The monthly data published at the start of the second quarter are fairly mixed and show no tangible signs of growth momentum improving in China. The GDP published for the second quarter has recently confirmed this sentiment. The slowdown at work since the start of the decade is continuing, but not accelerating. This may be reassuring in itself. There has in fact been a change in China’s growth rate over the past decade, as it concentrates on developing domestic demand; it is an era of more “qualitative, inclusive and innovative” growth. The extent of the slowdown is all the more difficult to measure as most of the available indicators are still based on the Chinese growth rate as it was in the past.
This slowdown is down to several factors; firstly, the rise in the cost of labour, encouraged by the expected ageing of the Chinese population and the cost of pollution. These factors are behind the ongoing shift in the Chinese economy. These far-reaching transformations resonate with the more difficult international environment, since the protectionist turn taken by the Trump administration, and the political determination at home to “take back control” of the economic sphere, while also taking action to limit companies’ debt. The combination of these three forces is causing weaker growth.
Now that this has been established, the scale of the slowdown must be assessed, and its consequences for the rest of the world.
What was the growth rate at the end of June 2019?
GDP growth was 6.2% year on year at the end of the second quarter of 2019. It was 6.7% a year earlier, far from the 10.2% recorded in early 2011. That said, the make-up of this growth is more reassuring, with a share of consumption that is far more in keeping with other major economies, and an increasingly normal contribution from investment.
The slowdown is unsurprising if we look at the monthly data… the PMI economic surveys published both by the NBS and by Caixin are very clear. The rebound in March was short-lived and manufacturing activity is still depressed. Most of the surveys’ components are heading downwards, activity and job figures included. The lion’s share of the slowdown can nevertheless be seen in the manufacturing sector, as is the case worldwide.
On the other hand, if we look at the sector breakdown of nominal GDP growth, the slowdown appears to be more evenly spread across all the sector components of growth, unlike in 2015-16, when it was concentrated in the manufacturing sector.
Manufacturing activity covers activities of various kinds that have varying growth profiles. A stronger rebound is apparent in sectors linked to infrastructure and consumption, for instance. These are sectors targeted by some of the support measures introduced over the past few months. Conditions are still depressed in semi-conductors, however, confirming the global trend in the sector.
Chinese external trade: a transformation with consequences for the rest of the world
External trade data, which are the most reliable as they can be verified by counterparties, confirm this state of affairs. Exports are sluggish, falling by 1.3% year on year in June, reflecting the slowdown in global demand that is weighing on demand for Chinese exports. More worryingly, however, imports are also sliding, by 7.4% year on year in June, this time demonstrating the weakness of domestic demand. For a number of years, the share of imports intended to meet domestic final demand has, indeed, greatly increased (59.6% of total imports). The slowdown in imports is also due to the return of a positive contribution from external trade to GDP growth. Data for the month of July confirm the trend; a very slow recovery of exports as imports continue to decline.
Exports to the United States, primarily of the products taxed since July 2018, accounting for a total of $250 billion, have significantly slowed. Firstly, sales have been redirected to other destinations, particularly Asia (South Korea, Taiwan and Vietnam), and also Mexico. Part of this redirection is probably because of a change in the production chain, with China exporting goods to be assembled then reshipped to the United States to third countries in order to evade the extra customs duties. The remainder is due to the refocusing of Chinese trade on new customers. For the last few months Chinese exports as a whole have been slowing down, as a result of slower global demand.
Remember that the share of exports in GDP has substantially decreased over the last decade. It has fallen from 37.5% in the third quarter of 2006 to 17.5% at the end of June 2019. The trade balance as a percentage of GDP was 8.9% at the end of 2008, and dropped to less than 2% at the start of 2018. This is a sign of China’s reduced dependence on the rest of the world.
The McKinsey Report “China and the world: inside the dynamics of a changing relationship” explores the link between China and the rest of the world according to eight dimensions: trade, firms, capital, people, technology, the environment and culture. It concludes that China’s dependence on the rest of the world has largely decreased, whereas the world is increasingly dependent on China. This is mainly the result of the refocusing of the Chinese economy on domestic demand.
The report notes, for example, that China’s trading behaviour is becoming more similar to the behaviour of the major economies, although strong barriers to entry remain in terms of capital, including the maintaining of a closed capital account and quotas for foreign investments. The degree of exposure to China of course depends a lot on regional proximity, the importance of commodities and capital flows, and the major economies are, for their part, less exposed to China, given the size of their domestic markets.
Exposure also varies depending on the sector of activity. China is highly integrated within the electronic capital goods sector’s value chain. These sectors are exposed to China on both the supply and the demand sides. The world is also still highly dependent on Chinese production in the light manufacturing sector and labour-intensive sectors. Likewise, the sectors upstream of industry are ever more dependent on China, with its industrial development; China accounted for 21% of global mining production between 2013 and 2017, versus 7% over the 2003-2007 period. This is especially true when it comes to rare earth metals; China was responsible for 95% of global rare earth metal production in 2011. These metals are vital for the manufacture of permanent magnetic devices, electric vehicles, wind turbines, high speed trains, luminescent materials for screens and medical scanners, amongst other things. It has already used this weapon in trade negotiations in the past, with the regulating of its export quotas from 2006. Note that President Xi Jinping visited some rare earth metal mines the day after US customs tariffs were increased on Chinese imports in May; this weapon will undoubtedly be used…
From the world’s factory to a leading industrial power
China is continuing to move into higher value industry, which is particularly apparent in the technology value chain. Past experience, in Japan and South Korea, for example, shows that, for this transformation to be successful, there must be four development focuses. Firstly, investments of a sufficient size must be made, basic technologies and know-how must be acquired, there must be a large market, and also an effective system for encouraging competition and innovation. China can draw on a high public investment capacity and a huge domestic market. It has yet to become proficient in certain technologies and to introduce an efficient legal framework. Its sometimes very high level of integration within global value chains is undeniably enabling it to make progress with its objective of acquiring knowledge and expertise. China can also count on its considerable human capital; it trains 4.7 million engineers a year, as many as the United States, Europe and Japan combined. Furthermore, the higher education graduate statistics show that it is the most popular area of study.
This drive to climb up the production chain is nothing new. The wish to develop research and therefore the country’s wealth goes back a long way. Deng Xiaoping said back in 1976 that: “strong production depends on the sciences”. Later, in 2006, President Hu Jintao stated that “science and technology are the backbone of China’s development strategy”. There have been many, successive research plans and programmes, ending with the most recent, “Made in China 2025”. The “Made in China 2025” initiative is the first of a three-stage plan aimed at making China a global industrial and technological power by 2049, the centenary of the People’s Republic of China’s founding. This initiative is about focusing production on innovation; in other words concentrating on quality rather than quantity, pursuing green development, optimising the structure of Chinese industry and promoting human talent. The aim is to completely modernise Chinese industry, and make it more efficient and better integrated so that it can get to the top of global production chains. The plan includes increasing the domestic content of components and basic materials to 40% by 2020 and 70% by 2025. China is therefore not concealing its very high ambitions, which have probably motivated the highly vigorous response from the US.
Although China is moving forward very quickly, it is still very much lagging in semi-conductors, which are vital for securing its autonomy in most high tech fields. This is a cause for concern for the Chinese authorities, as we have seen particularly after the announcement of measures to restrict Huawei’s activity. The US is unbeatable in this field, unlike in other sectors of activity where, although China is still a little behind in its development, it is able to work with other suppliers. Having said this, US companies in the sector need Chinese customers! Major Chinese corporations have often chosen to open research centres in the US to benefit from local talents. Restrictions on the repatriation of research work to China are now a considerable blow to Chinese research. The trade war between the countries is therefore centred on the technological field, where the position of global leader is at stake.
Economic policy at the service of industrial development
The main feature of the economic policy decisions taken since the summer of 2018 is support for the private sector, which is essential to this process of moving Chinese industry up the value chain. For instance, the measures aimed at reducing the tax pressure on companies by RMB 2,000 billion, through a VAT rate reduction mechanism, should encourage investment expenditure on research and development, to prompt innovation in new technologies. Note that these tax measures, which came into force in April, have not yet had their full effect. According to the tax authorities, at the end of May only 45% of the total tax allowance budget set aside for 2019 was effective. We’ll have to wait another few months to find out whether this will translate into extra profits and investment expenditure.
The private sector support aimed at through the various measures taken by the authorities since the summer calls for the boosting of infrastructure investment, which slowed significantly in 2018. At the end of June, investment in infrastructure grew by 4.1% year on year, after an average of 15% annual growth during the past five years. The measures announced to make it easier for local authorities to finance projects, through special bond issues, should start to produce results. The authorities’ proactive approach towards the “belt and road” initiative should be included in this infrastructure development drive, in the zones that were previously the most left behind, although the desire to increase Chinese influence on neighbouring countries remains a strong driving factor.
Household consumption: a key growth pillar
Trade tensions are also affecting Chinese households, directly for those working for export companies but, more generally, through the fall in confidence that they have triggered.
The share of private consumption in GDP growth has constantly increased over the last 10 years. This is the reality of the structural change at work in China. The last two quarters show a reduction in this contribution. Consumption, measured by retail sales, seemed to be holding up at the end of the first half, however. The retail sales published monthly have admittedly slowed. But a certain volatility sometimes makes these data and consumption in GDP terms difficult to reconcile. The rebound in retail sales in June may therefore be partially due to the growth in car sales. The change in the car emission standard at the start of July probably led to sales of cars sold through promotions during the last two months. The decline in sales recorded in July confirms this explanation. Income growth and buoyant loan origination, combined with tax measures, are still undeniable supports for consumption. Real estate, which seems resilient, is also a consumption support factor.
How will the authorities respond to the current economic conditions?
In this still difficult economic environment, the Chinese authorities should stay alert and take one-off action to avoid an excessive slowdown, as the People’s Republic of China ‘s70th anniversary approaches in October, which is a highlight of President Xi Jinping’s political agenda. They still have leeway in their fiscal policy, and in their monetary policy too, as the main central banks are making more accommodative noises. The PBOC is prioritising financing the private sector, and more specifically small and medium-sized companies, which have previously found it harder to find bank financing. But the PBOC will surely stay prudent, not wanting to create unlimited debt in the private sector. It should also endeavour to limit the banking system’s doubtful debt, particularly at regional banks, even though officially the ratios are very low compared with international standards. The PBOC and the banking regulation authority (CBIRC) have, for instance, taken over Baoshang, a bank established in Inner Mongolia, because of a “major credit risk”. This takeover is a rare event in the Chinese banking landscape and will be effective for one year. This episode resulted in a resurgence of tensions on the interbank market, which were quite quickly resolved by the PBOC’s generous liquidity support. The reform of interest rate formation remains on the agenda of the PBOC, the latter wishing to lower the rate of corporate financing.
What about the currency?
To end this review of the economic situation in China, let’s look at the latest currency developments. The Renminbi has responded every time the US’s position has hardened since the trade tensions started. Overall, the decline seems controlled, however. It bears no resemblance to the episode in summer 2015. This of course reflects the more efficient currency management policy, including the activation of the contra-cyclical factor, and the very effective control of the capital account, with strict rules governing residents’ capital movements, all helping to limit outgoing flows. However, after two months of growth in foreign exchange reserves, the latter fell by 15 billion dollars in July, a sign that downward pressure on the currency is rising as trade tensions increase.. The movementsof decline more marked were clearly political messages for the US, but the Chinese authorities do not seem to want to use the currency as a weapon in this war, but at the most, let the automatic stabilizers play. Yield spreads in China’s favour, as most of the main central banks opt for further monetary easing, argue in support of the Renminbi, as does the inclusion of Chinese assets in the main global indices.
To conclude, the Chinese economy is slowing, but not collapsing. This slowdown is the result of a considerable structural change in the Chinese economy, causing a change in its dealings with the rest of the world. The tougher trade relations imposed by the US are above all the country’s reaction to the movement of Chinese industry up the value chain, so that it is now competing with American companies in a growing number of sectors of activity. The strong presence of President XI Jinping and the Communist Party in the Chinese economy makes the likelihood of an excessive economic slowdown very low. The desire to extend China’s influ
