In May 2016, the People’s Daily, the mouthpiece of the Chinese Communist party, published a long piece excoriating China’s economic model. In the course of an expansive discussion about the dangers of debt-fuelled growth — captured in the memorable warning that “trees cannot grow to the sky” — the author suggested that China’s economic slowdown was here to stay.
This was striking, particularly because the piece was published during a housing boom unleashed by a government that had once again resorted to stimulus to boost the economy, this time to counter 2015’s disastrous stock market bubble and botched currency devaluation.
“China’s economic trajectory will be “L-shaped”, rather than “U-shaped”, and definitely not “V-shaped. I must underscore that the L-shaped curve is projected to last for a period of time rather than a year or two,” said the report, presented as an interview but with the byline of “an authoritative source”.
The article is commonly believed to have been penned by Liu He, President Xi Jinping’s chief economic adviser, who is leading negotiations with Washington to defuse the US-China trade war. But the Beijing rumour mill also suggested the involvement of Zhu Rongji, the hard-charging premier known for his unsentimental downsizing of the state-owned sector in the 1990s.
Regardless of the author’s identity, the People’s Daily publication looks in retrospect like a watershed moment in China’s recent economic history. It marked the end of the old-school resort to stimulus in favour of a more nuanced approach to policymaking, bringing with it a slower pace of growth.
In the absence of more aggressive stimulus, China’s economic expansion slowed to 6 per cent last quarter, at the lower bound of this year’s targeted range of 6-6.5 per cent.
The IMF recently cut its China GDP forecast for 2020 to 5.8 per cent from 6.1 per cent, a rate considered unthinkable just a few years ago, although some economists believe actual growth rates are already considerably lower.
Officially, the government is tied to growth above 6 per cent through next year to meet a longstanding goal of doubling per capita GDP, though this constraint may be removed if the pending results of the latest economic census revise up the size of the Chinese economy.
Don’t blame the trade war
Hopes for an economic growth recovery have been pushed into next year, but investors cannot be sure one is coming. There are reasons why growth could stabilise between now and the first half of 2020, but the structural forces that are dragging on the Chinese economy remain in place.
A US-China trade deal is unlikely to reverse this situation. If it holds, a signed deal between Washington and Beijing could ratchet down some of the bilateral tension and may help restore some of the loss of confidence among Chinese private business, particularly in the hard-hit manufacturing sector.
But the slowdown has far more to do with the outcome of an internal debate and with policy decisions made in Beijing around the time of the People’s Daily article to rein in off-balance sheet lending, loosely known as shadow finance. This played a crucial role in supporting private sector firms in the period after the global financial crisis, especially in key sectors such as property, but was also an important source of credit for companies controlled by local governments.
The collapse of such lending arrangements is seen most clearly in the sharp drop in bank claims on institutions such as trust companies, which channelled loans to industry and local governments, sometimes in open defiance of government regulators. This lending provided crucial support for the enterprises that drive Chinese economic growth, including small manufacturers and property developers but also companies controlled by local governments. These claims are at their lowest level, measured against GDP, since the start of 2016.
In the absence of such under-regulated lending, targeted stimulus measures, including frequent cuts to the reserve requirement ratio, have not been adequate to improve credit conditions. The September total social financing series released by the People’s Bank of China shows that the growth of outstanding bank loans has, if anything, fallen in recent months, while shadow finance, measured by components such as trust and entrusted loans, was down for a 16th straight month.
Although September data showed that banks were making more medium and long-term loans to corporates — the kind of loans that could be used for productive economic purposes — this may reflect an accelerated programme to replace non-standard loans to local government, such as those lent out via shadow finance channels, with cheaper bank loans. This suggests that the appetite to borrow for things like infrastructure projects may be even weaker than suggested by headline credit growth figures.
Weak credit appetite is one reason why inventory restocking will not provide a short-term boost to the economy, as happened in 2009, 2013 and 2016. While a forward reading of M1 growth pointed to the start of restocking cycles in those years, this measure of corporate cash flow is currently growing at close to its lowest rates on record, suggesting that inventory growth may turn negative again in coming months.
More pressure in store
China’s economy has been well supported by a still-resilient housing market, which has in turn helped boost household consumption. But the People’s Daily piece also contained one of the earliest airings of the leadership’s formulation that “homes are for living in”, rather than vehicles for speculation. Since publication, the government has maintained a surprisingly tough approach to housing market policy at the national level, and there are signs that developers are struggling in the face of tighter funding conditions. This has led to a fall in land sales, which will feed into housing starts and eventually construction.
Cooling tensions with the US, combined with more low-key stimulus measures, may eventually help the economy to stabilise. A housing meltdown may also tempt the government to ramp up its stimulus response because of the market’s centrality to growth.
However, a sugar rush from stimulus cannot mask the fact that China’s economy is in a trend of structural decline, which is set to continue. The direction of growth has not only followed that recommended in the People’s Daily, but before that in the gradual deceleration outlined in a 2012 report co-authored by the Chinese government and the World Bank (a forecast that presumed no shocks and progress on reform).
This is not a normal business cycle and investors should not be expecting growth to bottom and then rebound. If anything, they should pay more attention to the risks associated with managing a long-term economic slowdown.
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