China's economy continues to sag

Official GDP continues to slow despite repeated stimulus over the last 12 months. One reason for this is the trade war but the main reason is that the government has been cautious over lifting credit restrictions, anxious to avoid stoking a big new rise in debt burdens. I expect the world manufacturing cycle to pick up a little over the next year, but China’s growth will stay subdued and will not be a leader for world growth.

Official GDP numbers are flawed. I would put growth properly measured in the 3-5% range (officially 6% in Q3). But the labour force is barely growing today so the government faces no urgency to boost growth. Rather, the stimulus is aimed at preventing growth from collapsing altogether, while keeping the lid on the credit bubble.

The government is cautious

China’s problem is that it is at the end of a long industrial investment boom which has created over-capacity and raised debt ratios to high levels. To prevent debt ratios rising further the government is being cautious about unleashing a new credit boom, especially in the housing sector. As recently as 5 years ago there was very little household debt in China but it reached 52% of GDP at the end of 2018, a relatively high level for an emerging country. It is not high enough to cause a problem as such, but it would be unwise to encourage a further major run-up. Residential construction is a large part of the economy, accounting for at least 20% of GDP when all the linkages are taken into account, including construction materials such as steel, cement and glass, as well as household furnishings. So a weak residential sector makes it difficult to create a buoyant economy.

One area the government is trying to boost is infrastructure spending but it is also cautious about allowing local governments to borrow too much. So, while it has loosened the borrowing rules, the move has been limited. At the same time the scope for local governments to use land sales to finance infrastructure is constrained by the slow housing market. The net effect is that infrastructure spending is weaker than might be expected.

Tension with the US is here to stay

The planned interim agreement in the trade war will help, but tensions between the US and China are here to stay. International companies are turning away from China as a major link in their supply chains and trying to diversify to south-east Asia or elsewhere, or bring production home. Similarly, large Chinese companies are looking increasingly to invest outside China in the search for low costs, rather than in the interior.

An economy with slowing growth and high debt is often a candidate for a financial crisis. I still think this is unlikely because much of the debt is owed by state enterprises to state banks and therefore can be controlled by the government. The government is allowing bankruptcies and defaults in a managed way, trying to avoid all the losses falling on the public purse without risking a general panic. Emerging market debt crises usually arise when the currency collapses but China still has around $3 trillion in forex reserves which should prevent that. So China’s bubble is more likely to continue to gradually deflate rather than pop.