MERICS Economic Indicators Q2/2018
Credit tightening and trade conflict threaten growth
MERICS Q2 analysis: Chinese regulators face tough decisions
The onset of a slowdown of economic activity in the second quarter, which was reflected by GDP growth falling to 6.7%, coincides with the beginning of the trade war with the United States. After nearly a year of regulatory policy tightening, China’s deleveraging campaign as well as stricter environmental protection have started to affect the real economy. The consequences of an escalating trade war with the United States are not yet reflected in the current economic slowdown, but could accelerate it. As internal and external factors threaten to slow GDP growth more than the government might feel comfortable with, it puts China’s policy makers between a rock and a hard place.
It has become clear that tightening conditions are accompanied by economic pain. A shift in mood within the economy is already reflected in MERICS’s leading indicator, the MCCI, which remained below 100, indicating negative sentiment. Slower growth of key macroeconomic data has affected market sentiment, pushing down China’s stock markets, which have fallen 16% since the beginning of the year. The unfolding trade war could cause sentiment to deteriorate further. Following steady economic growth since 2016, the changing economic environment is a reminder that stable growth cannot be taken for granted.
The direct effects of the United States’ tariffs on economic growth are likely to be subdued as China’s export dependency has fallen considerably over the past years. However, the conflict’s indirect effects on the economy will likely lead to a less stable economic environment and pull down headline growth. Most notably the depreciation pressure of the CNY against the USD is increasing and the prospect of a return of capital flight looms. The external disruption will expose vulnerabilities within the Chinese economy just as China is attempting to address trouble spots.
But there are limits to how far the Chinese government can allow GDP growth to fall if it wants to deliver on its economic development goals. Over the next three years a minimum annual GDP growth of 6.4 percent is necessary for China to be able to double GDP and income by 2020 from 2010 levels. Growth can only fall by 0.4 percentage points before dropping below this critical base line of 6.4 percent. Although this seems unlikely for 2018, defending the minimum GDP growth in 2019 might force Chinese leaders to dial back on controls of credit growth and environmental protection.
China’s commitment to more restrictive policies will be tested as the trade conflict puts more pressure on the economy. At this stage a full-scale reversal of the deleveraging campaign seems unlikely as regulators remain vigilant in the face of financial risks. But as GDP growth is increasingly under threat, further policy fine-tuning can be expected. In this unpredictable policy environment, a return to a more expansive fiscal and monetary policy paired with stricter capital controls looks likely to be the Chinese leadership’s preferred defensive strategy.
The MERICS China Confidence Index (MCCI)
The MERICS China Confidence Index measures households’ and businesses’ 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 households’ consumption share of disposable income. All components have been tested for trends and seasonality. The MCCI was first developed in Q1 2017.
Focus topic: New Free Trade Ports unlikely to advance China’s economic opening
By Aymeric Mariette
China’s authorities have launched a new experiment to spur economic reform and opening. In April, the State Council announced a plan to establish so-called Free Trade Ports (FTPs) in Hainan by 2025. Local authorities in Shenzhen also released a document stating that an FTP should be implemented by 2020. The aim is to create an environment that is responsive to market needs, provides spaces for experimentation and that ultimately aim to strengthen the countries international competitiveness. But there is reason to be skeptical about the success of those plans.
For many years, the Chinese government has used specially designated zones for testing economic reforms in local experiments. The policies that proved successful would then be replicated nationwide. The best-known examples of this approach are the Special Economic Zones (SEZ) launched in the 1980s. Back then, SEZs like Shenzhen or Xiamen served as catalysts for liberalizing China’s planned economy and played a central role for China’s opening-up to the world.
Although China’s President Xi Jinping has re-centralized policymaking, testing reform measures remains an important tool for Chinese economic policies. At the end of 2013 the administration launched a series of “Pilot Free Trade Zones (PFTZ)” to honor the CCP’s commitment made at the 3rd Plenum of the 18th Central Committee, to let “market forces play a decisive role” in the Chinese economy. Shanghai was the initial PFTZ and by 2018 there were a total of 11.
Pilot Free Trade Zones: Broken promises of free capital flows and legal certainty
In this new round of reform, two experimental zones have raised high expectations among foreign investors as their goals to implement market-oriented standards are particularly ambitious: The Shanghai PFTZ aims at transforming the city into a world financial center. The Qianhai PFTZ in Shenzhen is intended to become a hub for modern service industry and for closer cooperation with Hong Kong. Like the SEZs before them, the PFTZs offer more liberal trade and investment conditions for foreign companies in a still fairly closed Chinese economy. In Shanghai a relaxation of China’s tightly controlled cross-border financial flows was on the table, as was the implementation of Hong Kong’s highly acclaimed legal system based on the Common Law in Qianhai.
However, so far this new round of experimentation has not met foreign investors’ expectations. In a survey conducted by the European Chamber of Commerce (EUCC) in June 2016, 83% of respondents stated they did not benefit from the reduced negative list system in the Shanghai Pilot Free Trade Zone, which lists sectors off limits for foreign investors. Capital controls were not fully loosened either. The experimentation with a free trade account, which enables companies registered inside the zone to freely move funds between the zone and overseas, was put on hold when central authorities cracked down on capital outflows in late December 2016. Neither was the attempt of Qianhai PFTZs to replicate Hong Kong’s business-friendly environment successful: The experiments designed to build an efficient rule-of-law system inspired by Common Law has not shown any result yet. As a result, foreign companies’ reception of the new zones remains muted: According to the latest available survey of the EUCC only 17% of respondents had established a presence in a PFTZ by 2017.
Free Trade Ports: one experimental zone inside another
President Xi’s call to establish Free Trade Ports “with Chinese characteristics” during the 19th CCP Congress was therefore met with skepticism in the international business community. The ports are to be created within existing PFTZs, effectively creating a new experimental zone within another. They are supposed to meet even higher international standards for trade and investment and are expected to compete with the successful free trade ports in Hong Kong and Singapore.
As of now, it seems unlikely that a Chinese FTP will be able to match the success of Hong Kong and Singapore. Both ports benefit from a smart combination of two types of regulations: First, they grant global shipping companies favorable tax and business regimes. Second, and that is maybe even more important considering the highly globalized character of the maritime business, they offer well-integrated financial and legal services, providing an efficient, open and free ecosystem for their customers’ trade.
The lack of reform progress in the PFTZs makes it seem unlikely that Free Trade Ports established under their tutelage will manage to provide efficient financial and legal services. A recent review by the central government of the policy experiments within the zones was not encouraging, with a few successful reforms in these two realms (see table).
One challenge to policy implementation is the lack of incentives to conduct bold reform. Compared to the 1980s local officials enjoy less policymaking autonomy. Moreover, the harsh corruption campaign during Xi’s first term has intimidated local officials fearful of being targeted for deviating from the Party line. The top-down approach has proven incompatible with the decentralized decision-making process that worked successfully in the initial FTZs.
China’s political system stands in the way of genuine economic freedom
The central government has realized that it has to loosen its grip in order to inspire genuine attempts economic reform on the ground. During the 19th Party Congress in the fall of 2017, the CCP leadership encouraged local officials to conduct bolder experimentation. This was also made explicit in the new guidelines to further reform inside selected Pilot Free Trade Zones published in May 2018, which called for further liberalization of the service sector. On June 30th 2018 Chinese authorities announced the introduction of a new negative list for all PFTZ, bringing the number of prohibited sectors for foreign investment down to 45 compared to previously 95.
The renewed efforts of Chinese authorities to deepen reforms are undeniable, but the question whether a truly efficient, open and free market can be built within China’s authoritarian system remains open. Institutionalizing corporate governance based on the rule of law remains one of the key difficulties as it conflicts with the CCP’s position above the law. Potential discrimination and policy ambiguity result in insecurity among foreign companies. For example, recent practice has shown that investment restrictions continue to exist even in industrial sectors not on the negative list. For example, in 2015, new restrictions appeared under the National Security Review experimentation launched in selected PFTZs in 2015. In the same way, authorities backtracked on liberalizing capital account controls in late 2016 when the government tried to rein in capital flight.
The establishment of Free Trade Ports may well inspire bolder experimentations in the Pilot Free Trade Zones. The PFTZs are and will remain important for policy experimentation. However, fusing China’s specific economic and political approach with international trade and investment standards remains an impossible proposition. It is highly unlikely, that free trade ports “with Chinese characteristics” will one day compete with Hong Kong or Singapore.
Economy: China’s economy faces headwinds despite stable Q2 growth
- Tighter government policies begin to impact the economy
- Impact of trade war still to come
- The Chinese economy continued its steady growth pattern, expanding by 6.7% in the second quarter and 6.8% in the first six months. For the past 12 quarters GDP has expanded on a remarkably stable course within a band of 6.7% and 6.9%.
- This leaves growth within a very comfortable range for a gradual and controlled deceleration to lower growth levels. For 2018 GDP growth is on track to reach the government’s GDP target of 6.5% to 7%, even in the face of a likely slowdown in the second half of the year.
- As in previous quarters the service sector outpaced other areas of the economy. It expanded at 7.8% compared to the first quarter, while manufacturing and construction were weaker, expanding by 6.4% and 4.0% respectively. Service sector growth was carried by transport and logistics (8.1%), IT services (31.7%) and business services (9.4%). All other categories, including real estate and financial services, grew below the average for services in the second quarter.
- In 2017 GDP was lifted by exports, but this has since been reversed. Net exports pulled down growth by 0.67 percentage points. Consumption increased its share in GDP growth composition, accounting for 78% in the second quarter, while gross fixed-capital formation remained relatively stable at 31.4%.
- The ongoing efforts to rein in credit growth have started to affect the real economy though slowing investment activity. Tighter implementation of environmental protection is affecting the manufacturing sector, although the direct effects are difficult to measure.
- In the months ahead, the growing impact of these policies can be expected to coincide with negative side effects of the trade conflict with the United States – from weakening exports, to currency depreciation and an increased risk of capital outflow.
- For the second half of the year, the slowdown is likely to be more pronounced. The comparable high GDP growth in the first half gives the government some flexibility in form of acceptable slower economic expansion. However, the stability-minded policy makers will want to avoid an uncontrolled and rapid deceleration.
- With the growth target for 2018 secured, the real challenge is to ensure stable growth for 2019. Further stimulus through investment as well as efforts to stabilize the CNY with the aim to guide a gradual and controlled deceleration to lower growth levels are likely.
International trade and investment: China’s export will feel impact of escalating tensions with United States
- Export and import growth remain solid in second quarter
- Steep fall in CNY exchange rate major policy concern
- The trade conflict between the United States and China has not yet affected trade flows which are growing at a faster pace than overall economic growth. Measured in USD, exports and imports grew by 12.3 and 20.5 % respectively in the second quarter. An unusual overall Chinese trade deficit in March has been reversed into a surplus. The initial round of tariffs imposed by the United States will not be felt until the next quarter.
- Stating that talks with China had yielded no significant concessions, the United States implemented tariffs on 34 billion USD worth of imports (a relatively small proportion of total imports) on July 6 with a focus on Chinese high-tech goods. China retaliated by imposing tariffs on an identical value of US goods. In response the United States threatened to further target 200 billion USD worth of Chinese exports.
- Since China imports much less from the United States than it exports it will quickly run out of products which it can subject to tariffs. Therefore, it is likely that China will begin adjusting its response, for example by targeting individual US companies.
- China’s dependency on trade has fallen from a peak in 2010, but exports still amount to 20 % of Chinese GDP. The United States is still China’s largest single export market, corresponding to roughly one fifth of all Chinese exports. In June alone China exported 42 billion USD worth of goods to the United States. This means that China will have to find other export markets if the trade conflict further escalates. But the size of the US market is so large that this will be a difficult task.
- China announced several adjustments over the second quarter to prove its commitment to open markets. The administration reduced the number of sectors barred for foreigners from 63 to 41. It lowered tariffs on some goods, particularly automobiles; and it relaxed foreign ownership caps in the automobile and financial sectors.
- Foreign direct investment into China increased by 4.1 % to 68.3 billion USD in Q2. This number included high-profile investments in high tech manufacturing from BASF and Tesla. The German car giant BMW also announced taking a majority stake in a joint venture with Brilliance.
- The CNY recorded the sharpest drop in its history in June. The exchange rate to the USD peaked around 6.3 in April and has now depreciated close to around 6.7. The fall is likely due to more than one reason, fears of the trade war played a part. A continued depreciation could cause severe problems: Firstly, China imports many key commodities, particularly oil. The prices of such commodities will increase if the currency depreciates. Secondly, if investors believe the currency will fall further they might begin selling off CNY-denominated assets to insulate themselves against losses, leading to capital flight.