China economic slowdown: reasons and impacts on financial market

There is perhaps little qualms that a global economic slowdown is expected this year but packed within this is likewise China’s deceleration. As the world’s second largest economy, what does this mean for financial markets?

China Source: Bloomberg

Economic data evidence

China saw its engines sputter into the second half (H2) of 2018, bringing about a broad sense of growth concerns. While the markets had long been expecting growth slowdown to occur, the realisation of this in data had only been apparent alongside the breakout of US-China trade conflict into H2 2018, altogether capturing the market’s attention.

One of the key leading indicators reflecting the slowdown in economic activity had been China’s purchasing managers indices (PMI). As shown in the chart below, the key manufacturing sector’s PMI on both the official National Bureau of Statistics of China (NBS) and the Caixin private gauge’s counts had displayed a downtrend into late 2018. The figures had in fact slipped briefly into contractionary territory, which is a reading below the 50.0 midpoint, at the end of the year. The decline had been mirrored in China’s industrial production performance, adopting a steady decelerating course since early 2018.

While seasonal effects in the form of the Chinese New Year effect had warranted second thoughts, the series of releases into April had perhaps offered little respite for markets. Meanwhile, it remains unknown at the point of writing as to how much longer the latest round of tariffs escalation seen in early May could sustain, but the market is recognising that this would likewise implicate economic performance particularly with trade numbers already wobbling into the end of 2018.

China Manufacturing PMI Source: Refinitiv

China Manufacturing PMI Source: Refinitiv

CN Industrial Production (YoY) Source: Refinitiv

CN Industrial Production (YoY) Source: Refinitiv

China customs trade Source: Refinitiv

China customs trade Source: Refinitiv

China economic slowdown reasons

The US-China trade conflict had been regarded as one key proponent of the slowdown but the reason for China’s deceleration is not entirely externally driven.

External factors: tariffs and global economic slowdown

As seen from the charts above, the slowdown in China’s production and trade coincided with the breakout of the US-China tariffs war into H2 2018. The US had progressively implemented tariffs on $250 billion worth of Chinese imports by the end of 2018, broken down to 25% on $50 billion and 10% on the remaining $200 billion as of December 2018. Over and above the cost this had done to trade and the economy, it had also significantly dented consumer and business confidence going into the year end thereby aggravating the impact upon economic conditions.

Meanwhile, China saw its economic conditions deteriorating into the end of 2018. It had not been the only region to weather the diminishing prospects for economic outlook. As seen from the International Monetary Fund's (IMF) April 2019 iteration of the World Economic Outlook, regions including the likes of the euro area, UK and Japan had suffered in kind from softer demand and thereby production. Across the globe, new orders had been evidently on a downtrend as well.

World trade, industrial production, and manufacturing PMI Source: IMF WEO, April 2019

World trade, industrial production, and manufacturing PMI Source: IMF WEO, April 2019

Domestic driver: deleveraging campaign

While domestic demand had contributed to softer conditions moving into 2019, China had its own battle with its high debt-to-gross domestic product ratio which invoked the concerns of a slowdown into 2018. The 19th National Party Congress in October 2017 had hailed the efforts of deleveraging and announced further reforms, taking advantage of a time when global markets were lifting off. The move to de-risk the bloated economy meant that financial conditions were tightened for domestic companies. While the market had widely recognised this as a ‘necessary evil’ to ensure sustainable growth in the longer term, it had no doubt kept a lid on growth from a domestic driver perspective.

Addressing the slowdown with policies

All the above said, in recognition of the slowdown and perhaps the limitations that the turn in developed central banks’ stance can support growth, the Chinese authorities had certainly gone on to adopt more policy support for the economy since the start of the year. This is alongside the downward revision in growth forecast for 2019 to between 6.0% and 6.5% from around 6.5% penned for 2018.

The step up of the traditional fiscal support had been very apparent at the start of the year, coming in at a rate that had largely overshot the market’s expectations. Premier Li Keqiang had announced in the 2019 National People’s Congress, which is China’s annual policy planning session, the plan for nearly 2 trillion yuan of cuts in taxes and other company fees. Under the plan, value added tax (VAT) for selected sectors including the manufacturing sector had been reduced. Personal income tax and deductions also came by later, this is expected to help stabilise the economy.

Separately, monetary policy support had also been noted alongside the fiscal ones since the start of the year. After markets declined sharply into the end of 2019, China had kicked off the year with a reserve requirement ratio (RRR) cut on 4 January.

US-China trade war and China’s policy response

After introducing one of the more supportive set of policies to prop up the economy in anticipation of a slowdown, the Chinese authorities had largely held a wait-and-see attitude to further calibrate their policies. This was prior to the early May breakout of trade tensions between US and China where announcements of fresh tariffs were made. While it remains early times for the impact from the fresh tariffs to set in, any transmission of these trade barriers into financial conditions impact would likely invite more reaction from the authorities. Further fiscal stimulus in the form of increased government spending and monetary policy such as the lowering of interest rates were just some of which that had been floated by the market as potential moves should the trade war bite further on economic conditions.

What does this mean for markets?

Yuan weakness

Amid the above-mentioned backdrop, the wind certainly does not appear to be blowing against the sail for the Chinese yuan. Over and above the potential of the escalating US-China trade tensions to affect the confidence in the Chinese currency, the increasing likelihood of easing by the People's Bank of China (PBOC) places pressure on the yuan to weaken. While the psychological 7.0 level may take a significant shock to overcome, the likes of the USD/CNH looks due to remain weak in the meantime.

USD/CNH mini Source: IG charts

USD/CNH mini Source: IG charts

Turbulence for Chinese market

By and large for the speculative Chinese market, which sees sentiment being a significant driver for prices, the extent in which growth is slowing down and the management of this slowdown in growth impacts its direction. With a proactive government, it becomes a function of the economic data performance and the policies expectations. While it may be difficult to tell where the direction of the current US-China trade war would take us, with the base case scenario of an eventual resolution looking further in sight at present, the weakness in the yuan expected would not be doing the Chinese stock market a favour. For indices such as the CSI 300, the bias may perhaps remain on the downside for some time to come with the currency factor unless a boost comes through from policy.

China 300 Source: IG Charts

China 300 Source: IG Charts

Conclusion

All in all, the period of strong economic performance in 2017 and early 2018 is now behind us with expectations of a slowdown expected. The good news is that the authorities are expected to continue, if not step up policy support that would at least stabilise the economy.

That said, the known/unknown would be trade tensions with US and China having announced a new round of tariffs. Depending on the duration that the multitude of trade barriers would remain in place, this could either diminish or make more pronounced the impact of a Chinese economic slowdown on financial markets, one to watch.


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