China – Entering sub-6% growth amidst trade truce

Key points

  • A structural slowdown will take the Chinese economy into a new chapter of sub-6% growth, starting in 2020
  • But the economy may be near a cyclical trough and its subsequent recovery could be helped by a trade truce
  • Prudent policy easing will continue to function as an auto-stabiliser should the labour market stay resilient

New year, same challenges

After a moderate slowdown in 2018, annual growth is likely to have decelerated at its fastest rate in seven years to 6.1% in 2019. External shocks from intensified US/China trade conflicts, and a synchronised slowdown in domestic and global manufacturing growth, were the main culprits, creating a shock that Beijing’s tepid stimulus could not fully offset. The economy is therefore expected to end 2019 on a soft note, recording its first sub-6% growth in the fourth quarter since the early 1990s.

Looking ahead, the 2020 macro picture will likely remain precarious. The raging trade war and cautious policy easing will likely compound the trend slowdown, taking annual growth to 5.8% in 2020 and 5.6% in 2021. Key to this forecast are three considerations: the evolution of “natural growth” in the economy, the prospect for the trade war, and the degree of policy easing from Beijing. We examine each factor in turn.

Natural growth to gravitate lower

China’s “natural growth” will likely slow further, even without considering any external and internal shocks. Our estimate of natural growth consists of two parts: a trend component and a cyclical component. The former is constructed by running a Hodrick-Prescott filter through official GDP and some third-party activity indicators[1]. Exhibit 1 shows this estimate as the blue trend line, which has declined at a steady rate of 0.2-0.3 percentage points (ppt) per annum in recent years. We assume a 0.25ppt trend growth deceleration to continue in 2020 and 2021.

The cyclical variation of the economy is shown by the pink line around the trend. This is captured by our Economic Cycle Indicator (ECI), which extracts the common trend among a number of short-term indicators that consist of both official and non-official data. A major finding of the ECI is a persistent duration of cycles that spans over 3½ years historically. If this pattern repeats itself, the current cycle – which started in mid-2016 – should be approaching an end in late-2019, giving way to a new cycle into 2020. We expect this cyclical component to subtract 0.1ppt from headline growth next year but add 0.1ppt in 2021 as growth rises above trend.

Exhibit 1: Natural growth gravitates lower

Source: Bloomberg, CEIC and AXA IM Research, as of 17/11/2019

Translating the above in economic language: the trend growth deceleration – driven by forces of ageing population and slower capital formation – should dictate a continued structural slowdown in well-followed indicators, such as industrial production and retail sales. The latter should, however, be more resilient in relative terms as economic rebalancing continues and further tax reliefs are likely for households. On the cyclical side, there are some tentative signs of stabilisation in trade, manufacturing and auto activities lately, which could be consistent with a bottoming of the cycle. Surveyed capacity utilisation is also near recent-year highs, suggesting scope for a capex recovery once the gloomy business sentiment subsides. An extended truce in the US/China trade war should, in our view, help to elicit a gradual pick-up in the ECI over the coming year.

Tariffs continue to bite, but worst behind for now

Besides the natural growth slowdown, the economy will continue to endure shocks. The trade war has been a major driver of export and manufacturing weakness in the past year and will likely continue to influence the economy in 2020. Fortunately, progress in recent trade talks has brought the two sides closer to a partial deal, which – if signed – should help to halt further tariff increases in the near future. However, the bar for a material rollback of existing tariffs is much higher, in our view, given the significant gaps remaining on thornier issues such as technology transfer, intellectual property protection and China’s industrial policies.

The road ahead, therefore, remains long and treacherous. We think that US President Donald Trump will keep existing tariffs in place to force concessions from Beijing on structural issues. Without significant breakthroughs in future trade talks – difficult in a US election year – an extended truce that preserves the status quo in tariffs is the most likely outcome for 2020. The outlook beyond that will depend on next year’s US election, with a second term for Trump threatening renewed tensions. Alternative outcomes would likely see continued negotiations but with less confrontational actions.

Without considering the long-term consequences of supply-chain readjustments, the immediate impact of tariffs on trade growth should fade after 12 months. This means that most levies imposed on Chinese exports in 2018 should fall out of annual growth calculations after 2019. What matters for 2020’s growth is, therefore, tariffs imposed in May and September of this year, which we estimate will have a lingering impact of 0.2-0.3%. Compared to the 0.8% shock in the past 12 months, this is a smaller drag on incremental growth for next year.

Cautious easing not enough to defend 6% growth

The escalation of the trade war has prompted Beijing to step up policy easing lately. Without this policy cushion, the economy would have fallen below 6% earlier. However, it is also true that Beijing has so far been more reserved with its easing operation than in past cycles, which we think can be explained by two reasons.

The first is an imperfect match between the desire and scope of using certain policy tools. On the monetary side, the People’s Bank of China has plenty of room to cut interest rates and banks’ reserve requirement ratio (RRR). Yet actual policy easing has been timid, due to a number of structural and cyclical concerns, including high domestic debt levels, rising food price inflation, housing market bubbles and excessive renminbi depreciation that could destabilise the financial system and antagonise trade negotiations. Also, the problem facing monetary policy now is more related to its ineffective transmission of cheap credit to the private sector than an overall lack of liquidity. Hence, simply cutting interest rates or RRR will not cure this structural ill.

In contrast to monetary policy – where the authorities have more scope than willingness to stimulate – the mismatch on the fiscal side is exactly the opposite. The aggressive tax/fee reductions suggest that Beijing is keen to deploy fiscal policy as its primary tool to rescue the economy. But with the budget deficit approaching 3%, and off-balance-sheet financing constrained by lower land sales and tightened control of local government debts, the scope for further stimulus has become more limited. How to extract more policy room and improve the quality of spending will be key to amplifying the fiscal power in 2020.

We think the other reason for Beijing’s restrained policy response is the resilience of the labour market. While official labour market data has moderated somewhat, they are far from ringing alarm bells. This is partly because China’s economic rebalancing has resulted in more jobs created by domestic-oriented sectors relating to consumption and services than by trade and manufacturing activities. In other words, the economy has become more insulated from the external and manufacturing slowdowns. 

Overall, we think Beijing can afford to continue this prudent policy setting so long as the labour market stays resilient. We estimate the combined monetary and fiscal boosts will add 0.3ppt to 2020 growth. Since current tariffs would not cut 2021 growth and the economy may be growing above trend by then, we expect no more incremental policy easing beyond next year. Adding all of the above together, we forecast 2020 GDP growth to be 0.3ppt lower than 2019’s at 5.8% and 2021’s to be 0.2ppt lower still at 5.6% (Exhibit 2). 

Exhibit 2: Growth enters sub-6% starting 2020

Source: Bloomberg, CEIC and AXA IM Research, as of 17/11/2019

Don’t discount upside risks

We see the risks around our baseline forecast as broadly balanced. A key downside risk is the housing market, whose surprising buoyancy this year could give way to a more pernicious downturn in 2020. Our forecast also makes no allowance for supply-chain adjustments in response to the trade war, which could have a lasting negative impact on the economy. More broadly, a sharper external slowdown could create additional headwinds for China’s growth progress.

On the flipside, our expectation of a mere trade truce could prove too conservative if existing tariffs are rolled back. Such a move could significantly lift export growth, boost business sentiment and accelerate the capex recovery. Also, Beijing could choose to stick to its target of “doubling GDP” by 2020, which will require greater policy easing to keep growth at above 6%.

[1] See Yao, A “Unveiling China’s Economic Cycle” AXA IM Research and Strategy Insights, March 2019

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