We can’t rely on China to drive global economic growth again

2019, a year in which monetary policy was supposed to be tightened across most of the OECD, has instead seen marked policy loosening (see Table 1). A summary of rate movements since January 2018 is presented in Figure 1.

Our expectation is that monetary policy easing will continue and rates fall to zero or close to it where they are not already negative. The exception is China, which has a different policy architecture that relies more on window guidance and quasi-fiscal measures, although policy is still expected to be eased there too. Initially, the market reaction to these rate cuts was for bond yields to fall in tandem, even at the longer end of the curve. This was taken as a signal these monetary measures were either too little or too late to prevent future low growth and low inflation (and hence low longer-term yields). However, since August there has been a remarkable reversal. Indeed, 10-year US yields surged from 1.42% to past 1.94%; German Bunds from -0.75% to -0.25%; Chinese government bonds from 3.00% to 3.30%; Japanese Government Bonds (JGBs) from -0.28% to -0.7%; UK gilts from 0.40% to 0.81%; Australian yields from 0.89% to 1.29%; and New Zealand’s from 0.99% to 1.39% (see Figure 2).

This sharp reaction seems both market positioning and a belief that the threat of a US-China trade war and a Hard Brexit is over. It also backs a firm belief that a rate-cutting cycle central banks saw no need for 12 months ago, has been sufficient to ensure there is no risk of a global economic downturn ahead. However, we beg to differ.

To compare like with like, a snapshot of OECD leading, not coincident, indicators does not point to a global recovery ahead (see Figure 3). For the US, UK, Japan, and the Eurozone--accounting for the lion’s share of global GDP--are still trending down despite the odd recent piece of better-than-expected economic data in Europe and the US. Japan’s weak Q3 GDP confirmed this. Moreover, lead indicators also show the situation worsening in Canada, India, and South Korea (see Figure 4). The exceptions to this slowdown are Brazil, which is no longer improving and offers little support to global growth; Mexico, benefitting from both the proposed new USMCA trade deal and the switch of supply chains away from China; Australia, where the economic picture is extremely mixed after a recent fall in jobs creation and a slump in retail spending; and China, where the lead indicator has shown a slight upwards trend despite the backdrop of a continued deceleration in the rate of its headline GDP growth.

At this stage, is seems unrealistic to expect that the US economy will be able to operate as a global growth engine going forwards, as it has in the past. It also seems highly unlikely that Europe will be able to operate as one, or Japan. India is not capable either. Consequently, the global recovery the bond market is pricing for will need to come from China – just as has been the case several times since the Global Financial Crisis.

In 2008-09 China undertook a vast stimulus package to help stabilise its economy estimated by the World Bank as equivalent to USD586bn and 13.4% of GDP. This worked, albeit at the cost of a rising debt-load and an estimated 20% write-off rate amongst loans made. It also flowed to the global economy. With global growth not enough for China to rely on once the initial V-shaped recovery was over, and with local growth slowing once stimulus wore off, China subsequently introduced similar, smaller, stimulus packages in mid-2012; mid-2015; mid-2017; and early 2019 ahead of October’s 70th anniversary of the founding of the People’s Republic. These can be tracked in China’s Total Social Financing data (TSF, see Figure 5). Crucially, however, there are no signs that China is prepared to undertake another large stimulus package compared to previous episodes: October’s weak TSF and bank lending are also signalling that, despite some seasonality factors.

Looking at the TSF data above one can see each Chinese stimulus package relied on a different sector. 2009 was led by CNY bank loans; 2012 by shadow banking and FX bank loans; 2015 by CNY bank loans and bond issuance; 2017 by local government (LG) bonds and trust loans; and 2019 again by LG bonds. Moreover, each package has generally a shorter time span and a lower amount than its predecessor. Additionally, one can make a strong case that China has now reached the stage where stimulus is no longer productive. Key infrastructure has been built in areas with high GDP where it can boost productivity most. Stimulus can continue, with duplicate roads and rails, or in areas with low GDP/incomes, but with far less impact on growth. Indeed, there have been reports that some local governments--already tapping 2020 quotas for bond issuance having exhausted 2019’s--are finding it hard to select worthy projects to invest in.

True, the PBOC can and does lean on banks to target lending to more productive borrowers like private, not state, firms and to SMEs, not corporate giants. However, given concerns over rising credit risks, Chinese banks continue to prefer to lend to the state sector wherever possible. Equally, private firms (who are less directed from the central government) are arguably less willing to borrow money for new investment in a slowing economy (reportedly, they are still having to rely on shadow banking where they do want funds). At the same time, overall debt levels in China are widely regarded as having soared to worrying levels in not just households and corporates, but with the local government sector: indeed, defaults have been rising sharply there too, especially as local authorities rely on rising land prices as revenue streams, a fact which incentivises them to channel stimulus packages towards white elephant real estate schemes over more productive investment. That debt overhang will naturally act as major constraint on Chinese stimulus going forwards absent major structural reforms.

So too might China’s concern over headline inflation, at least in terms of pork prices, given that headline inflation even surged to 3.8% y/y in October, while non-food slowed to 0.9% (see Figure 6) - clearly underlining the split between the impact of the African swine fever (and thus on pork prices) on the one hand, and weakening of domestic demand on the other. China is of course further constrained by what the impact on its currency would be if too much liquidity were to be thrown into the financial system too quickly: depreciation pressures could build rapidly again. As such, one can argue that while China talks about further stimulation, for now this remains more of a simulation and growth is likely to continue to slow.

That might sound strange just after China’s “Singles’ Day” on 11-11 saw record on-line spending of CNY268bn (USD38.4bn) in 24-hours, taken as a sign of a healthy Chinese consumer sector. However, these sales are largely driven by enormous discounts and will result in low/er profits despite high/er volumes in many cases and, quite likely, saw front-loading of consumer purchases rather than extra discretionary spending. Indeed, despite a positive 11-11, China’s overall economic growth looks far less bullish. Official Q3 real GDP came in at 6.0% y/y, after the 6.4% and 6.2% in Q1 and Q2 (see Figure 7), reaching its slowest quarterly y/y level in almost 28 years. The growth contribution from net exports was positive in these quarters, but this is mainly related to weak exports, which were outpaced by even more weaker imports (more on which in a moment). This weakening of domestic activity is expected to continue despite targeted stimulus measures. Indeed, the IMF already expects China’s growth in 2020 might fall to 5.8% y/y. We are a bit more pessimistic and expect growth to come in at 5.7% next year.

Lower domestic activity is clearly visible if one looks at October monthly figures, which confirm our view of a further slowdown (see Figure 8). Nominal retail sales came in at 7.2% y/y (and even 4.9% in volume terms). Fixed asset investment growth was also weaker, especially for the private sector: while the public sector picked up from 7.3% to 7.4% y/y, the private side dropped to 4.4%, reaching its lowest pace of growth since end-2016. Meanwhile, industrial production figures came down from 5.8% to 4.7% y/y, while SOE activity remained pretty stable in that period. In the previous two quarters, weak activity in the first two months was offset by stronger activity in the last month. Aside from some positive one-offs over the last few months, the overall downward trend is clearly continuing and builds the case for (more) stimulus in order to prevent the economy from weakening further into year-end. But, as said, this will likely encompass far more targeted and smaller packages compared to previous episodes, which will not see a major upswing in sentiment, merely a controlled pace of y/y deceleration.

So China is slowing and won’t be able to offer a new stimulus package on the scale of recent years. That is obviously bad news for global growth ahead, and so for bond-market bears too. However, things look to get worse than that: China is already exporting deflation again. For all the talk about the pain of tariffs, US import prices from China are -1.7% y/y (see Figure 9), close to the second-lowest seen since the depths of the global financial crisis. Worse, China’s response to its own slowdown and to the US-China trade war is increasingly to: reduce its imports; and shift its exports away from the US towards other markets. On the first point, look at 2019’s Chinese import growth figures across a spectrum of major countries (see Figure 10).

Obviously they are strongly negative vis-a-vis the US: but why should this be the case for South Korea and for Japan? And why is import growth from the EU and ASEAN so low when China is growing 6% y/y in real terms? It suggests either GDP growth is far lower than recorded official and/or import substitution is taking place. Backing that view, China’s rolling 12-month trade balance with North America has started to decline due to the trade war (see Figure 11). However, China’s trade surplus with Europe has started to climb despite sluggish EU GDP growth, and its surplus with the rest of Asia is surging. Only commodity producers/exporters such as South America, Africa, and Australia/New Zealand are able to maintain a surplus or moderate trade deficit with China.

Yet even there we see signs that China might be willing to turn towards local substitutes for imported commodities, such as coal, despite their higher price and lower quality. Indeed, mining investment is one area still growing rapidly in y/y terms (see Figure 12). Moreover, China’s National Energy Commission has recently announced that energy security is crucial for 2020-25, and domestic coal, oil, and gas will be increasingly relied on. If delivered, that would potentially leave food as China’s main area of unsubstitutable net imports – and concurrently reduce the number of countries who can directly benefit from its (lower) GDP growth. In other words, China looks like it will drive import prices lower directly via lower prices and reduce GDP growth to non-commodity exporters (in Europe and Asia) via its gain in net exports - and most so in countries that are most reliant on net exports to it for growth (like Germany).

That all means lower Chinese GDP growth is a double negative for overall global growth - unless its export drive and import stance changes dramatically. For example, Australia might see lower hard commodity exports, and Europe, like Asia ahead of it, may face a flood of cheap Chinese imports just as it grapples with low growth and low inflation. Might that even see a change in its stance towards free trade, as in the US?

To conclude then, a shift lower in Chinese import prices is already clear, where recorded. A shift lower in Chinese economic growth is already clear as well, and smaller and more targeted stimulus measures compared to previous episodes dampen the global outlook too. Moreover, we have a shift in China’s trade strategy towards lower imports and as high a level of exports as possible, even absent the US market, and despite China’s free-trade rhetoric and events such as the Shanghai Import Expo. All of these are likely to mean a new shift lower in bond yields again soon – and perhaps even a shift on global perceptions of the attractiveness of unfettered free trade. We may just have to ‘put in a shift’ while waiting for the markets to catch up to what the data already point to.