China Watch – Pressures are building

by: Arjen van Dijkhuizen

  • After escalation of China-US trade war, there are plans to resume talks soon
  • Trade tensions have left their mark on China’s financial markets
  • We expect CNY to stabilise versus USD, but revise our end-2018 forecast down
  • July data provide further signs that the economy is cooling …
  • … although growth of exports and imports remains solid despite trade conflict
  • Beijing is tweaking its policy mix further to stabilise economy
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After escalation of China-US trade war, there are plans to resume talks in late August

US-China trade tensions escalated over the summer. On 6 July, US ‘Section 301’ tariffs on a first tranche of USD 34bn of Chinese exports came into effect, which were matched by China. On 1 August, against the background of a sharp CNY depreciation versus USD since mid-June, US President Trump announced to raise the proposed import tariff on another USD 200bn of Chinese exports to 25%, from 10%. This was followed by a Chinese counter-threat on 3 August, to impose 5-25% tariffs on USD 60 bn of imports from the US. On 7 August, the US announced that the second tranche of ‘Section 301’ tariffs on the remaining USD 16bn of Chinese exports will be imposed on 23 August. This was followed by a Chinese announcement to again retaliate in equal terms. Meanwhile, with a recent thawing in relations between the US and EU/NAFTA-partners, the focus of US protectionism has again switched to China. These dynamics are shaped by US domestic political considerations, in the run-up to the November mid-term elections and with bipartisan support to be tough on China. That said, this week it was announced that bilateral trade talks – that broke down in June – will resume late August, when China’s Vice Commerce Minister Wang Shouwen will travel to the US to talk with Under Secretary of the Treasury David Malpass.

  

Trade tensions have left their mark on China’s financial markets

Rising trade tensions have left their mark on China’s financial markets. Year-to-date, China’s stock markets are among the worst performing globally, only outperforming hard hit EMs such as Argentina, Turkey and Venezuela. After coming in in July, following a spike in June, the China’s 5-year sovereign CDS premium has risen over the past weeks (but remaining at relatively modest levels). In addition, the Chinese yuan has weakened versus the US dollar in recent months. This lays bare the policy dilemma faced by the authorities. At the one hand, Beijing has committed to a more market-oriented exchange rate regime (and may also tolerate some weakness to compensate for US import tariffs). At the other hand, verbal interventions by PBoC officials and recent measures to make it more costly to short CNY are illustrative of our view that the central bank will not allow too much depreciation versus USD. Beijing has learned clear lessons from the 2015-16 wobbles, when one-sided CNY depreciation fears triggered large capital outflows and pressures on FX reserves.

We expect CNY to stabilise vs USD but revise our end-2018 forecast down to 6.7 (from 6.5)

Since April of this year, the Chinese yuan has dropped by close to 10%. Initially this was driven by the recovery of the US dollar, but afterwards, heightened trade tensions between the US and China and concerns about the Chinese economy have also contributed to the weakness in the yuan. USD/CNY has approached the 2016 high at 6.9649. Chinese authorities signalled that the weakness of the yuan may have gone far enough. Recently, the offshore forward points (for 12 months) have increased because of speculation that authorities may restrict banks’ ability to lend yuan offshore. The surge in these forward points look sizeable on an intra-day basis, but if the trend of the last three years is taken into account this move has been very small. Does this mean that Chinese authorities will let the yuan depreciate further? We do not think so. The 2016 peak in USD/CNY is an important technical and psychological level. Moreover, the CFETS currency basket is close to the low set in 2017. If China were to let USD/CNY to rise above the 2016 peak and above 7, then it is likely that investors would increasingly become nervous about their China exposure. This could trigger outflows. We think that Chinese authorities would like to avoid sharp outflows because then it may lose control of the situation. China has shown that it is willing to let its currency be more driven by market forces, but there is a limit to this and we think that they are close to this limit. Therefore, we expect a stabilisation of the yuan and even a recovery in the fourth quarter of 2018. We have adjusted our end-2018 USD-CNY forecast to 6.7, from 6.5 (Georgette Boele).

  

July data provide further signs that the Chinese economy is slowing …

The July PMIs published earlier this month by NBS and Caixin came in weaker than expected and below the June numbers, both for manufacturing and services. The activity data for July published today also suggest that the slowdown continues. Growth of industrial production stayed at 6.0% yoy, below market expectations (6.3%). Retail sales cooled to 8.8% yoy (June: 9.0%), also below consensus (9.1%). Fixed investment slowed to a record low of 5.5% yoy ytd (June/consensus: 6.0%), driven down by weak public investment (1.5% yoy), particularly infrastructure. However, foreign trade data published last week were remarkably solid (see below) The property market also showed resilience. All in all, Bloomberg’s monthly GDP estimate was stable at 6.7% yoy in July, a bit below the 7.0% average for the first half of 2018.

… although growth of imports and exports remains solid despite trade conflict

Foreign trade data published last week were remarkably solid and better than expected, showing that the escalating trade conflict has not yet taken its toll on these flows. Export growth edged up to 12.2% yoy (June: 11.2%, consensus: 10%), confirming still strong external demand despite the rise of trade frictions. Import growth jumped to a six-month high of 27.3% yoy in July (June: 14.1%, consensus: 16.5%). In the first seven months of this year, imports grew by 21% yoy. That is even higher than the already strong growth rate of 16% for 2017. This partly shows that domestic demand remains relative solid, but also stems from the fact that exports remain strong as well (as processing imports are strongly correlated with exports). In terms of destination, imports from the EU and Germany were very strong at around 20% yoy (after a weak June). Growth of imports from the US also remained solid at around 10% yoy. That said, both imports and exports may well have been boosted by the frontloading of purchases to circumvent tariffs implemented per 6 July (and 23 August). Going forward, we still expect a moderation of export and import growth in the coming quarters, certainly (but not only) in case of a further escalation of the trade conflict with the US.

  

Beijing is tweaking its macro policy mix further

In a meeting on 31 July, the Politburo made clear the government will adopt a more proactive fiscal policy and prudent monetary policy to ensure stable economic growth. We expect the authorities to further relax its macro economic policy stance, tweaking (but not completely abandoning) its longer-term financial deleveraging campaign. In recent months, the PBoC has lowered banks’ reserve requirements and used its Medium-Term Lending Facility as well to safeguard systemic liquidity. Banking regulators have also taken steps to support bank lending to the real economy, particularly to SMEs. This has resulted already in an easing of financial conditions. We expect the government to relax fiscal policy as well, and expect the issuance of local government bonds to pick up in the coming months. Partly reflecting Beijing’s likely policy reaction, we expect China’s slowdown to remain gradual despite the escalation of trade tensions.