The slowdown in the US and eurozone economies continues to surprise the Federal Reserve and the European Central Bank, explaining their recent sharp turn towards dovishness. ECB president Mario Draghi coined another of his memorable phrases last week, saying that “pervasive uncertainty” meant downside risks, even relative to the central bank’s latest downgraded growth forecasts, were still predominant.
Policymakers in the advanced economies have uniformly attributed the downturn to “external” economic shocks, which is code for concerns about the loss of economic momentum in China.
Towards the end of last year, these concerns seemed wholly justified. China’s GDP grew by only 6.4 per cent on the official figures in the 2018 calendar year, the lowest growth rate in three decades. According to a recent study published by Brookings, the true rate of growth, on more accurate data, may have been 2 percentage points below that.
Furthermore, Chinese activity growth in the Fulcrum nowcasts nosedived to just 4 per cent in December. This triggered much of the slowdown in global growth, especially in the trade and manufacturing sectors.
So what has gone wrong with the Chinese growth engine in the last year? Two factors have been important: a shift in monetary policy towards deleveraging and a further knock to confidence from trade war fears.
Monetary policy shifted its focus towards deleveraging, especially in the shadow banking sector, which has been the main source of financing for infrastructure investment since the global financial crash in 2008.
In the 2018 calendar year, overall credit growth (known as total social financing) grew in line with nominal GDP, broadly as the authorities intended. But the effects on fixed-asset investment in state-owned enterprises were more severe than they meant them to be and, by the year end, investment growth had dropped to almost zero.
Small businesses have for years relied on lending from the shadow banking sector to finance expansion, so they were also badly affected by the authorities’ decision to squeeze that sector. The intention was to redirect lending by state-owned banks away from the SOEs and towards small private businesses, which represent the most dynamic source of new growth in the economy.
This shift has not taken place, in part because banks have been reluctant to lend to private companies against a background of rising debt defaults and declining business confidence. In addition, the demand for credit has been weak. The People’s Bank of China has made repeated attempts to encourage more bank lending to the private sector, so far with limited success.
Against this troubled domestic backdrop, the further hit to confidence arising from fears of a trade war with the US has clearly not helped. The imposition of new US tariffs on Chinese exports was a relatively limited event last year, reducing Chinese GDP by only about 0.3 per cent, according to several independent estimates.
But the increased intensity of tariff threats from the Trump administration late last year risked doubling this direct hit to GDP from trade, and adding an additional downside shock to domestic investment and consumption. The economy seems to have anticipated these shocks ahead of implementation, weakening domestic demand further.
Overall, the nowcast shows that activity growth fell by about 3 percentage points during 2018. At a very rough guess, about half of this may have come from the effects of the toughening in deleveraging policy throughout the year, with the rest stemming from fears of a greatly exacerbated trade conflict towards year end.
The question for 2019 is whether the easing under way in fiscal and monetary policy will be enough to promote an economic recovery, given the backdrop for trade policy emerging from the present round of Donald Trump/Xi Jinping talks. These have not reached a firm conclusion, but both presidents have strong domestic political reasons to avoid a major escalation of the conflict. Markets have already priced in a successful outcome and it seems reasonable to assume that the damage to economic confidence more generally will abate in coming quarters.
On the domestic policy front, premier Li Keqiang delivered the government work report at the National People’s Congress on March 5. Sometimes compared to the State of the Nation address by the American president, this report included a description of policy intentions for 2019, and economic objectives for the coming year.
Overall, the tone was consistent with Mr Li’s policy stance of several years. Although supportive of growth-sustaining measures, he is strongly opposed to a return to old-style demand management that would involve a blunderbuss increase in leverage, especially in the shadow banking system. In fact, he has already expressed concern that releveraging may have gone too far, given the very strong monetary and social financing data for January.
Instead, support for demand will be more nuanced, and probably more focused on fiscal policy, notably tax cuts, than previous stimulus packages. Although the official target for the budget deficit is only 2.8 per cent of GDP, compared with 2.6 per cent last year, there will be off-budget increases in local government bond financing and other measures that will boost demand. Overall, the fiscal thrust this year will probably be in the region of 0.5-1.0 per cent of GDP.
On the monetary policy side, the official target is to keep overall leverage in the economy unchanged this year, with total social financing growing in line with nominal GDP (ie 9.5 per cent). However, many independent economists think that this target will be exceeded by perhaps 2 per cent, allowing overall leverage to resume its upward trajectory, albeit at a slower rate than seen in earlier stimulus packages. That also seems to be the message from the latest monetary data.
Encouragingly, the latest nowcasts show that the economy has rebounded from the severe weakening recorded towards the end of 2018, and activity is back in line with Mr Li’s new target of 6.0-6.5 per cent growth in GDP in 2019. Assuming that there is no return to escalating trade wars, the worst may be over for the Chinese economy.