Why US trade war is less to blame for China’s economic slowdown than the home-grown deleveraging campaign
Aidan Yao says China has softened its aggressive campaign to tackle debt in the face of the trade war, but it will be tougher this time around to stimulate the economy while retaining the benefits of its reform measures
The Chinese economy is confronting a double whammy of stiffening domestic conditions and the trade war with the US. Economic growth has slowed noticeably in recent months, particularly in infrastructure investment and credit supply, while financial markets have suffered setbacks, with both equities and the yuan retreating to near 2016 lows. Talk of an economic hard landing has resurfaced, amplifying the recent sell-offs in Chinese and wider emerging markets.
Intensifying domestic constraints have been the main reason for the economic slowdown to date. While trade tensions have dealt a heavy blow to investor confidence, their impact on trade activity, and hence growth, has so for been limited. China’s exports to the US have risen 12 per cent on average over the past three months, in line with growth in total exports.
While trade conditions will undoubtedly deteriorate if additional tariffs are levied on US$200 billion of Chinese goods, the trade war, up to this point, has not been a major contributor to slowing growth.
Instead, this slowdown is home-made, driven almost entirely by a marked tightening of monetary and fiscal conditions. The latter is, in turn, a result of the deleveraging campaign making inroads into the real economy. Contrasted with the early phase of the operation, which focused on trimming the fat off the financial system, the deleveraging campaign has started to tackle debt in the real economy this year.
The most noticeable area of restraint is in the official sector, where debt accumulation – in the form of bond issuance and shadow-banking credit supply – slowed dramatically in the first half of the year. The government’s off-balance-sheet activities have also been curtailed by the withdrawal of financing guarantees for local government funding vehicles (LGFVs) and the termination of many private-public-partnership projects.
A dramatic turn to austerity in both on- and off-balance-sheet government spending has led to a free fall in infrastructure investment, whose growth collapsed to its lowest in almost 20 years. With infrastructure accounting for about a quarter of total fixed asset investment, reduced spending in this area has subtracted more than 3 percentage points off investment growth in 2018.
While the move to rein in local government debt is laudable, undertaking such an aggressive operation amid rising growth headwinds and financial-market fragility is dangerous. As the experience of 2015-16 – pricking the equity bubble and reforming the exchange rate while the economy was in free fall – would suggest, the cost of mismanaging the short-term versus long-term objectives can be high.
With these lessons learned, Beijing has moved swiftly to preserve stability. The recent high-level meetings by the State Council and Politburo have sent clear signals of a changing policy priority to support economic growth and financial markets.
This has been followed by noticeable monetary easing, with required reserve ratio cuts, liquidity injections and various regulatory/administrative easing to encourage lending to local governments, LGFVs and small and medium-sized enterprises.
These changes have spurred a sharp rebound in local government bond issuances. Since July, a total of 1.6 trillion yuan of local government bonds have been issued, compared to 1.4 trillion yuan in the entire first half of the year. The local authorities have also been encouraged to speed up on-budget spending, which is supported by robust tax intakes and strong land sales this year. Together with a faster approval of private-public-partnership projects, infrastructure growth should soon hit the bottom and start to recover towards the end of the year.
While the policy cycle has clearly turned, the pendulum has not swung all the way to the extreme. Compared to previous policy easing – in 2008-09, 2012-13 and 2015-16 – the latest round of stimulus is likely to be more restrained.
This is partly a result of the accumulated imbalances, particularly in debt, from previous stimulus measures, creating more limited policy room and undermining its effectiveness on economic growth. But also, the government has become more willing to trade off short-term growth (in speed and quantity) for long-term growth (in quality and sustainability).
This implies that the current stimulus will have three characteristics. First, the scale of credit impulse will not be as large as before, as Beijing tries to preserve the fruits of deleveraging and supply-side reforms. Second, the nature of the stimulus will change incrementally, with less focus on credit support for the housing market and industrial sectors, but with more help to SMEs and households via tax cuts. Finally, the stimulus is likely to go hand in hand with reforms, which are already being carried out on the tax system, financial regulation and state-owned enterprises.
Overall, the quality of the stimulus should improve from previously, although its effectiveness in generating growth may not be as great and swift as before. With less policy room to manoeuvre, Beijing faces a tougher balance between preserving short-term stability and generating long-term sustainability. The job of managing the world’s second-largest economy is getting tougher by the day.
Aidan Yao is a senior emerging Asia economist at AXA Investment Managers