Wang Tao: China's Economic Outlook for Next Two Years Plagued With Uncertainty
While domestic deleveraging-related policy-tightening has helped to slow economic growth in 2018, higher tariffs and trade-war-related uncertainties will likely be the main headwind for China in 2019. Our base case assumes the recently imposed U.S. tariffs on $200 billion of Chinese exports will increase from 10% to 25% in January. There is also a risk of the U.S. imposing tariffs on all Chinese exports in 2019.
We estimate that the 25% additional tariffs on $250 billion of Chinese exports will impose a drag of more than 0.8 percentage points on gross domestic product (GDP) growth in 2019. The first-round direct impact through weaker exports is expected to weigh on GDP growth by 0.5 percentage points. The second-round impact through slower global demand and weaker corporate profits (investment) and employment/wages (consumption) will add a drag of more than 0.3 percentage points. On employment, weaker exports growth alone could lead to a loss of 500,000 to 1.2 million jobs in 2019 (we estimate export manufacturers employ about 18 million workers while all export-related sectors employ 40 million), but overall job losses could be multiple times that as the spillover effect on investment and consumption rises. The negative impact from China imposing tariffs on imports from the U.S. should be largely offset by cuts of import tariffs across the board.
The biggest negative impact of sustained trade tension and higher tariffs from the U.S. will likely be on business investment and employment through increased uncertainty and gradual shifts in supply chains. Production related to exports to the U.S. may move out of China even as others serving the Chinese market move into China. Such a long-term impact is hard to quantify, but we think it will lead to lower-trend GDP growth for China over the next few years.
We expect China’s policy easing to offset part of the negative trade shock, leading to GDP growth slowing to 6% in 2019 and stabilizing at 6% in 2020. Policy easing will likely intensify as the trade war’s negative impact rises in the coming months. The biggest support is likely to come from stronger infrastructure spending, while corporate and personal income tax (PIT) cuts should help as well. We forecast net exports to have another 0.5-percentage-point drag on GDP growth in 2019 (a smaller drag in 2020), infrastructure fixed-asset investment to rebound sharply to more than 10%, while property and manufacturing investment weaken, and consumption growth to slow by 0.5 percentage points to 6.7% in real terms. Weakness in consumption should come from slower income growth, weaker property sales and some job losses in export-related sectors, partially offset by PIT cuts and other policy support.
We estimate that the negative impact on GDP growth will be 1.5 to 2 percentage points if the U.S. imposes 25% tariffs on all Chinese exports. In this event, China’s retaliation will likely remain limited while the yuan will depreciate further as China’s current account deficit will rise to 0.5% to 1% of GDP. China will likely roll out a bigger stimulus, but we expect growth will fall to 5.5% nevertheless.
If the upcoming Xi-Trump meeting at the G-20 summit can lead to a de-escalation of the trade war, with the current U.S. 10% tariffs not increasing to 25% (and no additional tariffs on another $250 billion-plus), we would expect GDP to grow by 6.2% in 2019 and 2020. In this case, China’s policy stimulus would be lowered, current account balance would maintain a small surplus, and the dollar-to-yuan exchange rate might hover around 7 in 2019. If a grand deal between the U.S. and China leads both to removing additional tariffs and the further opening of markets, growth might pick up further to 6.3 to 6.4% in the next couple of years, while China could continue to push forward with a gradual deleveraging.
How much policy easing and stimulus could we expect?
The impact of policy easing so far has been limited. Since late July, the People’s Bank of China (PBOC) has increased the liquidity offering, including through reserve requirement ratio (RRR) cuts; local government bond issuance being pushed up; public-private partnership scrutiny being eased to support infrastructure investment; asset management product implementation guidelines being relaxed to slow “shadow credit” contraction and improve credit market conditions; and additional tax cuts being announced. These measures have so far not had much impact on economic activity, as they have been modest and gradual as the government is concerned about the negative impact of a large stimulus on financial stability. Also, tighter rules on implicit local government debt, environmental protection and shadow credit have likely slowed the effect of policy easing more than usual.
We expect more stimulus measures as the economy weakens and the trade war escalates further. The Economic Work Conference in December will likely strengthen the supportive tones of the October Politburo meeting, sending a stronger and clear signal of policy easing, which should help speed up the transmission of policies. We also expect a bigger budget deficit, more funding support for infrastructure spending, multiple RRR cuts, and additional tax cuts. In addition, we expect a stronger commitment to support the private sector and continued market-oriented reforms and further opening-up to help boost business confidence and market sentiment.
Infrastructure investment is expected to do the heavy lifting again in 2019, with its growth rebounding from 2% this year to more than 10% in 2019E. We expect the explicit budget deficit to rise modestly to 3% of GDP; special local government bonds to expand (by an extra 500 billion yuan [$72.07 billion] to 700 billion yuan), and funding to local government financing vehicles to increase, all of which should help support stronger infrastructure investment. We think less-tight controls on implicit local government debt and stronger and clearer easing signals from the senior leadership will help push local governments and banks to quicker action. While further easing will likely intensify from December, much of the impact may be felt in the second quarter of 2019.
An aerial view of Jiangdong New district, Haikou, Hainan province on Jan. 3, 2017. Photo: VCG
Additional tax cuts could be over 1% of GDP in 2019, but the multiplier effect is likely limited. Some of the 1.3 trillion yuan in tax cuts already announced in 2018 will be effective (personal income tax) or have additional savings (corporate) in 2019. Moreover, China is reportedly considering additional cuts to the value-added tax (VAT) and corporate profit tax, as well as a cut to corporate contributions to social security. We think the overall cut will likely exceed 1% of GDP in 2019. Cuts to the personal income tax should help lower-middle-income families and boost low-end discretionary consumption. VAT and corporate-tax cuts should help increase corporate earnings but have a limited multiplier effect, as companies are unlikely to expand capital expenditures with tax savings amid a weak economic outlook. An announcement of new tax cuts may come as early as mid-December and is likely to be largely rolled out after March’s meeting of the National People’s Congress.
We expect overall credit growth to rebound modestly with the help of more monetary easing. Although monetary policy will likely be labeled “prudent,” we expect multiple RRR cuts in 2019 to help ensure ample market liquidity. We don’t think the PBOC will cut its benchmark rates, but expect market rates to trend lower, with 7D Repo (DR007) softening to 2.4% and the 10-year Chinese government bond yield sliding to 3.3% by the end of 2019. We expect China’s broad credit growth (total social financing except for equity, asset-backed securities, and write-offs, plus total local government bonds) to rebound from 10.5% in 2018 to 11%. Bank loans will likely stay strong, and credit support for private sectors and small-to-midsize enterprises may improve thanks to recent policy easing. Shadow credit may stabilize or see a slight expansion in 2019 after a sharp unwinding in 2018. New issuance of local government bonds would be around 2.8 trillion to 3 trillion yuan.
Inflationary pressure should be limited. While China’s retaliatory tariff increases on imports such as soybeans and a weaker yuan are expected to push up import costs and the consumer price index (CPI), this should be dampened by China’s slower economic growth and downward pressure on the labor market. Despite high oil prices and food/pork prices, we expect CPI inflation to moderate to 2% in 2019 and 1.8% in 2020, with the producer price index moderating to 1.8% on softer demand but less-tight supply.
We don’t expect notable property policy easing nationwide unless property starts and construction collapse, which is not our baseline for 2019. That said, some cities may ease restrictions at the margin next year. Of course, further general easing of liquidity and credit may indirectly help the property sector.
The policy stimulus may be smaller than in previous cycles... China still has fiscal space for another stimulus, given that government debt, including implicit local government debt, is about 70% of GDP. However, concerns about negative consequences and medium-term financial risk will likely result in a smaller stimulus this round than in the past. In addition, after the significant buildup in infrastructure in recent years, the limit of good investable infrastructure projects on top of the base of 17 trillion-plus yuan may also pose a constraint. While we expect broad credit growth to rebound to 11% in 2019, this is only modestly up from the 2018 pace (10.5%) and still much weaker than 13.6% in 2017. In contrast, credit growth more than doubled in 2008-09 to over 36% and increased by over 4 percentage points in 2015-16 trough to peak. We expect the augmented fiscal deficit to widen by nearly 1.5 percentage points in 2019, compared to 2 percentage points in 2016, though it could increase.
In 2015-16, the economic slowdown was led by a serious property downturn that exposed severe excess capacity issues, which meant that credit expansion was largely ineffective for supporting growth. In addition to the stimulus, the government’s aggressive supply cut/excess capacity cuts were critical in reviving the producer price index and industrial profits, while a robust global export rebound also helped. This time, the biggest headwind is coming from exports, while property inventory and industrial excess capacity are both much lower. The potential gain from supply-side measures will also likely be lower.
Beyond the policy stimulus, China may push for more reforms and opening. Given various constraints, Chinese authorities will likely increasingly rely on reform and market-opening measures to achieve their growth objectives. For example, the government is responding to the trade war with more tariff cuts, further opening of domestic industries and financial markets, increased cooperation with other trading partners, and more export-tax rebates. In response to weak business confidence, the top leaders have reiterated strong and unequivocal support for the private sector and a commitment to continued market-oriented reforms, including state-owned-enterprise mixed ownership reform. More corporate tax cuts are also planned. If followed through, these measures could help unlock China’s growth potential despite the external shock.
Will the yuan be a part of policy easing or a constraint to policy easing?
The yuan exchange rate should face rising depreciation pressures in 2019. First, with exports affected by higher tariffs and trade war uncertainty, we see China’s trade surplus dropping to 2.8% of GDP in 2019 and current account surplus disappearing or even recording a small deficit for the first time in 24 years. Second, we also see the onshore-offshore rate differential narrowing. These factors, plus sustained trade-war-related uncertainty, should together add to depreciation expectations, likely leading to more capital outflows. Moreover, the larger the stimulus China uses to offset the trade war impact, the bigger its deficit will be, and the faster its external balance will likely shrink.
Although China’s traditional policy stimulus faces some constraints, we still do not see China using a sharp depreciation as part of its policy mix to counter the higher tariffs and boost growth. While yuan depreciation can mitigate higher tariffs, it will not fully offset the trade war impact, especially a severe impact on specific sectors and the increased uncertainty, which could lead to cuts and shifts in investment. Moreover, a large depreciation would likely hurt domestic confidence, trigger outflows and risk financial stability. In addition, we think China is sensitive to U.S. pressure on the currency and wants to avoid any potential conflict in the financial area.
With continued strong management, we expect the dollar-to-yuan exchange rate to be 7 at the end of 2018, and 7.3 at the end of both 2019 and 2020. For the rest of 2018, we think the PBOC will keep exchange rate below 7 using its tools of managing the daily fixing with countercyclical factors, and controlling capital outflows. In 2019, as depreciation pressures increase, we expect the PBOC to let the yuan depreciate modestly to relieve some pressures, but to continue to tightly manage the exchange rate on the stronger side. We also expect more measures to open up the domestic market to encourage inflows.
In the event of a full-blown trade war, whereby 25% or higher U.S. tariffs are imposed on all Chinese exports to the U.S., or the dollar strengthens further from its current level, we would expect the yuan to depreciate more by the end of 2019, to around 7.5. On the other hand, should the U.S.-China trade war de-escalate, and/or the dollar weakens against other major currencies notably, the dollar may be kept around 7 against the dollar in 2019.
How might the property market and consumption evolve?
We expect property sales to decline by 4% to 6% in 2019 and another 0% to 2% in 2020. The fading of the shantytown subsidy program, which had contributed significantly to sales in 2016-17, is the main reason for sales weakness. We estimate that if the total shantytown target for 2019 is lowered to 5 million units (it was 5.8 million units in 2018) and the share of monetary subsidy declines by 10 percentage points, this should drag down residential sales by about 5 percentage points. In addition, an expected slowdown in export growth, trade-war related uncertainties, and yuan depreciation expectations will all likely weigh on property-market sentiment. That said, any liquidity and credit easing would indirectly help the property market.
Property new starts and investment will likely be more resilient owing to low inventory levels. Year to date in 2018, property new starts have risen by 16%, helped by strong growth in recent months. Real estate fixed-asset investment grew by 10% year to date. Against the background of tight credit access for developers, this combination of data might suggest that new starts could be inflated somewhat, as developers might have started the projects to unlock development loans. Given the low inventory levels and the usual lag between starts and sales, we expect new starts to drop slightly (up to 2%) in 2019, while property investment growth might moderate to 2% to 4% positive growth. Starts will likely decline more in 2020 while property investment might weaken further.
Our baseline property forecast is highly sensitive to shifts in sentiment and policies. Property market sentiment has stayed strong in the past two years, helped by shantytown subsidies that lowered inventories and pushed up prices. With the supportive policies fading, shadow finance unwinding, the correction in the equity market, and trade war-related weakening of activity and confidence, we would expect property market sentiment to weaken in the coming year as well. Against the background of slowing urbanization, residential property sales in 2018 are 30% higher than the previous peak cycle in 2013, and housing starts also reached a record high. As such, property activities could be highly sensitive to sentiment shifts.
In the case of a more significant property slowdown, China could ease current tightening policies. We think previous property policy tightening has likely peaked, and a property tax will also likely be further delayed or muted. In the case of a sharper property slowdown on top of a trade war escalation, China could ease current home purchasing restrictions, as it did in 2015, although this is perhaps the least preferred choice for the government. Of course, liquidity and credit easing would help as well. With inventory now much lower than in 2015, property policy easing this time could also have a heavier supply-side focus — for example, building more public or shantytown renovation housing, elderly care homes, community recreation centers, tourism-related hotels or resorts, etc. On balance, the risk of a property-led hard landing is still smaller today than in 2014-15, with property inventories much lower, and excess capacity in related industrial and commodity sectors less severe.
Consumption is expected to slow, but modestly in 2019, before stabilizing in 2020 along with headline GDP growth. The exports slowdown should hit employment and income, the negative impact of which may be partly offset by policy support for infrastructure investment and the personal income tax cut already in the pipeline. As market sentiment and income growth softens, consumer confidence will likely cool, the impact of which may be amplified by today’s tighter rules on consumer lending and much higher level of household debt.
That said, consumption growth should remain resilient and upgrades continue, albeit at a slower pace. Sustained positive income growth (5% to 7%), continued improvement in household credit access, and continuation of reforms focusing on supporting job creation and social safety net improvements should all keep real consumption growth at 6% to 7% in the next few years. Key downside risk should come mainly from a full-scale trade war and/or a deep property downturn. That said, even as national consumption headlines soften, we would still expect to see signs of the longer-term consumption upgrade trend, as the number of lower-tier city consumers that can afford better products continues to rise, more hard and soft infrastructure to facilitate consumption in health case, tourism and leisure gets built, and consumers’ desire for more consumption of leisure and services continues to grow.
Wang Tao is the head of Asia economics and chief China economist of UBS Investment Bank.
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