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China: Domestic cooling down while external heat rises further

Economic Comment


•  Most recent economic figures confirm our view of a continuous slowdown of Chinese economic growth
•  A further depreciation of the Chinese yuan (against currencies of major trading partners) bodes well for exports, but also weighs on domestic demand due to higher import inflation
•  Trade war escalation can be characterized by ‘one step forward, two steps back’. An interim deal in the short term could lower tensions, but ultimately we do not believe an overarching deal can be struck
•  More fiscal and monetary stimulus is on the cards, but this will be less massive and more targeted than during previous episodes

Chinese economy continues to face downward pressures

Figure 1: Domestic cooling down continues
Figure 1: Domestic cooling down continuesSource: NBS, Macrobond

July and August figures showed that the Chinese economy is still in a weak momentum during the first two months of 2019Q3. Retail sales and industrial production were particularly weak. Total investments in fixed assets held up, but the activity of the private sector remains vulnerable given the ongoing discrepancy with public investments (Figure 1). Aside of some positive one-offs, the overall downward trend is clearly continuing, building the case for (more) stimulus in order to prevent the economy from weakening further. In the previous two quarters, weak activity in the first two months was offset by stronger activity in the last month (Table 1). Should this not be the case this time, growth in the third quarter will be even lower than in the second quarter. This would be in line with our current forecast as average GDP growth in the first two quarters was 6.3% y/y and we expect overall growth to come in at 6.2% for 2019, before falling further to 5.7% in 2020.

Table 1: Will September bring recovery (again)?
Table 1: Will September bring recovery (again)?Source: NBS, Macrobond
Note: all data for Table 1 (excl. retail sales) are in nominal terms. There is no price deflator available to calculate figures in volume terms for all months.

It is important to stress that the growing weakness is not directly attributable to the escalating trade war with the United States (US). It has both to do with the structural transformation of the Chinese economy, which reduced the contribution of old ‘low hanging fruit’ growth drivers, combined with an increasing focus on the quality of economic growth, with a focus on risk reduction and pragmatism with regard to large and massive fiscal stimulus. In addition, the old dynamics of additional public investments and the resulting growth do not outweigh the ever-increasing level of debt. Ongoing domestic weakness is underlined by the performance of imports, which have been shrinking across the board for quite some time now. For almost all key trading partners, year-on-year (y/y) growth of imports has declined in 2019 compared to last year (Figure 2). It is interesting to note that countries who dominantly export commodity goods to China, such as Australia (iron ore and coal) and Brazil (soybeans, iron ore and petroleum), are still experiencing higher demand from China compared to other trading partners.

Figure 2: Much lower imports from key import partners
Figure 2: Much lower imports from key import partnersSource: General Administration of Customs, Macrobond, Rabobank
Figure 3: Trade war effect clearly visible in exports to the US
Figure 3: Trade war effect clearly visible in exports to the USSource: General Administration of Customs, Macrobond, Rabobank

The external environment has clearly heated up

The disappointing export growth compared to last year is primarily caused by an increasingly cooling world trade activity, as we described in our most recent economic quarterly outlook. But the further escalation of the US-China trade war also plays a role, which is clearly visible in the contraction in exports to the US compared to 2018 (Figure 3). On balance, the contribution of net trade to economic growth is positive, as the weak development of export growth is surpassed by even weaker import growth, but the underlying weakness is clearly there. Looking ahead, the weakening of the Chinese currency also plays a role in this respect. The yuan has recently depreciated against the currencies of major trading partners (Figure 4). This could have a positive effect on exports from a relative price competitiveness point of view.

While we expect more downward pressure on the Chinese currency going forward, there is also clearly a downside to this development: higher import inflation on top of the effect from higher tariffs on imports from the US. This both affects the purchasing power of Chinese consumers and producers.Higher import prices could have a further detrimental impact on private consumption, which have also been affected by higher pork prices. Due to this, the headline consumer price index (CPI) is approaching the 3% target. But there is a clear split between food and non-food price consumer price developments (Figure 5). Although higher import prices in turn can lead to higher domestic price levels, this is more of an artificial CPI effect and not a clear sign of increasing domestic demand.

Figure 4: Sliding Chinese yuan
Figure 4: Sliding Chinese yuan Source: Macrobond
Figure 5: Higher food prices, negative producer prices
Figure 5: Higher food prices, negative producer pricesSource: NBS, Macrobond

Expected next steps in the trade war

What first seemed to turn out to be a relatively quiet summer with the prospect of a new round of negotiations in September, escalated again mid-Summer. As a result, new and higher import tariffs have been implemented by both countries, and additional tariffs have already been announced (Figure 6). These developments are in line with our long-held view that the trade war is a long-lasting conflict on different fronts (see, for example here and here). There is clearly a pattern here which one can best describe as: one step forward, two steps back. We deem that the most positive short-term outcome is a ‘mini-deal’. This would for instance encompass China buying more agricultural products from the US in exchange for lower sanctions against Huawei and/or a postponement of the announced tariff increases.

Should there eventually be a broader agreement of any kind, this will also involve an enforcement mechanism, something China clearly does not support, as well as changes that they would need to make under (US) pressure with regard to their own economic model and sovereignty with regard to domestic laws and regulations, for example in the field of intellectual property rights. All in all, given that tensions between the two countries will continue for a longer period of time, Chinese policymakers are likely to step in in order to mitigate the negative impact on the economy.

Figure 6: Trade war escalates further
Figure 6: Trade war escalates furtherSource: Rabobank

Building a strong case for (more) stimulus?

Figure 7: Credit growth not taking off (yet?)
Figure 7: Credit growth not taking off (yet?)Source: PBoC, Macrobond

In order to cope with weaker economic developments and prospects, policymakers have already implemented and announced a number of stimulus measures. But as most data for 2019 shows, this has not yet realized the desired boost in economic activity. This of course may be related to increasing uncertainties in the economy as a whole. In addition, the so-called reserve requirements for most banks have been further reduced in order to provide more liquidity, aimed at supporting higher loans growth. It is expected that the reserve requirements will be further reduced later this year and next year. This is not surprising considering the recent credit growth developments (Figure 7). In addition to these measures, a recent change in the definition of the benchmark policy rate, the Loan Prime Rate, has been made. This rate now has been cut from 4.31% to 4.25% over the last two months. In general this new measure should contribute to a better transmission of monetary policy to the real economy. 

More room for local governments’ bond issuance destined for infrastructure investments is on the cards as well. All in all, from a fiscal point of view, the focus will continue to be mainly on the side of lower taxes and infrastructure, while on the monetary side it is aimed at stimulating lending to private companies. If one takes into account the domestic and external weakness, there is a strong case to start the stimulus engine. But this will be likely encompass a more targeted and smaller package compared to previous episodes of economic weakness, such as during the economic weakness during 2015-2016.

Björn Giesbergen
RaboResearch Global Economics & Markets Rabobank KEO
+31 88 726 7864

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