China is once again causing severe headaches for global investors.
Until recently, the economy was coping well with a tightening in financial conditions, designed to reduce speculation and excessive leverage in the financial system, especially among shadow banks. In early 2018, China remained a zone of firm growth in an emerging world that was clearly reacting badly to the rising dollar.
However, the very weak domestic demand data published in May have shaken market confidence. Consumption and investment appear to be slowing. Deleveraging, it is feared, might cause a recession in domestic demand, just at the moment when US tariffs on Chinese exports will weaken the foreign trade sector. Chinese equities have dropped 23 per cent from the peak and the renminbi has fallen 6 per cent against the dollar.
So is the Chinese zone of stability now becoming a new source of idiosyncratic risk to the global economy? This is what happened in 2015-16, when a sharp drop in China’s growth rate led to a flood of capital outflows, followed by a currency devaluation, strains on the liquidity of the financial system and intense concerns about global deflation.
China became a big part of the problem, not part of the solution, and these strains continued until the Federal Reserve postponed its plan to normalise US monetary policy.
Fortunately, however, there are significant differences between the present situation and the crisis of 2015-16.
First, the economy is not as weak. The decline in domestic demand in May very likely exaggerates the risks of a big slowdown in investment and consumers’ expenditure.
The drop in retail sales was caused, in part, by the timing of public holidays and a postponement of car purchases ahead of the scheduled cuts in import duties in July. Consumption growth has probably dropped by about a percentage point this year, but consumer confidence and the labour market remain buoyant.
Meanwhile, the slowdown in fixed asset investment, which triggered market concerns, seems to be mainly related to the shrinkage of the shadow banking sector. While it is true that infrastructure investment is slowing markedly, this can quickly be reversed by an easing in fiscal policy in the second half of 2018. In addition, there is more scope this time to ease monetary policy without losing control of the exchange rate (see box below).
The weakening in the latest indicators of domestic demand has clearly affected market sentiment, but in practice they do not track the business cycle very well. The Fulcrum nowcasts and the Goldman Sachs activity trackers continue to report that underlying growth remains well above 7 per cent. Activity growth is expected to slow from here, but — in contrast to 2015-16 — the fiscal and monetary authorities probably remain in control of the situation.
Furthermore, while the imposition of US tariffs on China’s exports is a clear and present danger, the scale of the impact on the growth rate needs to be kept in perspective. Even an extreme escalation of the trade war would probably reduce China’s growth rate by less than 1 per cent per annum.
In summary, a China-specific shock to global stability does not seem very likely at present.
China’s monetary stance is often difficult for foreigners to comprehend. Policy relies on several instruments simultaneously, including interest rates, quantitative controls on credit, sterilised forex intervention and directives to banks and other financial institutions.
Although the NPC announces formal targets for gross domestic product growth and inflation, the PBoC’s intended stance of monetary policy remains somewhat obscure, even to the IMF. It is also subject to political direction.
While these instruments give the PBoC effective control over domestic monetary conditions, the opaque framework often confuses market participants.
The long-term objectives of Yi Gang, the new governor of the PBoC, are to open China’s markets, to shift policy away from direct controls and towards interest rate control in a more liberalised financial system, and to maintain financial stability. However, that will take many years to achieve.
Until early 2018, the stance of monetary policy was clearly tightening. Interest rates were rising, growth in shadow bank credit was falling rapidly, and the exchange rate was appreciating. However, the slowdown in domestic demand, the threat of US tariffs and clear signs of stress in Chinese credit and loan markets have led to a marked change in stance.
On June 20, the State Council announced that monetary policy would be eased, thus underlining that the authorities’ strategy to reduce leverage and improve the quality of growth is still subject to a downside limit on growth of about 6.0-6.5 per cent.
The PBoC swiftly reduced reserve requirement ratios and policy interest rates in late June. The cut in RRRs is intended to finance a rise in bank lending to small enterprises, which have been squeezed by the drop in shadow banking. In addition, debt/equity swaps are being encouraged to reduce corporate leverage ratios.
This easing in the monetary stance has resulted in a sharp decline in the renminbi exchange rate, especially against the dollar. The PBoC has specifically denied that this is intended to offset the effects of US tariffs on China’s exports, but these claims should be treated with considerable scepticism.
Because of the new system of exchange control introduced in 2016, the latest burst of capital outflows is not sufficient to stop the PBoC from easing monetary policy further, should this prove necessary. With inflation stable at 2 per cent, real interest rates still in positive territory, and scope to slow the reduction in leverage if necessary, there is plenty of room to ease monetary conditions.
Goldman Sachs calculates an overall indicator of China’s financial conditions (FCI), including interest rates, credit and money growth, credit spreads, asset prices and the exchange rate. Overall, financial conditions are about 3 percentage points tighter than 18 months ago. This may explain the recent slowing in domestic demand, but the FCI is expected to ease sharply in the near future.