China’s Dour Economic Data

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By Uday Khanapurkar

China’s economic growth prospects for 2019 appear to have received a rude setback right at the outset. Data recently released by its National Bureau of Statistics (NBS) for the last quarter of 2018 report that economic growth, at 6.4 percent year-on-year, has reached a 28-year low. With this, growth for 2018 amounts to 6.6 percent, barely scraping by the politically mandated minimum of 6.5 percent. Moreover, scrutiny of the December data and China’s available policy responses reveal troubling portents for its economy in 2019.

Retail sales, for instance, made only a feeble recovery in December 2018, rising to 8.2 percent year-on-year, from 8.1 percent in November 2018. More importantly, growth in retail sales has been slowing fairly consistently over the last two years. With final consumption expenditure said to have accounted for 76.2 percent of China’s GDP growth in 2018, the effects of a protracted slowdown in retail sales in 2019 would discernibly stifle economic growth. Meanwhile, demographic pressures are adding to China’s consumption woes — births fell by a sizeable 2 million in 2018, reaching the lowest level since the years of the Great Leap Forward.

Likewise, exports and imports fell by 4.4 and 7.6 percent respectively in December 2018, reversing a prolonged bout of frontloading prompted by the Trump administration’s threats to levy tariffs on all Chinese exports to the United States. Trade tensions with the U.S. are clearly unsettling China’s manufacturing sector, confidence in which had already been waning prior to the tariff impositions. China’s manufacturing Purchasing Managers’ Index (PMI) — a composite metric capturing the performance of large manufacturing firms — fell below the 50 mark in December 2018, indicating a contraction in activity for the first time in 18 months. Export order contractions played a large part in this. Even in aggregate terms, manufacturing output growth in December 2018 slowed to 5.5 percent year-on year from 6.1 and 5.6 percent in October and November respectively. Sluggish manufacturing performance can be partly explained by firms’ ambivalence regarding whether Chinese and American leaders can strike a trade deal in advance of the March deadline agreed upon at Buenos Aires. In hindsight, it would appear that Chinese manufacturers have displayed some prescience in this regard, with reports emerging that a deal is unlikely to materialize in January 2019.

Furthermore, with China’s policy instruments facing significant impediments, Beijing’s capacity to manage a growth slowdown in 2019 also appears increasingly suspect. The modest, cautious easing of monetary policy that was sanctioned in 2018 has reportedly not translated into adequate credit growth, inspiring fears within China that the economy is facing a liquidity trap. Rather, banks were observed to have used the released liquidity to purchase bonds as opposed to lending to companies. This was hardly unexpected. China’s ambitions to deleverage its enterprises and boost investment efficiency are, in essence, diametrically opposed to monetary stimulus. Additionally, investment efficiency levels are known to be substantially low in China, thanks to prior misallocations, making it likely that stimulus will only work in significantly large doses. Monthly trends of industrial production illustrate this — despite months of policy easing, figures deteriorated during most of 2018 with a slight improvement in December. Similarly, fixed asset investment did not adequately respond to the stimulus, posting only modest improvements in December 2018.

The Chinese are clearly spooked by these developments. Policymakers are contemplating the use of quantitative easing, whereby the People’s Bank of China (PBoC) would purchase bonds issued by the finance ministry, in order that the government may carry out extensive spending activities to shore up the real economy while mitigating the debt uptick. This would mark a notable departure from the norm since outright quantitative easing is currently illegal in China. A sudden shift to easing is unlikely, however, since it could severely hamper expectations and confidence in the Chinese economy. This, in turn, would encourage capital flight and lead to an erosion of China’s foreign exchange reserves, an outcome China desperately attempted to evade in 2016. As such, China’s monetary policy shifts are unlikely to serve as quick fixes to the economy’s woes.

While China arguably has more room in the domain of taxes to stimulate the economy, these too will be burdened by complexities. A section of the Chinese public expressed dismay over recent tax cuts for households, making it uncertain whether enough has been done to ensure that the growth in disposable incomes will translate into consumption. In the case of corporate tax cuts and exemptions that are being designed, the effects are only expected to manifest after six to nine months. Moreover, Chinese authorities are likely to be cautious in their relinquishment of tax revenues. Strengthening social security in China is increasingly being recognized as imperative to the preservation of consumption levels as the population ages. Tax planners in China are thus left to crack the vexing equation of reducing taxes in such a way that disposable income increments facilitate consumption without hampering the welfare system.

Attention has been drawn, however, to what seems like an exception in the grim data that came out of China this week and which deserves due recognition — the services sector. China’s service PMI increased to 53.9 in December 2018, beating market expectations that it would only reach 52.9. With this, the services PMI is the highest it has been since July 2018. This has allowed the composite PMI in China to increase consistently throughout the fourth quarter of 2018, despite manufacturing contractions. Additionally, NBS data for December 2018 report robust growth in the services sector. Moreover, the tertiary industry accounted for 59.7 percent of China’s GDP growth in 2018, indicating the progress it has made in its endeavor to structurally rebalance the economy. Nevertheless, it is difficult to ascertain whether the recent uptick in services figures should either guarantee stability or warrant optimism regarding the state of China’s economy.

Service sector figures comprise of certain industries that do not necessarily contribute to what is called the real economy, i.e. the actual production of goods and services, exclusive of financial market transactions. Revenues of financial services firms, for example, are included even though part of this revenue is likely to consist of interest from misallocated loans. Similarly, real estate revenues are included in services accounting. Increases in housing prices, therefore, would likely reflect as part of the growth in the services PMI — this is arguably the case in China, where prices reached an annual peak in December 2018, having risen consistently since June. Rising real estate prices tend to dampen consumption demand since households are compelled to save income, as well as incur debt, for housing purchases. China exhibits the expected symptoms with household borrowing to GDP figures also having risen consistently in 2018. A more useful metric of China’s economic growth prospects in 2019 would, therefore, be disaggregated services figures or retail services, data for which is, unfortunately, not disclosed by the NBS.

Indeed, the critical nature of these services to China’s economy going forward cannot be overstated. Maintaining and improving the performance of the retail services sector will be absolutely vital to generating sustainable growth in China’s real economy and enhancing living standards. Only if growth in the retail services sector continues will Chinese policymakers muster the political will to allow the contractions in manufacturing and industry that are concomitant to deleveraging. In fact, the ongoing panic in China’s policy circles is in large part attributable to ambivalence regarding whether the retail services sector could adequately absorb jobs lost due to downward pressures on manufacturing and industry — the Mercator Institute of Chinese Studies had predicted as much in a 2016 policy brief. Furthermore, to the extent that services consumption is being financed by increasing consumer credit, any improvement in its performance is less organic and prone to destabilization. These problems are unlikely to be remedied in the short run and will require a more sustained effort.

It would thus appear that China should prepare for a fairly rough first half of 2019 and that much of the economic data will get worse before it gets better. How China’s leaders respond to these circumstances will have profound consequences. Much will depend on whether policymakers decide to open the floodgates of economic stimulus and kick the reform can down the road, choosing to address the challenge once the first centennial goal is securely achieved in 2021. In such a scenario, growth would remain stable in the short run, although investment efficiency would likely cascade and the risks of a shock would be amplified significantly. Domestic political imperatives render such a trajectory more likely than would be generally expected. China’s economy, and its people, would be better served if its leaders and policymakers were to view the impending recession as part of a movement toward more organic, sustainable growth in the long-run, as opposed to an indication of political failure.