Trade Fight Complicates Beijing’s Stimulus Calculus

Chinese slowdown is likely to lead to another, but more modest ramp-up in debt

By Nathaniel Taplin

In the past, most urban Chinese worked in construction and factories; today more jobs are in the service sector, which is still doing well. Photo: Zhu Xiang/Xinhua/Zuma Press 

It is an inconvenient time for a Chinese downturn—unless you are a trade warrior in Washington. Signs of distress are clear: Chinese stocks are in a bear market, the yuan is at a one-year low and investment growth is at its slowest this millennium.

In the past, the Chinese state has often stepped in with lots of financial firepower to smooth downturns—primarily by getting government-owned banks to lend more. Once the stimulus kicks in, it has resulted in higher commodity prices and big movements in currencies. The most lasting impact is an increase in China’s frightening debt burden, now more than 250% of gross domestic product.

Should investors expect a repeat this time? In short, yes—but probably less than before, because China’s political landscape has changed, as has the economy. Moreover, the current downturn is unlikely to be as severe as the last big ones in 2009 and 2015.

Another reason for a more modest stimulus is that President Xi Jinping has championed higher-quality, less debt-intensive growth. Reluctance from Beijing to launch a big stimulus could enhance the Trump administration’s leverage with China on trade later this year.

Although China’s growth targets receive a lot of attention, that isn’t what Beijing really cares about. Instead it’s the labor market and financial stability. A change in employment patterns is one big reason Beijing’s response to slowing growth may be more modest this time.

In the past, most Chinese not working on the farm were employed in construction and in factories producing industrial goods for the domestic economy and consumer goods for export.

These companies are struggling with heavy debt and tightening credit.

Change in employment by Chinese job sectors from 2007 to 2017.

Source: CEIC

But today, most urban Chinese work in the service sector for companies like tech giants Alibaba and Tencent or other companies serving China’s surging consumer market. That sector is still doing well.

Nearly 100 million more Chinese worked in services in 2017 than in 2010, according to Chinese government statistics. Meanwhile employment in industry—including the export sector—peaked in 2012 and there are now around 130 million fewer workers than in services.

So what will a modest stimulus look like and how will it play out inside China and in global markets?

To maintain stability and keep people working, China’s first priority is to ensure its overleveraged banks and businesses stay afloat by preventing housing, steel and cement prices from falling sharply as investment dips. Commodity prices are still likely to sell off further, until the new round of stimulus feeds through. But big cuts to excess steel capacity and to China’s enormous housing overhang make a crash less likely.

Another goal of a modest stimulus will be to prevent heavy capital outflows and protect the country’s $12 trillion bond market. Beijing will try to ease enough to keep banks lending to small businesses but not too much that people will fear a big devaluation and move their money out of the country. China’s newly reinforced capital controls make this less likely, but rising U.S. interest rates will pose a test.

If Beijing can strike that balance, the stock market should stabilize and bond defaults will remain modest. Domestic consumption should stay healthy, though a decline in exports would hurt workers and could reduce consumer spending.

What might change the current calculus? Inside China, investors would be wise to keep a close eye on housing and factory-gate prices—steep falls in either would hit indebted industrial and property companies hard. A more substantial stimulus effort would likely follow, pushing commodity prices back up higher and heaping pressure on the yuan.

If big capital outflows do reappear and the yuan falls further, Chinese companies or local governments could default on dollar bonds. Alternatively, a strong defense of the yuan by China’s central bank could suck too much cash out of domestic money markets, triggering a deeper downturn. 
Then there is the trade conflict. Exports remain solid for now. And a weaker yuan, down around 6% against the dollar since April, may help offset pressure from tariffs.

The most likely outcome remains a muddle-through. Monetary policy will be eased, if not as sharply as in the past, and some of the progress on indebtedness will be undone. China will avoid its long-feared debt crisis this time.

Less likely but still possible is a rapid fall in prices for housing or steel and a new wave of cash flowing out of China. Major turbulence in global commodity, currency and debt markets won’t be far behind.

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