Three shocks: US protectionism, currency depreciation and weak financial markets
The Chinese economy continued to slow down in Q3 (+6.5% y/y in Q3 from +6.7% y/y in Q2) due to slower performance in the secondary industry. From a demand perspective, investment growth continued to decelerate while consumption remained resilient.
Trade remained strong as US corporates front-loaded orders in anticipation of further tariffs and weaker RMB helped to cushion the impact of recent US protectionist measures. We estimate that the 10% RMB/USD depreciation that occurred between March and September 2018 helped absorb an increase of cost of USD50bn due to tariffs.
Business surveys portend weaker growth in the next months. Both official and private Manufacturing PMIs have decreased compared to Q2 levels on the back of weak new export orders and heightened tensions with the US. Official non-manufacturing and private services PMIs indicate further strength helped by the resilience of domestic demand and proactive policies to promote services.
Looking further ahead, three big ticket items will likely shape the macroeconomic outlook for China: trade war threats, the movement of currency depreciation and depressed financial markets.
The stimulus therapy… or how to keep the (economic) ball rolling
In the short-run, economic growth will depend on a wide range of expansionary measures.
We pencil a general government balance below -4% GDP over 2018 and 2019. Expansionary measures, already at work, consist of tax cuts (for households, SMEs and innovative companies); export tax rebates and infrastructure spending have also been enacted. So far, we estimate that measures which have been announced represent c.2% GDP.
On the monetary side, the authorities have to deal with their traditional dilemma: boost growth without creating too much leverage and too much financial risk.
We expect financial regulation to remain relatively tight to keep shadow banking activities under control. A more stringent framework regarding the housing markets is expected to tame property-related risk going forward.
What will likely not be avoided is a continued rise of leverage. Non-financial corporate debt has already increased to 164% GDP in Q1 2018 (from 160% GDP end 2017); credit quality is deteriorating (NPL ratio up to 1.9% in Q2 from 1.75% in Q 2018). While this leads to an increase of financial risks, we believe that systemic risk is contained so far considering: (i) the large pool of saving of China (45% GDP); (ii) limited external debt (14% GDP); (iii) and a unique financial system configuration highly centered on the public sector.
Regulators have slightly eased financial conditions. The regulator (CSRC) has eased conditions for share buybacks as an attempt to revive financial markets. Combined with the support of China’s national teams and the PBOC, this new framework aims at providing a floor and ultimately boosting financial markets in the short run.
On trade, policies were twofold. On the one hand, China continues the opening of its domestic markets with tariff cuts for various products ranging from agri-food to textile and automotive.
On the other hand, it pursues gigantic trade initiatives such as the Belt and Road (already in place) or the Regional Comprehensive Economic Partnership (in negotiation).
Looking ahead, the impact of these measures is not visible yet in the real economy. We expect the impact to start kick-in from Q4 onwards. Here are our four calls:
- We maintain our GDP forecast for this year (+6.6%) and 2019 (+6.3%). The soft landing is expected to continue but the pace might be a bit more bumpy than expected. While trade contribution is set to slow on the back of protectionist measures and more moderate growth in global demand, domestic demand will remain resilient powered by stimulus.
- We cautiously expect: (i) a more constructive approach between China and the US in the coming months, as the Trump administration hinted the possibility of a trade deal; (ii) the negative impact of trade tensions with the US to be partially mitigated by expansionary policies and China’s efforts to increase trade partnerships with other economies (EU, Asia-Pacific markets).
- We project the RMB per USD to remain low in the near term (6.9-7RMB per US) in the context of trade tensions and divergence in monetary policy with the US.
- Last, on financial markets, the intervention of the national team (group of state-backed institutional investors) will likely provide some support in the short-run. The long-term outlook will heavily depend on China’s ability to reinsure private investors. A potential improvement of trade relations with the US next year, stabilization effects from stimulus measures could help. Yet, a resolution of structural issues namely a clear plan to stabilize corporate leverage and open the economy further will be critical.
Impacts for corporates: diverse sales outlook, re-leveraging and non-payment risk
The impact for corporates will transit through three channels: sales, debt and payment.
We expect domestic sales growth to remain broadly resilient. Private consumption remains firm (growing c.7% y/y in real terms) and fundamentals namely incomes, jobs and credit are still supportive.
Expansionary fiscal measures but also trade related measures to reduce import costs (through tariff cuts) will help to keep demand in-check and import related products at affordable price. We see some pressure points: (i) for sectors related to the housing sector as tighter regulation is set to hinder activity; (ii) exports due to the impact of the already implemented US tariffs.
The main risk for the next coming months will be the re-leveraging of the economy.
At the current pact, corporate debt could exceed 170% of GDP at the end of this year.
This would be a historical high and would erase all the efforts that have been put last year. This increase credit risk but it is also negative for private sector’s confidence.
Last, non-payment risk could increase as Chinese importers paying in USD dollar might see it difficult to pay their bill as costs rise due to RMB depreciation.
This would translate mechanically to a more moderate growth in imports.
Sector-wise, domestic consumption related sectors (consumer staples, healthcare, agri-food, e.g.) would still have some legs sustained by positive households fundamentals and fiscal stimulus.
A mixed outlook could be expected for sectors that are heavily related to global trade and subject to tariffs (electronic, automotive e.g.) as domestic sales will likely not be enough to compensate for slower exports sales (electronic) and higher tariffs (imported cars).
Last, (i) capital intensive sectors such as construction, machinery and equipment, (ii) basic raw material will likely remain under the radar as regulations related to the property market get tighter.