China has been on the verge of a hard landing for many years, according to some analysts. Will they finally be right in 2019? Andy Rothman, Investment Strategist at Matthews Asia, sees the hard landing still not on the horizon.
AsiaFundManagers.com: China’s economy has seen a deceleration in the end of 2018. Has the China collapse arrived?
Andy Rothman: Let’s look at the largest part of China’s economy – consumption. Income growth is, of course, the foundation of consumer spending, and in 4Q18, inflation-adjusted (real) income growth slowed a bit, to 6.2% YoY, down from 6.9% in 4Q17. That degree of slowdown was within my expectations, and it is worth noting that last quarter’s pace was roughly the same as the 6.3% recorded in 4Q16.
Collapse in auto sales reason for deceleration
Andy Rothman: One data point that did surprise on the downside in the last quarter was the nominal growth rate of retail sales of consumer goods by larger firms, which slowed to 2.6% from 7.3% in 4Q17. But, this sharp deceleration was due almost entirely to a collapse in auto sales, which fell by 8.3% YoY, in contrast to a rise of 4.4% during 4Q17.
AFM: What are the reasons for the collapse in auto sales?
Andy Rothman: This new car collapse was largely the consequence of a temporary tax cut from late 2015 through the end of 2017, which brought forward demand – retail sales of autos by larger firms rose 10.1% in 2016 and 5.6% in 2017 – rather than being a reflection of a lack of spending power or sentiment on the part of consumers. For this reason, new car sales are likely to remain weak in 2019.
In fact, nominal retail sales by larger firms excluding autos rose 7.7% during the last quarter, compared to 8.6% in 4Q17 and 8% in 4Q16. Not a dramatic deceleration, especially when a sharp fall in global oil prices also contributed to slower growth in retail sales, as gasoline prices were down.
AFM: How has the consumption of private households changed?
Andy Rothman: Adjusted for inflation, the growth rate of retail sales accelerated in December to 6.7% YoY, up from 5.8% in November and 5.6% in October, although down from 7.8% in December 2017.
China household consumption is strong
Andy Rothman: Here is another perspective: household consumption rose 8% YoY in 4Q18, upfrom 6.1% during 4Q17, despite the sharp slowdown in auto sales last year. This acceleration reflects the rising share of consumer spending on services, as well as the strength of spending on services. Services now account for 44.2% of household consumption, up 1.6 percentage points from a year ago.
And the household consumption data covers the full range of spending on services, such as education, health care, rent, travel and entertainment, while the services spending captured by the retail sales data is limited to only restaurant dining and other food-related services. Retail sales covers spending by companies and government agencies, while, of course, household consumption data – which is only published quarterly – excludes those organizations.
Growth wasn’t bad, but sentiment was terrible
AFM: So, when the growth deceleration was not that drastic, why was market sentiment in China terrible?
Andy Rothman: The most important driver of pessimism was fear of a trade war with the U.S. Domestic investors told me they were concerned about far more than just a disruption of shipments to China’s top export market. They worried that President Trump might escalate the conflict beyond tariffs, limiting the ability of Chinese to study in the U.S., or banning Chinese imports of American semiconductors, which are the foundation of China’s tech sector. The negative consequences of a possible cold war-style relationship between the world’s two largest economies weighed heavily on domestic sentiment last year.
Another factor was the unintended consequences of the government’s efforts to de-risk the financial system. Shadow banking was cut sharply last year, with shadow loans outstanding down by almost 11% YoY as of December, in contrast to a rise of 15% through December of 2017. Total credit rose by about 10% last year, but the composition of the new flow changed: traditional bank loans accounted for 81% of new credit, up from a 51% share in 2013 as shadow banking was curbed. There was a similar clampdown on peer-to-peer lending. While these changes are good for the long-term health of the financial system, they created short-term pain for many private firms, who were among the largest recipients of shadow credit.
AFM: What about the trade conflict – do you expect a solution any time soon?
Andy Rothman: I expect a 1H19 resolution to the short-term trade dispute between the U.S. and China. Trump seems to believe that resolving this problem and lifting his tariffs on Chinese imports is important to his re-election prospects, and he has therefore adopted a more realistic negotiating strategy, dropping his irrational focus on the bilateral trade deficit as well as demands for Xi to make deep structural changes, such as eliminating his industrial policies and support for SOEs. I think Xi recognizes that Trump’s remaining demands, including better market access for American firms and stronger protection for intellectual property rights, will contribute to China’s economic progress, and Xi also wants to avoid a conflict that could escalate into a tech war, jeopardizing China’s access to US semiconductors. A Trump – Xi deal will not resolve the longer-term challenges in the bilateral relationship, but it will lift short-term fears of an escalating trade war.
China starting to embrace entrepreneurs
AFM: How are the distortions in the shadow banking system affecting the economy?
Andy Rothman: Xi has already pivoted away from his rhetorical embrace of SOEs, with recent public statements expressing support to entrepreneurs. His banking regulators have also announced a series of measures designed to boost lending to private firms. While it isn’t clear how effective those measures will be, the impact on entrepreneurial sentiment should be apparent in the coming quarters.
Modest easing of monetary and fiscal policy is also a reason for optimism this year. China’s banking regulators have indicated that they will take steps to mitigate the impact of the shadow banking crackdown, including increasing interbank liquidity, which will lower interbank rates. Mortgage rates have already begun to decline. This will be accompanied by modest fiscal policy easing, including further tax cuts and a small boost to infrastructure spending.
AFM: Mr. Rothman, thank you for your insights.
Investment Strategist, Matthews Asia
Andy Rothman lived and worked in China for more than 20 years, analysing the country’s economic and political environment, before joining Matthews Asia in 2014. As Investment Strategist, he has a leading role in shaping and presenting the firm’s thoughts on how China should be viewed at the country, regional and global level.