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Is China using the trade war to mask slow-down?

Glenn Freeman  |  13 Aug 2019Text size  Decrease  Increase  |  
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China's economic slowdown began before the trade war and the Middle Kingdom is using it to justify slower growth, a new Morningstar report suggests.

In a new report entitled China's Economy in the Doldrums as Trade War Impact Looms, Morningstar analysts Preston Caldwell and Allen Cheng suggest China's economic problems pre-date the trade dispute that ignited in early July 2018.

"We think the official GDP figures have missed both the timing and the magnitude of China’s slowdown,” say Caldwell and Cheng. “We think that growth began slowing at the end of 2017 following a credit slowdown.

"Quite plausibly, China deferred recognition of its economic slowdown until the end of 2018 in order to use the US-China trade war as a scapegoat for slower growth."

Official figures indicate the services sector has been the larger driver of the growth slowdown. Meanwhile, nominal growth in the industrial sector is down almost 700 basis points since the beginning of 2017, but real growth has been reported as flat, write the Morningstar analysts.

Caldwell and Cheng believe that in the past – such as between 2014 and 2016 – official figures have hidden a real growth slowdown.

"China’s march to deleveraging has ended for now, but the gap between credit growth and nominal GDP growth has stabilised."

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They say that China's exports to the US actually stabilised in the second quarter of 2019, after falling "precipitously" in the first quarter.

"Net exports to the US were actually up slightly year over year, as an 8 per cent drop in exports was more than offset by a 28 per cent drop in imports.

"Nevertheless, the pattern of recent months suggests a deferred impact from incremental tariffs, which weren’t hiked until May," say Caldwell and Cheng.

Australian shares hit hard

Donald Trump's most recent threat to hit US$300 billion of Chinese goods with 10 per cent tariffs buffetted share markets and stoked more investor fear. The ASX was one of the hardest hit markets, falling 2.44 per cent last Tuesday. 

China's responded by devaluing its currency, a move that only exacerbated the fear. Morningstar warns the US tariff rate on China is set to surge to 17.5 per cent on all remaining untargeted imports.

Whether Beijing allows the currency to weaken further remains an open question, which may yet lead to more hostilities.

"Clearly the situation has turned ugly and the behaviour of both players is unpredictable," wrote Morningstar's Peter Warnes in the latest Your Money Weekly.

Warnes weighed up the stakes of the trade hostilities for both sides.

While Chinese companies have been instructed to stop buying US agricultural products, at the same time, rising tariffs on Chinese imports potentially leave US consumers and the manufacturing sector worse off.

Warnes highlights the recent slide in global markets as the end of long-running investor complacency around unresolved trade tensions.

For China's economy, flattening credit growth has been the broader problem in the second quarter. Morningstar research predicts the stalling of credit growth will continue, and that China’s economic growth will remain flat for the rest of the year.

The continuing role of fixed asset investment

Morningstar analysis shows China's fixed asset investment – government and business expenditure on buildings, engineering construction, machinery and equipment – slowed to 5.5 per cent in the second quarter, from 6.3 per cent in the first quarter.

"While the acceleration of local government bond issuance and easing restrictions on these bonds to fund infrastructure projects have supported a limited investment recovery since mid-2018, we do not expect a large-scale stimulus as China’s leverage remains high," say Caldwell and Cheng.

A bigger decline was seen in manufacturing fixed assets, which fell to 2.2 per cent in the second quarter, from 4.6 per cent in the first.

The real estate sector held up better, with investment up 10.8 per cent in the second quarter, only slightly below the 11.4 per cent growth in the first quarter. But growth from this sector is tipped to begin slowing, with developers facing restrictions in accessing the bond market.

Other metrics also show slowing growth for real estate investment, including starts by developers.

The Morningstar report assesses machinery sales across two companies within its research purview – Sany Heavy Industry (SHG: 600031) and Zoomlion Heavy Industry (HKSE: 01157) – which both recently reported preliminary first-half 2019 net profit that beat analyst expectations.

Two other industrial segments of cement and steel also held reasonably firm in the first half of 2019, but Morningstar believes this is unsustainable over the longer term.

Companies here include:

Consumption growth weak in second quarter

Morningstar notes China's official retail sales growth jumped to 9.8 per cent in June, from 8.7 per cent in March.

"However, the uptick was mainly driven by a higher inflation rate, to 3.1 per cent from 1.8 per cent, due to soaring food prices (pork, vegetables, and fruits), while real retail sales growth contracted slightly to 6.7 per cent from 6.9 per cent," the report notes.

It cites extreme weather linked to climate change, and African swine fever, as the main reasons behind the hike in food prices.

"We expect more pork price inflation, but its impact will be limited, as we estimate that the pork share of the consumer price index basket is only about 2 per cent.

"National Bureau of Statistics household survey data also painted a picture of weaker consumption growth, with expenditure growth, excluding residence, falling to 6.8 per cent from 7.1 per cent in the first quarter."

Surveys of household consumption in China indicate an improvement in demand for food, clothing and other household goods – growing 6.4 per cent versus 3.6 per cent during the second quarter – but Morningstar believes this is more than offset by falling services sector growth.

Demand growth of education and entertainment services fell to just 4 per cent in the second quarter, from 18 per in the first quarter.

Healthcare demand was steady at around 10 per cent, but well down from 17 per cent in the second quarter of 2018.

A less glowing picture

Morningstar's alternative measure of demand for real consumer goods indicated more moderate improvement in the second quarter, to 3.8 per cent from 1.3 per cent in the first quarter.

Morningstar's staples index, measured on a trailing 12-month basis, slid again to a very weak 1 per cent from 2 per cent – as demand for staples has been pulled down by collapsing meat demand driven by high prices caused by swine fever.

Impact of trade war looms as average tariff rate surges

China - US trade balance

Source: China General Administration of Customs, US Census Bureau, Morningstar

Caldwell and Cheng expect corporate sales growth among Chinese companies Morningstar covers to outpace volume growth for the remainder of 2019, as they prioritise sales of higher-priced premium items over cheaper product lines.

"In the meantime, we expect improving profitability for most of the companies, as the 3 per cent value-added tax rate cut that applies to the manufacturing sector came into force in April."

Social financing growth flat after Q1 rebound

Total social financing is a Chinese Government term to describe the aggregate volume of funds provided by China’s domestic financial system to the private sector within a given timeframe.

It comprises 10 sub-indices including:

  • Renminbi loans
  • Foreign currency loans
  • Entrusted loans
  • Trust loans
  • Undiscounted bank bills
  • Corporate bonds
  • Non-financial corporate domestic equity financing
  • Insurance company repayments
  • Investment property
  • Financing via other financial instruments.

Total social financing also includes off-balance sheet forms of financing that exist outside the conventional bank lending system, such as initial public offerings, loans from trust companies and bond sales.

"Over the second quarter, the People’s Bank of China continued to inject liquidity and roll out policies to encourage financing to small- and mid-size enterprises, with a visible impact on interbank rates.

"However, the impact of credit has been underwhelming: our adjusted total social financing measure remained in line with the previous quarter at 11.4 per cent year-on-year growth, despite the prior quarter’s bounce-back from trough growth of 10.3 per cent in December," say Caldwell and Cheng.

While lending conditions have shown signs of improvement -- such as high government bond growth and a slowdown in shadow banking’s decline – this was offset by the decline in borrowing from non-financial enterprises and households. Overall, bond borrowing is still lower than the 2016 easing cycle, as credit spreads remain high.

China's credit growth declined, in line with Morningstar's prediction that this will remain at around 11 per cent or 12 per cent in 2019. This range of credit growth provided a boost to the economy without creating a full recovery as was seen in 2013 and 2016.

This article is based on the report, China in the doldrums as trade war looms, which can be found on Morningstar.com

is senior editor for Morningstar Australia

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