China is slowing down, but it has ample policy space to re-start

Our baseline is that there is ample policy space in China to re-start the economy swiftly, and that Beijing has no interest in allowing “warning shots” to the over-leveraged real estate turning into a systemic crisis.
Gilles Möec

Chief Economist

AXA IM

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A cluster of disappointing data suggest the Chinese economy is slowing down significantly, and it is starting to show in European exports. It is not the first time China goes through a “bad patch” since it has become a crucial source of traction for global trade. In 2015 already, Chinese demand softened, with a transitory but visible impact on German GDP. This time as well, bad news on the cyclical front is compounded by financial stability concerns.

Our baseline is that there is ample policy space in China to re-start the economy swiftly, and that Beijing has no interest in allowing “warning shots” to the over-leveraged real estate turning into a systemic crisis. The Chinese government has to constantly find the right dosage between addressing the imbalances of its economy and the sources of social tension– which sometimes implies a transitory cost to growth – and supporting the improvement in living standards which is also key to preserving political stability. The pendulum has gone too far in favour of the first goal recently, and some adjustment in the dosage is needed.

Chinese slowdown redux

For a change, investors may focus more on cyclical developments in China than in the United States, with questions on financial stability over there adding to the concerns. The last weeks have come with a steady flow of disappointing data releases. The PMIs fell into contraction territory in August in both manufacturing and services (see Exhibit 1), while retail sales and industrial production came out below expectations and decelerating from July. The slowdown in Chinese activity is starting to affect the performance of key economic partners. Trade data can be very volatile, but when smoothing seasonally adjusted German exports to China over three months, a steep decline has emerged since June (see Exhibit 2). This will hurt.

This is not the first time the world economy has to deal with a “bad patch” in China since it became a key source of traction for global trade. We have often commented in Macrocast on the role Beijing accepted to play in 2009 to offset the global recession. However, one of the consequences of China’s economic outperformance then had been a significant appreciation in its currency (+25% against the dollar from 2007 to 2015). Although the government strategy at the time was – already – to rebalance its economy towards domestic demand and consumption in particular, China’s export performance had started to deteriorate markedly, enough to take the manufacturing sector and domestic investment along. In August 2015 – when China stunned the market with a surprise devaluation in its currency – its manufacturing PMI had fallen to 47.1. Moreover, on the domestic side the post-2009 stimulus combined with the emergence of mass access to financial markets had pushed the valuation of assets unsustainably high, resulting in a steep correction of the equity market in the summer of 2015.

The impact of the 2015 “Chinese bad patch” was visible on the German economy. We can build an illustrative counterfactual German GDP by keeping for 2015 the average growth rate in German exports to China observed over the previous 10 years (14%), instead of the actual data – it troughed at -8.3% in Q3 2015. Using this simple approach, the Chinese slowdown directly shaved 0.3% off German GDP growth in 2015 (see Figure 3). It is probably a conservative quantification, since this calculation does not consider the second-round effects from lower Chinese demand on German exports to third countries and on German investment and employment. Since 2015, the Chinese market has become even more important (see Exhibit 4). The same shock today would thus mechanically leave a deeper imprint on Germany’s growth rate. Losing roughly half a point of GDP to a Chinese slowdown looks small when compared to the massive gyrations in GDP observed since the beginning of the pandemic, but it would be significant in normal circumstances given the “cruise speed” of the German economy (its potential growth rate does not stand markedly above 1%). In a first-round view, the replication of the 2015 “bad patch” would only have a marginal impact on the other big Euro area economies which remain much less reliant on the Chinese market, but they would quickly feel some consequences of a less dynamic German export machine given the intensity of trade integration in the EU.

This time Chinese exports are one of the rare bright spots in the Chinese data flow and there is no pressing need to change the FX regime, but otherwise the resemblance in the trajectory in soft data and some features of market turmoil between the current slowdown and the 2015 is uncanny. Your humble servant remembers the kilometers of op-eds hastily written at the time arguing the Chinese economy was in for a long and painful adjustment. However, with a few fits and starts, by the spring of 2016, the improvement was significant. We consider that this time again Beijing’s policy space is wide enough to re-start the economy quite swiftly. The Chinese government must constantly find the right dosage between addressing the imbalances of its economy and the sources of social tension – which sometimes implies a transitory cost to growth – and supporting the improvement in living standards which is also key to preserving political stability – its ultimate goal. Some adjustment in the dosage is needed.

Time to hit the “pause” button?

The current loss of altitude in Chinese domestic demand is largely self-inflicted. We’ve been discussing in Macrocast since the middle of last year Beijing’s choice not to “over-stimulate” in response to the pandemic crisis, which has resulted in a lingering weakness in consumer spending. The cyclical cost of the Chinese government’s focus on containing runaway leveraging behaviors may be too high.

The interplay between cyclical and financial stability concerns is always key to understand Chinese policymaking. In 2015, some domestic policy actions contributed to ignite the market downturn, for instance a probe into the interbank market to curb leverage, followed by a clampdown on margin trading in the stock market, not dissimilar to today’s crackdown on some speculative activities. Beyond the short-term relief it triggered for Chinese exporters, the currency devaluation of 2015 was presented as an essential step in a process of partly liberalizing the capital account and moving towards a more market-based management of the currency which was itself a key plank of the wider economic reformist agenda at the time. This was de facto saluted by the IMF which included the Chinese currency in its basket of reserve currencies in 2016. 

Not all of the ongoing slowdown can be traced back to policy decisions – the resurgence of the pandemic in China triggering the return to tough mobility restriction measures on a localized basis of course played a role – but restraining policy support since 2020 as well as the ongoing volatility-inducing regulatory push are no doubt complementary aspects of a conscious strategy. What is the current policy agenda? Our colleagues Aidan Yao and Shirley Shen have just written a very compelling piece on the recent regulatory sweep in China, with action in four different realms: (i) de-risking the economy; (ii) ensuring fairer competition; (iii) better controlling data and (iv) promoting social equality and addressing China’s demographic challenges. Their common denominator is that they all respond to the Chinese leadership focus on “common prosperity” in their search for a more inclusive and social stability-supporting economic model which may imply some sacrifice on intensive growth. To take a concrete example, China’s property boom has of course boosted growth, but far-rising home prices are contributing to inequality and social tension. Curbing unfettered growth in this sector goes combines political and financial stability objectives .

In our view, beyond the political preferences expressed in the “common prosperity” strategy, it may also be that the Chinese leadership is thinking hard about ways to avoid the fate of Japan 30 years ago. The parallel has its limits of course – Japan is a full market economy which remained a strategic ally of the US even at the peak of their economic rivalry – but there are still some lessons for China. Japan’s remarkable economic catch-up in the 1960s and 1970s seemed to threaten the US economic dominance at home, and it is striking how the same texts deploring the loss of the US economic substance to Japanese competitors in the 1980s could be re-used almost word for word today, simply substituting China for Japan. This seemingly irresistible march was however stopped when the accumulated domestic imbalances, notably in the real estate sector, triggered the financial crisis of the late 1980s, ushering in 30 years of unconventional monetary policy to deal with the debt transfer from the private to the public sector.

It is in this context that we think we need to consider the Evergrande issue. This is the second biggest real estate company by sales in China, which has run USD300bn of liabilities, and which according to Bloomberg is not going to be able to meet its debt obligations on 20 September. The Financial Times reported that local authorities have already refused to bail out the company. The editor in chief of the state-backed “Global Times” opined last Thursday that the central government should not intervene and let lenders deal with the situation, which has been interpreted in the market as an indication that Beijing is not going to help here. 

Still, dealing with moral hazard in times of cyclical weakness is a delicate art. While Beijing seems to be ready to send a “warning shot” to other leveraged players in the real estate sector, we suspect the authorities are also keen to avoid systemic contagion, especially as the economy as a whole is softening. Beyond the individual fate of Evergrande, the Chinese government directly controls more levers than its Western counterparts, especially via the banking sector. In a nutshell, the correction of excess in the real estate sector will have systemic consequences only if the Chinese government allows it.  All this would be consistent with a shift to an accommodative monetary and policy stance and some postponement of the next steps of the regulatory push.

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China is slowing down, but it has ample policy space to re-start