Feature Stories | Aug 13 2018
This story was first published for subscribers on August 2 and is now open for general readership.
A trade war, if that is what is to eventuate, will do little to help a Chinese economy already showing clear signs of slowing.
-Data showing easing growth
-Targeted stimulus implemented
-Trade war looming
-IP remains the stumbling block
By Greg Peel
In the June quarter, China’s economy grew by 6.7% year on year and the US economy grew by 4.1%. On face value, China still looks like the winner, except that 6.7% was a drop from the March quarter’s 6.8% and 4.1% in the US was up from 2.2%.
And while China’s economy is set to soon exceed that of the US in size, the US remains a far more mature economy for which 4% growth is very strong, while a still maturing China has seen its growth slow from double digits earlier in the century. The rate of growth of a maturing economy will, by default, slow, given output in dollar terms will still grow but will represent a diminishing percentage growth rate, but recent data indicate nevertheless that the Chinese economy is notably slowing.
The Chinese government has long been trying to reduce China’s reliance on exports as a driver of GDP and instead promote domestic consumption, as the wealth of the country’s population increases. Consumption weakened in the June quarter. Fixed asset investment (infrastructure, property development) and industrial production shrank further due to a push to reduce debt.
Retail sales may post a first ever single digit growth rate this year (since records began), suggests Singapore’s DBS Bank. Retail sales had grown in excess of 10% (year on year) every month since January 2004 with one exception, but the March quarter this year saw 9.8% and June 9.4%. Industrial production growth fell to 6.7% in the June quarter from 6.8% in March.
Fixed asset investment growth plunged to 6.0% in June from 7.5% in March. Real estate investment in particular fell to 9.3% growth from 10.4%.
Trade also disappointed in the June quarter, DBS notes. Growth in exports fell to 11.9% from 17.3% while import growth remained flat only because higher oil prices offset slowing domestic demand.
One might point to the imposition of trade tariffs by the US and tit-for-tat from China, but to date the dollar value of trade upon which tariffs have been imposed on either side is relatively minimal.
But that may be set to change.
Some Good News
2016 and 2017 were two strong years for China’s property market. Analysts had expected 2018 would be the year when property data rolled over. But as Citi reports, this has not been the case.
Property sales in the March quarter (June quarter data pending) grew by 3.3% year on year despite Citi’s forecast of an -8% decline for 2018. Property starts rose 11.8% against Citi’s 5% full year growth forecast. Land purchases, which lagged significantly early in the year, rose 7.2% in the March quarter against Citi’s 6% full year growth assumption.
Citi points out that Chinese property data are of particular importance to metals markets. A widely followed measure of metals demand is Chinese floor space starts. These were up 8.1% in 2016 and 7.4% in 2017 and, as noted, 2018 has begun with 11.8% growth year on year.
Property and associated activities account for around a third of steel and base metals demand in China, Citi notes.
Of concern for global markets at present is the elevated level of Chinese debt. Mind you, Chinese debt has been a concern for a decade. Remember the old “hard landing” versus “soft landing” debate? That went on for years, but eventually faded as each year went by with China’s economy stubbornly refusing to land hard.
It all began with China’s massive fiscal stimulus package implemented late in 2008 in response to the GFC. Beijing took the fiscal route before the Fed chose the monetary route early in 2009 with the introduction of QE. But Chinese debt growth has remained a concern ever since.
Typically, stimulus, be it fiscal (government) or monetary (central bank) is implemented at a time the economy is in recession or at the very least slowing, while strong economic growth leads to monetary tightening and fiscal restraint. Hence the Trump Administration has been criticised by its detractors for substantially increasing the US budget deficit through tax cuts and infrastructure spending plans at a time the US economy is growing strongly late in the cycle, and government debt is already at elevated levels.
History will show whether Trump’s assumed outcome – resultant strong economic growth ultimately leading to debt reduction – will be achieved, but in the meantime, Beijing has to wrestle with needing to stimulate a slowing economy without pushing debt further over the line. How can this be done?
The answer is carefully, based on specific targeting.
Two weeks ago Chinese premier Li Keqiang signalled at a state council executive meeting that monetary and fiscal stimulus will be further fine-tuned to boost domestic demand. But as Citi notes, the official announcement was careful enough as to not imply a large stimulus package.
The government had earlier lifted the proportion of allowed R&D expenditure tax deduction to 75% for medium and small-scale technology enterprises. That allowance will now be extended to all enterprises, equating to a tax cut. Beijing has also called for an acceleration of local government bond issuance to promote infrastructure projects.
Tax cuts and infrastructure spending. Sounds familiar.
But this is not to the scale of the US.
In order to encourage the participation of private investment, Citi notes, the government will promote a slew of investment projects in the fields of transportation, oil & gas, and telecoms. The government will effectively guarantee the funding demand of projects already under construction, guiding financial institutions to lend to local governments to prevent these projects being half-finished and non-performing.
China’s banks have been reluctant to lend to local governments this year due to tightened regulation on the financial sector and on local government lending, which are all part of encouraging debt reduction. Now the government will support local government financing demand for key projects, mitigating a rising risk of local government defaults.
The government has also pledged to guide the use of liquidity released via reductions in the bank reserve ratio requirement (RRR) to support small and micro enterprises and encourage commercial banks to support those enterprises in bond issuance.
With its statement, the Chinese government is sending a clear signal that it is preparing to defend growth, just as ANZ’s economists expected. Most of the measures announced are regarded as micro level structural reforms but the statement clearly articulates that fiscal policy should be “more proactive”, the economists note.
ANZ expects infrastructure investment to accelerate and thus drive up overall fixed asset investment. FAI growth fell to 6% year on year in the June quarter when the same quarter last year saw 21%.
ANZ does not expect such a number to be seen again, given the statement reiterates a desire not to “flood the economy” with stimulus. This will be no 2008. Policymakers are still mindful of debt risks in ANZ’s view.
Don’t Mention the War
This all sounds well and good, however “An acceleration in trade friction between China and the US will damage external balances over the long run,” suggests DBS Bank.
The White House has prepared another tranche of tariffs on Chinese exports, this time to the tune of US$200bn compared to the US$35bn now in place. Being was swift to “call” the US with a matching US$35bn but cannot match the raise to US$200bn, given last year China only exported around US$150bn of goods to the US. Originally the new tranche was to attract a 10% tariff but citing "illegal retaliation" from China, and likely frustration from failing to crack Beijing, Trump has lifted that level to 25%.
The new tariffs target a wide range of consumer goods, which DBS suggests will pose a more significant long term impact on China’s current account surplus, thus reducing money supply, if implemented. At the time of writing, DBS will have based that prediction on a 10% tariff level.
The “if” is the salient point. The new tariffs will come into effect in early September, pending consultation with the US industries impacted, assuming no resolution with China is reached in the meantime. Despite the odd stumble, Wall Street continues to trade towards all-time highs on a pervading assumption that such a resolution will ultimately be reached.
Talks between US and Chinese trade representatives have supposedly been ongoing for months now, but nothing has been resolved. According to White House economic advisor Larry Kudlow, talks between the two delegations have been fruitful and progress has been made. The reason nothing has yet been resolved is, according to Kudlow, that no deal has been able to get past the Chinese president.
Kudlow’s tone has not been a positive one.
While most on Wall Street and across US industry agree something had to be done about global trade imbalances, most are anti-tariff. Most everyone, for example, wants NAFTA back, and the consensus is that while something specifically needs to be done about China, and if it has to involve tariffs so be it, but why attack America’s allies at the same time?
Sure, the case can be made that US trade deficits with its allies owe a lot to distorted tariffs already in place, but surely a joint action of all US allies and trading partners together turning the screws on China would be a better path to follow?
To that end, we have now seen the EU at least agree to negotiate trade terms with the US that can satisfy both parties. We have the Mexican president suggesting a new deal will be forthcoming. But America’s closest ally, in both senses of the word – Canada – remains offside, while Australia nervously hopes that exemptions will remain in place.
Maybe Trump’s tactics will prove triumphant, but real evidence is yet to be seen.
The Crux of the Matter
Trade deficit/surplus imbalances are one thing, but when it comes to China the real sticking point is that of investment flows. The White House has accused Beijing of directing foreign investment into US firms while implementing restrictions on inbound investment, with the intention of acquiring intellectual property and forcing technology transfers.
Back in the noughties, the US manufacturing sector thought it was on a winner when it retained design and sales/marketing operations in the US while shifting the actual manufacturing stage – high cost and low value-add – to China, where it was so much cheaper.
Seemed like a great idea at the time. But that soon changed when Chinese manufacturers started exporting fridges (to use one example) to the US which looked remarkably similar to the same fridges US companies had been manufacturing in China, but were that much cheaper in the stores.
It was in this way China began to “export disinflation”. Then Fed chairman Alan Greenspan had cut US interest rates to low level in the wake of the 2000 Tech Wreck and subsequent recession, but was slow to increase rates once more as recession turned to growth. There were no apparent signs of inflation to justify such a move.
Thanks to China.
Persistent low rates then supported a housing market boom in the US, and particularly a housing lending market boom. And the rest is history. Thus we have Trump some credit in noting that in all this time no president, Democrat or Republican, has taken China to task.
And China is no less than brazen. Areas of the Chinese economy are off limits to foreign investment, while restrictions apply in others. Such restrictions mean foreign companies can only exploit the Chinese market by forming joint ventures with Chinese companies, and they must hand over their technology.
That’s aside from technology that is simply copied without consent. It’s not just fridges that look remarkably similar, so too do Chinese smart phones.
One Way Tide
Between 2005 and 2013, the scale of Chinese investment into the US was no greater than that into Australia, NAB’s economists note. Australia had all the right rocks available. However in the interim the US has been by far the greatest recipient of Chinese flows.
Yet in aggregate, the EU has received an even larger share of China’s investment since 2005, with the UK, Germany, France and Italy making up almost two-thirds. The automotive sector has been the main target, with large scale investment in Daimler, Volvo, Peugeot and Pirelli, alongside investment in finance and energy.
In part, NAB notes, this reflects a lack of any EU-wide investment review board equivalent to the FIRB in Australia and counterpart in the US. There has been a push to establish such an entity, but this has been met with resistance from smaller EU members who welcome Chinese money with open arms, such as Greece.
The same frustration with regard reciprocal investment is apparent in Europe. Between 2000 and 2017 EU investment in China marginally exceeded that of China into the EU, despite Chinese restrictions, but 2014 saw an acceleration and China will overtake the EU in cumulative flows this year.
Reforms of the investment climate in China have been slow, NAB notes, despite promising rhetoric from authorities. Improvement was seen in openness from 1997 to 2006 but then little changed through to 2014, when Beijing introduced the “negative list”.
Thereafter, foreign investment was allowed into any sector not on the list. As at the end of July, an updated and narrower list came into effect, but new sectors now open for investment are those of little foreign attraction, NAB notes, such as armaments, or those dominated by state-owned firms in which competition is difficult.
Negotiations between the EU and China for an investment treaty began in 2013, but little progress has been made given China’s slow pace of reform. NAB suggests, however, that now both parties are being hit with US sanctions, perhaps things may speed up a bit.
The biggest stumbling block for Europe is nevertheless the same as that for the US – intellectual property theft. Beijing has vowed to improve enforcement but until actual tightening is evident, scepticism will linger, NAB believes.
So the ball is in Beijing’s court. While Wall Street remains nervously confident an all-out global trade war will be averted, months are passing with little progress and the deadline that will trigger US tariffs on a further US$200bn of Chinese goods is looming.
Many despair at Trump’s bully-boy tactics but the ball is firmly in Beijing’s court.
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