China Watch – Gradual slowdown to resume

by: Arjen van Dijkhuizen

  • Data for May give mixed picture, point to resumption gradual slowdown
  • Strong import and export growth despite weaker global trade indicators
  • With US decision on Section 301 import tariffs nearing, tensions might flare up
  • We expect further, moderate CNY depreciation versus USD
  • Beijing tweaks its cautious tightening approach to prevent ‘overtightening’
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Latest macro data in line with gradual slowdown view

The Chinese economy started 2018 on a strong footing, although the activity data for May published today suggest that the well anticipated slowdown has indeed arrived. The economy has been supported by strong external demand and some rebound in real estate sectors driven by robust land sales. This has offset ongoing drags from targeted tightening and a marginal lower trend growth of credit. Moreover, in light of rising risks stemming from tensions with the US, Beijing softened its financial deleveraging campaign a bit. The authorities have e.g. cut bank reserve requirements, mainly to ease the pain for smaller institutions that rely strongly on wholesale funding. Going forward, we still expect the Chinese economy to resume a very gradual slowdown in the course of this year.

  

Full data set for May provides a mixed picture

The macro data for May published over the past weeks are quite mixed. The PMIs published in early June pointed to a somewhat improving picture. The official manufacturing PMI reached a eight month high of 51.9, while Caixin’s PMIs for manufacturing and services were stable. Imports and exports data also were strong (see below). However, the macro data for May published today were clearly weaker than in the previous month and below expectations. Industrial production growth slowed marginally, to 6.8% yoy (April: 7.0%). However, retail sales growth dropped by almosts a full %-point, to 8.5% yoy (April: 10.1%). And fixed investment dropped to a record low of 6.1% yoy ytd (April: 7.0%), driven down by slowing infrastructure spending. According to Bloomberg’s montly GDP tracker, the full data set for May translated into a marginal slowing towards 7.0% yoy (April: 7.2%), still above the official growth numbers.

Import growth accelerates further in May …

The consensus expectation (including ours) was for a material slowdown of China’s import values in 2018, reflecting a gradual GDP slowdown and fading base effects after a stellar 2017. That has yet to happen. If we look through the Lunar New Year distortions in early 2018, the general impression is that import growth remained very strong in 2018 so far. It reached a four-month high of 26% joy in May, confirming the resilience of domestic demand despite the ongoing financial deleveraging campaign. Import value growth (in USD terms) in the first five months of this year averaged 21% yoy, compared to 16% in full 2017. That partly reflects price and exchange rate effects. Still, own calculations suggest that estimated import volume growth has been even stronger than import value growth so far this year. Moreover, in CNY terms, import value growth has accelerated to 15.6% yoy in May. Import volumes of commodities (particularly iron ore and copper ore) also accelerated in May. All in all, while we raised our import growth forecasts for 2018, we still expect some slowdown in the second half of 2018 partly reflecting base effects.

  

… while export growth remains solid as well

Meanwhile, export value growth (in USD terms) has remained robust as well, despite signs that global trade volume growth is cooling amidst rising trade tensions between the US at the one side and China, the EU, Canada, Mexico etcetera at the other. Export growth was stable in May (12.6% yoy), and averaged over 13% yoy in 2018 so far, almost double the 2017 average. This strong external picture was quite broad-based. Export growth to ASEAN was the strongest at almost 18% yoy, but solid numbers were reported for the US (+11.6%), Japan (+10.2%) and the EU (+8.5%) as well. Meanwhile, the export subindices of both the NBS and Caixin manufacturing PMI improved in May, although Caixin’s version remains below 50 (49.2). All in all, the export numbers do not point to a weak external picture. Still, we expect some slowdown of export growth in the second half of 2018, even though we do not expect trade tensions between the US and China to run out of hand (see below). Meanwhile, with import growth continue to outpace export growth and given China’s promises to take action to reduce its bilateral surplus with the US, China’s surpluses on the trade and current account balances clearly trend downwards. We have lowered our current account balance forecasts for 2018 and 2019 to 1.0% of GDP (from 1.5%).

While risks of a large-scale trade war fallen since April, …

US-China tensions have eased somewhat compared to April, when the US threatened to impose 25% import tariffs on a cumulative USD 150 bn of Chinese exports. High level negotiations have continued and have reduced the risk of a large-scale, damaging trade war. In late May, both countries worked out some kind of truce, with China promising for instance to boost (mainly agricultural and energy) imports from the US. Moreover, the US softened its sanctions approach versus China’s fintech ZTE, to prevent a collapse of that company. However, all this does not mean that risks have disappeared. With domestic criticism rising following the ZTE case, the White House announced that a final list of (up to) USD 50bn of imports from China subject to 25% tariffs will be published by 15 June.

… tensions could flare up again if the US would indeed impose import tariffs

It remains to be seen how soon tariffs would indeed be implemented after the publication of such a list. US trade laws give the president the possibility to delay activation by 30 days and another 180 days, if negotiations are yielding sufficient progress. Should the US indeed proceed with these Section 301 tariffs it is likely that China will retaliate and will not stick to its promise to boost imports from the US. All in all, we still stick to our base scenario in which we assume US import tariffs on up to USD 70bn of Chinese exports and only a limited impact on the Chinese economy (see our scenario analysis published late April here). Longer term, we still think that issues regarding China’s treatment of intellectual property rights will be more difficult to agree on and could well linger on for longer, reflecting the strategic competition between the US and China on the technology front. In addition, the conclusion of the recent G7 Summit does not provide much comfort that trade issues between the US and its major trade partner will be resolved soon.

  

FX reserves have started falling somewhat again due to valuation effects

In 2015-16, China lost 25% of its FX reserves, due to rising capital outflows amidst CNY depreciation fears. Thanks to tighter capital controls and fading CNY depreciation expectations, FX reserves have risen for twelve consecutive months since February 2017, by a cumulative 5.5%. However, this pattern has changed so far this year, with FX reserves falling (although marginally) three out of the last four months. According to the State Administration of Foreign Exchange (SAFE), that mainly reflects the strong US dollar and rising interest rates. Going forward, we expect Beijing to remain able to keep FX reserves under control.. The current account surplus is falling, but the gradual financial opening of China paves the way for more net capital inflows over time (with mainland China being gradually included in global bond and equity benchmarks). Still, this financial opening may result in higher volatility in FX reserves and FX.

While EM turmoil has risen, we have kept our USD-CNY forecasts unchanged

Meanwhile, after appreciating by almost 10% versus the US dollar between late 2016 and mid April 2018, the CNY has lost some 2% versus USD again. That mainly reflects general dollar strength, amidst rising US rates and an accelerating US economy. Compared to other EM FX, the CNY has continued to do relatively well, in fact leading to some real effective appreciation. We expect a further moderate CNY depreciation versus USD in the remainder of this year and the next and have left our USD-CNY forecasts for end-2018 and 2019 unchanged at 6.50 and 6.70

Following a period of targeted tightening …

While CPI inflation remains subdued at 1.8% yoy (far below 3% target), PPI inflation rose to a four-month high of 4.1% yoy in May driven by higher commodity prices. Meanwhile, Beijing’s has extended its targeted tightening campaign in the first part of this year, fitting within the broader strategy to reduce systemic risks (a.o. from shadow banking). As in 2017, the PBoC has continued with mini hikes of policy rates for its open market operations and lending facilities, pushing money market rates higher. In the past months, rates for 7, 14 and 28 day reverse repo operations were raised by 5 bps (to 2.55%, 2.7% and 2.85%, respectively). This gradual monetary tightening is also reflected in Bloomberg’s Monetary Conditions Index. Lending growth is coming down, although stabilising since 2017. Beijing has also gradually reduced fiscal accommodation (shown for instance by slowing infrastructure investment). Federal and local authorities have also continued with tightening rules regarding a.o. housing (finance), local government (debt), asset management practices and liquidity management (for more background see our Short Insights, China’s cautious tightening approach published last week).

  

… policy makers have eased their approach to prevent ‘overtightening’

The PBoC has kept the benchmark 1-year lending rate at 4.35% since October 2015, as it does not want to aggressively tighten its monetary stance. What is more, Beijing has occasionally softened its approach to prevent ‘overtightening’ by supporting system liquidity and easing the pain for hard hit segments of the financial sector. For instance, on 25 April the PBoC cut the reserve requirement ratio by 100 bps, lowering funding costs for banks. And on 5 June, the PBoC added net CNY 204 bn of liquidity into the banking system through its Medium-term Lending Facility. In addition, in reaction to the weaker data published today, the PBoC has so far decided not to follow the Fed again and refrained from raising repo rates further. Also in the area of macroprudential regulation, recently implemented guidelines for asset management and liquidity risks have come in softer than the initial draft had suggested. All in all, we expect Beijing’s cautious tightening campaign and China’s gradual slowdown to continue.