Outlook for China's Economy in 2019

By Zhong Zhengsheng and Zhang Lu

China's economic growth in 2019 will hinge on the global environment, the economic cycle, and the nation's economic transformation.

In the face of Sino-US trade friction, slower growth momentum and rising debt levels, what can we expect for China's economy in 2019?

The main factors to watch are the performance of the global economy, the domestic economic cycle and the extent of progress in China's economic upgrading. The outlook for the global economy in the remainder of 2019 is not optimistic.

>>>Shenzhen, once again, is at the vanguard of China's development, with anewroleas “apilot demonstration area of socialism with Chinese characteristics.”

Fiscal policy will need to play a more active role in stemming the downward economic trend.

T he big challenge is the sharp upturn in Sino-US trade friction. While the situation has not spun out of control, it is difficult to predict with any certainty how the two sides can resolve their outstanding differences. Meanwhile, major central banks have turned to looser monetary policies. But if central bankers were asked what follows massive monetary stimulus, the simple answer might be more of the same. The options are somewhat limited.

The Chinese economy had been described as “stable but weak” but more recently it is showing more obvious signs of a downturn. In the process, macroeconomic policy has helped cushion the downturn, but more counter-cyclical intervention may be necessary. Yet there is good news in the area of economic upgrading and transformation. The economy has acquired more resilience thanks to increased industrial concentration, progress in promoting high-quality manufacturing, and a rise in the contribution of services to the gross domestic product (GDP). China also needs to bear in mind that temporary trade setbacks should not be used as an excuse for further delays in economic reform.

A Shifting Global Environment

There have been two major changes in the external environment of China's economic growth: the instability in the China-US relationship and shifting global monetary policies.

On one hand Sino-US relations face new uncertainties as trade talks between the two countries appear to have stalled. This has been weighing on global economic growth. In June, the International Monetary Fund (IMF) lowered its expectations for global and Chinese economic growth. The Japanese, South Korean and European economies have also come under more pressure.

On the other hand, major central banks have been shifting from tighter monetary policies to looser ones, though the remaining room for monetary easing has narrowed. The US Federal Reserve's Federal Open Market Committee, at its meeting in March, decided on a target for ending its balance sheet reduction activities. It further signaled a dovish outlook for monetary policy at its June meeting and at the July meeting it finally cut rates by a quarter point. The European Central Bank (ECB) announced as early as at its March meeting that it would launch a new round of targeted longerterm refinancing operations from September 2019. In June, Mario Draghi, president of the ECB at the time, referred to additional stimulus measures that would be necessary in the coming quarters. In Japan, the central bank has continued its quantitative and qualitative monetary easing with yield curve control. The major central banks have effectively put on hold their efforts to “normalize monetary policy.”Other countries such as Malaysia, New Zealand, the Philippines, Australia and Russia, have also cut interest rates and India has trimmed rates three times since the beginning of 2019.

In the face of failed efforts to normalize monetary policy, there is limited space for monetary easing by major central banks. Since 2015, the Fed had raised interest rates nine times to 2.5% before cutting rate at the end of July. The Fed had room for nine cuts in the rate reduction cycle, considerably less than in reduction cycles considerably less than in reduction cycles of the past. As far as the ECB is concerned, the benchmark interest rate is now zero, and the deposit facility interest rate is a negative 0.4%. More decreases in the benchmark rate will only worsen the situation, dealing a further blow to the profitability of Europe's banks. As the ECB's treasury bond purchases in Germany, Finland and Slovakia have been more than onethird of each of those country's bond stock, there is little room for another round of quantitative easing. The Bank of Japan (BOJ) faces a similar situation, holding 40% of Japan's treasury bonds. Although the BOJ has stated its intention to buy 80 trillion yen of treasury bonds a year, the actual purchase in 2018 was only 26 trillion yen. Further expansion of quantitative and qualitative easing is highly unlikely.

Fiscal policy will need to play a more active role in stemming the downward economic trend. The better economic performance of the US compared to that of other countries since 2018 is largely due to President Trump's tax reform. For China, the People's Bank of China has more tools for monetary easing than some of the other major central banks. Yet, constrained by restrictions on macro level leverage ratios and the need for risk prevention, monetary policy plays a less critical role than fiscal policy in China. For example, in the second quarter of 2019, China made a structural adjustment of its monetary policy against the increasing downward pressure. Instead of cutting interest rates or making an overall reduction in the required reserve ratio on bank deposits, at least some of the time, policy makers adopted targeted cuts in bank reserve requirements aimed at rural banks and implemented according to bank size.

China's year-onyear GDP rise in the first quarter:

6.4%

China's GDP rose a year on year 6.4% in the first quarter, a sign of economic stabilization, but this was followed by a 6.2% reading in the second quarter, the lowest growth in 27 years. This was despite the fact that infrastructure projects were started ahead of schedule, enterprises (including importers) stocked goods in advance because of the anticipated reduction in value-added tax in April, and some positive developments in the Sino-US trade talks. During the same period net exports contributed 1.5% to GDP growth, the highest contribution since related data became available in 2009, and in March alone, industrial value-added output soared 8.5% from a year earlier. This limited good news was unsustainable, however.

Counter-cyclical policies were withdrawn in the second quarter of 2019, following signs of first quarter recovery. The program of “six stabilities”(stability in employment, finance, foreign trade, foreign investment, investment overall and public expectations) was not mentioned at the Chinese Communist Party's Politburo meeting on April 19. The regular first-quarter meeting of the central bank repeated a call for greater control over liquidity. This was followed by a less proactive fiscal policy and slower money and credit expansion. Consequently, industrial output growth was at a record low in May. Infrastructure investment also showed slower growth. Manufacturing investment weakened, and there were signs of cooling investment in real estate. China's economy was again facing greater downward pressure.

Under these conditions, infrastructure projects may be the main way to hedge against a further economic deterioration in the second half of 2019. The focus will be put on high-quality manufacturing and consumption as part of longer-term policy.

New Infrastructure Policies

China has looked to new policies to boost infrastructure spending. The General Office of the Central Committee of the Communist Party of China and the General Office of the State Council issued the Circular on the Issuance of Special Local Government Bonds and Project Financing on June 10, relaxing funding rules to boost support for infrastructure projects. The circular allows local governments to use proceeds from special purpose bonds as capital for qualified major investment projects. Local governments will not be penalized for some types of hidden debt as long as they are in line with regulations. In addition, an executive meeting of the State Council on June 19 called for accelerating the reconstruction of older urban residential areas. These projects are mainly concerned with infrastructure. Other instruments in the policy toolbox for the second half of 2019 include raising the quota for new local government bond issuances, reducing the capital ratio of investment projects, and even lifting budget deficit limits. With such a push for more economic stimulus, we can expect accelerated infrastructure investment in the second half of 2019.

Unfavorable government policies are expected to weigh on the real estate sector in the second half of the year, however. The circular by the China Banking Regulatory Commission issued on May 17 kicked off a new round of crackdowns on illegal funds moving through the trust sector to help finance property developers. While new housing as measured by construction area has been declining and inventories remain low, demand for housing construction can still support real estate investment if sales hold steady and funding sources are adequate. Real estate sales will be aided if local governments ease restrictions on residential permits in big cities as part of a national effort promoting urbanization. So real estate investment in the second half of 2019 is most likely to decline, though in an orderly manner.

As far as manufacturing investment is concerned, the high technology sector has been a focus. Since 2019, investment in manufacturing overall has fallen rapidly, highly related to the decline of enterprise profit growth and the low confidence among entrepreneurs. The latter cannot be improved without reductions in Sino-US trade friction. Additionally, banks may be less interested in supporting manufacturing as demand rises for funds to support infrastructure projects. Fortunately, the April meeting of the ruling Politburo emphasized the need to support manufacturing.“To promote steady economic growth, China will encourage high-quality development in the manufacturing sector, thereby guiding traditional industries to accelerate industrial upgrading and strengthen emerging industries.” As the Sino-US trade standoff envelops science and technology, it is essential that government support for the hightech sector be maintained.

The contribution of services to GDP in 2018:

52%

Outlook for Exports

The prospect for exports is not optimistic, however. In terms of Sino-US trade tensio, progress at the negotiating table will take time and China's exports are certain to be impacted to some degree. China needs to expand its trade relations with other trading partners. It is reasonable for the country to step up the bilateral trade negotiations with the European Union, Japan, South Korea, and the Association of Southeast Asian Nations so as to help Chinese exporters offset difficulties in the US market.

Consumption growth, another driver of economic growth, remains constrained. Two main factors in the consumption picture have offset the benefits of reduced taxes. One is the decline in automobile sales and the other is the slowdown in household income growth, which has limited borrowing ability for the purchase of big-ticket items. Stimulating consumption is likely to be a focus of policymakers in medium and longer term.

In the long run, slower economic growth is inevitable, amid a complex international environment and the prolonged Sino-US conflict. However, the continuous advancement of China's economic transformation has brought some positive effects.First, there has been an increase in industrial concentration so that the environment for development has been optimized. The supply-side structural reform since 2016 has significantly alleviated the problem of overcapacity in the industrial sector. Enterprises that survive cutbacks in surplus industrial capacity have generally benefited from greater competitiveness in technology, productivity and financing. The price level of their products and their profit margins have generally been optimized.

In recent years, the real estate sector has also undergone significant improvement as far as industry concentration is concerned. With lower financing costs and faster capital turnover, it is easier for large-scale property companies to implement a “long-term mechanism” for healthier development in the real estate sector.

Second, the upgrading of the nation's manufacturing structure will help enhance long-term growth potential. In recent years, China's consumption structure has been significantly upgraded, with consumption in rural areas growing faster than in urban areas. Service sector consumption has also been expanding at a faster pace than consumption of goods. Meanwhile, import-related consumption has expanded faster than consumption of domestic goods. This provides a strong internal driving force for the upgrading of China's manufacturing structure, which holds the greatest potential for longterm economic growth. In 2017 and 2018, investments in high-tech manufacturing and the production of equipment were increasing significantly faster than China's manufacturing industry overall. As of the end of 2017, they accounted for 13.5% and 41.6% of manufacturing investment overall, respectively. Against the background of Sino-US trade friction, the reduction of entry barriers to key industries entry will gain greater attention in an effort to speed China's medium- and longerterm growth.Last but not least, the growing role of services will contribute to enhancing the resilience of China's economy. Services accounted for 52% of China's GDP in 2018, up from 40% in 2007 - at the outset of the global financial crisis. There are many benefits to be derived from this shift. For example, the larger proportion of services means more employment opportunities, which is conducive to China's long-term stability on the road to a high-quality growth. Additionally, the development of emerging producer services, such as big data and the “Internet of Things,” has a positive spillover effect on the improvement in industrial productivity. Services are also less susceptible to the swings in trade relations, potentially offsetting the future setbacks in goods trade with the US.