China's economy in Q3: Negative effects of trade conflict are increasingly measurable
MERICS Economic Indicators
Anxiety rises as GDP growth continues to slow
China’s economic slowdown continued over the third quarter of 2019, with real GDP growth falling to 6 from 6.2 percent in the previous quarter. The minor uptick in key macroeconomic indicators seen towards the end of the second quarter proved to be short-lived.
The Chinese government has continued to roll out support measures to shore up growth, but their effectiveness is questionable as they have failed to lift either business or consumer sentiment. The measures include cuts in corporate and personal taxes and fees worth around 1.35 trillion CNY in the first seven months of this year. Premier Li Keqiang has announced further tax cuts totaling 2 trillion CNY by end of the year. The People’s Bank of China (PBOC) announced further reductions to the banks’ required reserve ratio (RRR), effectively freeing up more liquidity. The weaker USD/CNY exchange rate has helped offset some of the negative effects of the ongoing trade war with the United States. Continuous expansion of fiscal and monetary stimulus has cushioned against the economic slowdown, but growth continues to fall.
In 2019 the negative effects of the trade war have also become increasingly measurable in the manufacturing sector. The year was, so far, also marked by a deteriorating domestic and external economic environment: it saw rising consumer inflation, falling corporate profits, softening private investment, continued risks in the financial sector - including in local government finances. The slowdown is beginning to expose regional and industrial weak spots.
Despite the increasingly evident slowdown, China’s growth rate is still too high for sustainable economic development and needs to come down further to facilitate structural rebalancing of the economy with a stronger emphasis on the private sector, innovation and services. GDP growth for 2019 is still within the government’s target range of between 6 and 6.5 percent. However, as growth now risks sinking below 6 percent, Beijing is concerned to prevent the deceleration from happening too fast.
China’s leadership is likely to get increasingly anxious as the economy’s resilience is put to the test. More stimulus measures can be expected in the coming months. It will also be a crucial and testing time for the private sector. If private market players do not respond favorably to government stimuli, there is likely to be yet further expansion of state control over the economy. It looks as if the most challenging times are yet ahead.
The MERICS China Confidence Index (MCCI) measures household and business confidence in future income and revenues. The index is weighted between household and business indicators. It includes the following indicators: stock market turnover, future income confidence, international air travel, new manufacturing orders, new business in the service sector, urban households’ house purchase plans, venture capital investments, private fixed asset investments and disposable income as a share of household consumption. All components have been tested for trends and seasonality. The MCCI was first developed in Q1 2017.
Focus topic: Currency depreciation
China will not be able to use yuan depreciation to shield its export sector from US tariffs
By allowing its currency to slide China has partially cushioned itself against the damage caused by the trade war with the United States. Letting the yuan weaken has moved the cost of tariffs away from China’s exporters, though it has not removed them completely. However, it has eased the pressure on corporate profits and employment levels, two of the pillars supporting China’s social stability.
The cost has been shifted onto China's external finances, making it more expensive for the country to import, invest abroad, and service foreign debt. There is not much room for further controlled yuan depreciation as the parts of the economy taking the costs have limited ability to bear them. If China’s currency depreciates further, financial markets may react with large scale sell-offs of CNY-denominated assets.
The yuan has depreciated in the past year. The market has sold yuan whenever the trade war has escalated. Announcements of tariffs cause the yuan to slide, while news that trade talks are progressing sees it strengthen. Overall, there has been more escalation in trade tensions than reconciliation. The bellicose trend, combined with a slowing Chinese economy, means the downwards pressure on the yuan has been too high.
The People’s Bank of China (PBOC) does not appear to have resisted the pressure. They have avoided selling foreign currency reserves, which would have been one possible response to pressure on the yuan. China’s foreign currency reserves increased by more than 27 billion USD in the last year. Instead, the PBOC has been careful to move its daily dollar fixing rate gradually with the market, while carefully managing capital outflows.
The only time the PBOC appears to have lost control was in August when the USD/CNY rate breached 7 CNY per US dollar. At that point, both the onshore and offshore yuan diverged significantly from the central bank’s fixing rate. At the start of the trade war in early 2018, the CNY traded at 6.5 per USD: it now trades around 7.1, a depreciation of 8.5 percent.
A weaker currency has ensured China’s exports only contracted slightly. In September, China’s year-to-date exports had fallen by 0.1 percent. By supporting exports, China’s authorities have kept some of the negative effects from the trade war from causing instability. This was an especially important goal ahead of the 70th anniversary of the founding of the People’s Republic of China (PRC), though it is a policy priority at any time.
However, as allowing the yuan to depreciate merely shifts the cost of US tariffs, the major burden is likely to be borne by:
The government. A sliding currency hurts China’s external purchasing power, which means that economic foreign policy becomes more expensive. Projects such as the Belt and Road Initiative (BRI) global infrastructure network, or acquisitions of foreign tech companies, are becoming more costly. Depreciation is also a setback to the goal of internationalizing the yuan, as the market has lost some confidence in the value of the currency.
Corporates. Many will suffer due to depreciation. Chinese companies import enormous amounts of USD-denominated commodities such as oil and gas. They have also shown a large appetite for acquiring foreign businesses in recent years. All these things are becoming more expensive. Furthermore, Chinese companies have been steadily increasing their exposure to foreign currency denominated debt. Servicing these debts will be increasingly difficult as the yuan depreciates.
Consumers. They will feel the costs in two ways. First, imported goods will become more expensive. Second, currency depreciation can cause the money supply to grow, creating a greater risk of inflation. If exporting firms sell dollar earnings to the PBOC then the domestic money supply will tend to increase as the PBOC must print money. To stop this causing money supply and inflation to rise, banks were instructed to keep a large share of their assets in reserve. But this is no longer the case as reserve requirements are being reduced to support the slowing economy.
So far, there is not much room for further yuan depreciation. The government has started to backtrack on its economic foreign policy but continues to funnel considerable amounts into global infrastructure projects in the framework of its Belt & Road Initiative. Domestically, corporate debt defaults have not picked up. Rising living expenses may prove the most troublesome result: consumer price growth reached 3 percent in September, exactly at the target. Both food and housing costs are rising quickly. In September food prices grew by 8.4 percent. Earlier data from August saw the average house price in 70 cities surveyed by the National Bureau of Statistics increase by more than 9 percent. These price hikes are not so far driven by depreciation, but as time goes by, they are likely to be exacerbated by it.
The specter of capital flight further narrows the room for yuan depreciation. If investors begin anticipating more depreciation, or if they conclude that over-large losses have already been incurred, they may begin selling off yuan denominated assets. Capital controls currently prevent this outcome, but if the pressure becomes too great, the controls might not hold without draconian enforcement. If capital flight begins, a sharp depreciation would follow. China would then again have to spend its foreign currency reserves to defend the yuan as it did in 2015.
So far, the negative effects of tariffs that were imposed during the trade conflict with the US have an impact on China’s economy as a whole. But some sectors may not be able to handle much more pressure as they are facing difficulties of their own. Furthermore, if the market expects more yuan depreciation, then capital outflow pressures will grow, causing difficulties in the financial sector. If tariffs are not lifted or, even worse, if more tariffs are implemented, China will not be able to use the currency to shield the export sector.