last year, nominal retail sales growth expanded by just 8.1%, the slowest rate since 2002 – and, in real terms, expanded at half the speed of the rate just 18 months prior. Alarmingly, consumption growth has become increasingly reliant on household debt – albeit from a low base – adding a new risk to the outlook. Consumer loans have more than doubled in the past three years, rising by 20% in just 2018, reaching near USD40trn in 2018. As a result, the household debt-to-GDP ratio has jumped by 10pps since the start of 2017. Of course, levered consumption works counter to plans to halt the rapid growth in debt growth, with interest payments absorbing a greater share of income.

Another pressure valve has been the increase in external debt. For now, China's foreign debt doesn't look large relative to GDP, and over one-third of China's external debt is denominated in CNY, leaving around USD1.25 trillion in foreign-currency borrowing. The largest share of that dollar-denominated debt is held by Chinese banks, the PBoC and MoF. However, there are sectors, such as property developers, that could run into headline-grabbing problems in 2019. Therefore, China’s potential for injecting volatility into the global financial system should not be ignored.

Added to the depressed growth in fixed asset investment and household consumption, external demand will be negatively affected by the trade war because the front-loading which occurred in H2:18 will become a headwind to export growth. That means that the economy is unlikely to find a bottom in the near term, even with a supportive policy mix. Instead, GDP growth is forecast to slow from 6.6% y/y in 2018 to 6.1% y/y in 2019. That would be the most sizable decline in GDP growth – in both absolute and relative terms – in over five years, undermining China’s L-shaped recovery. 

The PBoC is clearly concerned about the economy, committing to intensifying counter-cyclical adjustments. However, a widespread acceleration in credit is unlikely due to the continued crackdown on non-bank financial institutions, the difficulties facing smaller banks, and the depressed economy. The RRR was cut four times last year, and both credit and money supply growth subdued. Last year, TSF increased by CNY19tr – down 15% y/y. For most of the year, commercial banks opted to hold extra reserves rather than lend money to the real economy. The is likely to persist in 2019 even though we anticipate another 200 bps cuts in the RRR in 2019, in tandem with additional injections through the targeted medium-term lending facility and other medium-term lending facilities, pledged supplementary lending, and open market operations. However, monetary policy has lost traction, with the subdued economic climate limiting the demand for loans that aren’t simply being used to roll over existing debt.

One thing we are sure of is that the PBOC is not in a position to follow any Fed hikes, so we therefore expect the interest rate differential to narrow even further in 2019. Against the USD, then, the CNY is likely to be pressured – the extent to which will depend on the trade war and rate trajectory in the US. Generally, as growth continues to come under pressure, the government is likely to accept a weaker CNY. The biggest risk is that China may misjudge the delicate balance it faces in the financial market and real estate sector, derailing the gradual nature of the slowdown, and sparking panic such as in late 2015.

Economic support measures are set to intensify in 2019. Chinese leaders will do more to support the economy: strengthening counter-cyclical adjustments, implementing an active fiscal policy, supported by a stable monetary policy. Hence, in terms of the policy mix, fiscal policy will be leaned on more heavily, whilst the focus for monetary policy is on improving the transmission mechanism rather than loosening significantly. Nevertheless, we foresee no large-scale stimulus.

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