What’s new in the outlook on China for 2019?

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If there’s one thing about China that market observers tend to focus on it’s the level of GDP growth. In this article we take a look at the four main GDP components – net exports, government expenditure, investment and consumption – in judging what to expect in 2019.

Net exports: Sino-US trade war uncertainty

We should not expect any net export contribution to growth.

In our view, there are three potential outcomes for Sino-US trade relations in 2019 (with probabilities shown in parentheses):

  1. China and the US reach agreement by March 2019 (when the trade-war truce will expire) on settling all major issues and tariffs are rolled back (10%)
  2. Trade talks stall or become derailed and the 10% tariff rate on USD 200 billion of Chinese exports to the US rise to 25%; US President Trump threatens to levy 25% tariffs on all imports from China (30%)
  3. Negotiations continue beyond March with no further tariff escalation (60%)

The odds for these outcomes may change quickly, depending on the political tug of war between China and the US. Even under our base case scenario (3, above), Chinese net exports would likely not contribute to GDP growth in 2019, as they have largely been a drag on GDP growth in recent years (see Exhibit 1). Some forecasters even go so far as to forecast a current account deficit for China in 2019, though we are not that pessimistic.

Exhibit 1: China’s growth contribution by GDP components

Source: CEIC, BNP Paribas Asset Management (Asia), as at 18/12/2018

Government expenditure: fiscal support via tax cuts

The stimulus from tax cuts could amount to 0.9% – 1.6% of GDP, with cuts in VAT the main focus.

There is a new policy initiative for tax (particularly VAT) cuts to support growth. Tax reform started in May 2018 when Beijing cut some of the VAT rates by 1%, followed by a cut in social security taxes in September and an increase in the tax-free income thresholds and introduction of special deductions for individuals in October.

More tax cuts are expected in 2019 with the focus on VAT, which accounted for more than a third of total government revenues in 2017. Chinese corporate taxes average 67% of profits, far higher than many other countries. Furthermore, China’s VAT cuts are supposed to be permanent, so they should help stimulate investment[1].

The market estimates that the economic stimulus from the VAT cuts would range between 0.9% and 1.6% of China’s GDP in 2019. The tax cuts could push Beijing’s fiscal deficit to a projected 4.0% of GDP (versus 2017’s 3.0% and 2018’s target of 2.6%). But the ultimate impact on the fiscal deficit could be lessened by spending cuts[2] and/or the drawing down of fiscal deposits, which are estimated at RMB 2.8 trillion as of August 2018[3].

Investment: infrastructure and private investment recovery

Relaxation of the funding constraint on local governments should boost infrastructure investment, while policy-driven credit support may help private sector “animal spirits” to recover.

Infrastructure investment, with local governments accounting for over 90% of the total, started to stabilise in October 2018, while manufacturing investment has already been recovering after months of selective policy easing. Infrastructure investments are expected to continue to recover, albeit moderately, to about 10% year-on-year next year from the current 4.0%.

Private sector investment growth lost momentum in 2018 (Exhibit 2), in my view due to a structural downward shift in growth expectations (Exhibit 3) since President Xi took office in 2013 and changed the country’s policy objective from chasing growth quantity (the “old” China model) to achieving growth quality through structural reforms (the “new” China model).

The old China followed a supply-expansion development model, in which economic agents build/invest/produce first to expand supply that creates jobs and income. This model worked for more than 30 years when high growth rates created swift demand catch-up. But it broke down when President Xi took office and started implementing his “new normal” policy to keep GDP growth at 6%-7% a year and to push through structural reforms. This means an end to the swift demand growth capable of absorbing all the supply/production/investment excesses that have built up in the economy.

Exhibit 2: Fixed-asset investment by the private sector

Source: CEIC, BNP Paribas Asset Management (Asia), as at 18/12/2018

Exhibit 3: A structural decline in growth expectations

Source: CEIC, BNP Paribas Asset Management (Asia), as at 18/12/2018

To revive “animal spirits”, the private sector needs to adapt to the new China model and Beijing needs to implement genuine supply-side reforms to unlock the incentive for private investment. But in the short term, credit availability and profitability will determine the ability of firms to invest, so Beijing is trying to increase credit support for the private firms through:

  1. The use of the central bank’s re-lending facility to fund the private sector
  2. The imposition of lending targets on banks for private firms[4], and
  3. Discriminatory cuts in the bank reserve requirement ratio (RRR) whereby banks that lend more to the private sector will get above-average RRR cuts.

Consumption to benefit

Consumption upgrade to continue

Sustained, though moderate, income growth, improving household access to credit and continuing reforms focused on creating jobs and improving the social safety net should add to the above-mentioned policies to keep consumption growth resilient. The key downside risks are an escalation of the trade war and a deeper-than-expected downturn in the property market.

The long-term trend of China’s consumption upgrade should continue as average household incomes outside the rich cities approach and even exceed the rich-income threshold[5].

A new structural reform direction

Beijing looks set to start using ‘competitive neutrality’ as the guiding principle for state-owned enterprise (SOE) reform and industrial policy.

The OECD has developed this framework to guide a country’s structural reform and industrial policy based on the experience of developed markets, such as France and Australia, which also have SOEs. Its principle states that a public sector business or agency should not have any competitive advantage or disadvantage over the private sector due to its public ownership status.

Beijing intends to apply this framework to reform the SOEs so as to create a level playing field for the various players, including the domestic private sector and foreign firms. Potential focus areas include enhancing transparency, reducing subsidies and reforming corporate governance to separate the government from the business.

If implemented properly, this will also go a long way in reducing trade tensions with other countries. The main challenge, as always, is implementation. The hope is that the prevailing international trade pressure on Beijing to change its structural behaviour would lead to proper implementation of the competitive neutrality principle.

The bottom lines

Going into 2019, China is treading a fine balance between structural reforms that are deflationary and cautious policy stimulus to support growth amid the trade-war uncertainty. We expect GDP growth to slow to 6.2% year-on-year in 2019. Inflation is expected to remain benign at 2.5% year-on-year in such an environment.

Such a macroeconomic backdrop is positive for bonds. It seems that China’s bond market sentiment has turned from worrying about defaults to cheering about disinflation, as the yield on Chinese government bonds has fallen towards 3.0% from almost 5.0% a few months ago and corporate bond yields have also rolled over. The question is supply. While we expect most of the funding to come from provincial government bond issuance, thus expanding the Chinese ‘municipal government’ bond market – a development that international investors have been hoping for – Beijing can also tap its fiscal savings or cut spending to contain the expansion in its fiscal deficit.

Trade tension with the US is the biggest uncertainty hanging over China’s equity markets. Its impact falls not just on the exporters directly concerned but also on capex and employment/wages in export-related sectors, such as machinery, home appliances, automobiles and parts, and electronics. The consumer discretionary sector also faces headwinds under slowing economic growth exacerbated by the negative impact of trade. Expected policy easing should favour large cap and old industry stocks first before spilling over to other sectors.

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[1] Because the expected tax cut in China is permanent, it is not supposed to suffer from the Ricardian Equivalence, which argues that economic agents are forward-looking so if they receive a temporary tax cut financed by government borrowing, they anticipate future taxes will rise. Thus, their lifetime income remains unchanged and so spending/investment remains unchanged.

[2] If spending cuts are equal to the amount of tax cuts, there will still be a positive balanced-budget multiplier effect on the economy.

[3] These include unspent revenues, profits from land sales, levies or profit from state firms and bond sales revenues and other sources such as government fees. See https://www.bloomberg.com/news/articles/2018-08-10/china-has-a-stealth-410-billion-stash-to-boost-the-economy

[4] The CBIRC is mulling to introduce a “1-2-5” target to support the private sector, with loans to private firms accounting for 1/3 of new corporate loans at large banks, 2/3 at mid- and small-sized banks and 50% in the entire banking system in three years.

[5] See “Chi on China: Mega Trends of China (1): Domestic Demand for Financial Assets”, 5 August 2015.

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Chi Lo

Senior Economist for China

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