Since the peak in late January, Chinese asset prices have strongly underperformed their global counterparts. The equity market in local currency terms has fallen by a quarter compared to the US market, corporate bond defaults have rattled the fixed income market, and the RMB/$ rate has dropped by 8 per cent. It seems clear that a China-specific shock must have been to blame.
Many economists claim that the Chinese authorities no longer have the macroeconomic tools available to address rising recession risks caused by domestic deleveraging and foreign trade wars. They believe that fiscal and monetary policy may be out of ammunition. However, pessimists have been worried before in similar circumstances, and China has always been able to cope. The same is likely to be true once again in 2018/19.
The Chinese bear market this year is highly unusual, because it has not been accompanied by any downgrade in growth expectations for the economy as a whole. In fact, as asset prices have slumped, economists have actually been upgrading their consensus forecasts for GDP growth by about half a percentage point:
Nor has nominal GDP growth slowed to any great extent. Year-over-year growth was 9.8 per cent in 2018 Q2, compared to only 6.5 per cent in the trough of 2015, when deflationary forces appeared to be taking control. This time, inflation is steady.
Although activity growth has not been slowing overall, deleveraging in the shadow banking sector, following the new economic strategy outlined last year, has led to a greater-than-expected slowdown in infrastructure investment and to much lower revenue growth in the financial sector.
The initial decline in equities was triggered mainly by fears that the deleveraging strategy was biting harder than intended. New issues in the corporate bond market dried up, and the flow of credit to households and small businesses outside the SOE sector tightened significantly.
In the latest bear phase, however, broad credit growth has started to recover and the main cause for increased economic pessimism has been greatly increased trade hostility from the Trump administration. This is now getting much worse.
Last week, news reports from Washington carried contradictory stories about an imminent intensification of the trade war against China. This reflects a deep fissure between hawks (Lighthizer, Navarro and the president himself) and doves (Mnuchin, Kudlow) about the next move.
Looking ahead, there is a wide spectrum of conceivable outcomes. Possible, though unlikely, is a resumption of meaningful trade talks between the US and China, resulting in a comprehensive new trade agreement. This would follow the precedent of the apparent progress being made in recent Nafta talks. However, it seems more likely that the trade conflict continues to escalate over a long period ahead.
American concerns about Chinese economic policy are not confined solely to the Trump administration, and these concerns encompass industrial strategy as well as “unfair” practices relating to foreign trade. As the FT’s Gideon Rachman argues, it will be very difficult for President Xi to allay these US concerns without abandoning the core principles of his own economic strategy.
The most likely next step is the imposition of further tariffs, initially at 10 per cent, on another $200bn of Chinese exports to the US, with the announcement likely very soon. Following that, hawks could argue for 25 per cent tariffs on a further $267bn of inbound trade, thus covering virtually all of China’s exports to the US.
While this degree of escalation seems quite likely, the direct economic impact on China could be less than generally supposed. A recent estimate by Morgan Stanley economists is fairly typical of many such studies recently published. It suggests that the impact of the tariffs expected on the next $200bn of Chinese exports will be to reduce GDP growth in China by about 0.5 per cent, much of which can be offset by policy changes in China itself. This is similar to the PBoC’s official estimate. It would represent a significant adverse shock, but not a game changer, for Chinese growth.
In the fairly likely event that the trade war intensifies further in the next couple of years, could Chinese demand policy still deliver enough of a stimulus to cope with the shock?
In the two previous foreign shocks in 2008-09 and 2013-15, fiscal policy was eased substantially via infrastructure spending, and monetary policy contributed via rapid expansion in credit flows from the shadow banking sector. At times, these two factors were difficult to disentangle.
Sceptics about China argue that fiscal expansion is losing effectiveness because public debt is high, the shadow banking sector is now deleveraging sharply, and the responsiveness of economic activity to each unit of credit expansion is falling.
This is true to some extent, but it does not completely rule out a return to off balance sheet fiscal expansion if the authorities are willing to delay their objectives for restricting credit growth. Fiscal policy will ease for seasonal reasons in the second half of 2018. The latest monetary data for August suggest this is already happening, and this should be reflected in some recovery in fixed investment before the year end. A much larger fiscal boost would be available if needed in 2019.
Turning to monetary policy, there may be more scope for the PBoC to respond this time by lowering domestic interest rates. Deleveraging policy has now been relaxed, and broad-based credit growth has started to recover.
Furthermore, in the 2015/16 crisis, attempts to reduce rates were hampered by large scale capital outflows and concerns about uncontrolled devaluation. Since then, tighter capital controls have stemmed private sector outflows, and have enabled the PBoC to reduce interest rates independently of the actions taken by the Federal Reserve. The recent major divergence between Chinese and US rates is a new factor which gives more monetary ammunition to the Chinese authorities.
Up to now, a moderate policy easing has been able to handle a moderate-sized economic shock. The Chinese authorities remain (just about) in control.