Road to 2020: part 3
This is the third part of the five part 2020 investors' questions series.
3. Will China experience a sharp economic slowdown in 2020?
What does the data say
China's economic growth slowed to 6.0% in the third quarter of 2019, compared to 6.2% in the second quarter and 6.4% in the first three months of the year. Economic data releases through the third quarter were below consensus expectations, with industrial output growth falling to 4.4% year-on-year, its lowest level in 17 years, while exports slipped 1% from a year earlier, and exports to the US slumped by a sharp 16%. A weakening in the domestic economy and a deteriorating external environment due to US-China trade tensions have both played a role in the softening of the data.
However, not all has been negative as we did see growth particularly in the property sector and spending in services. The country has been doing its utmost to support the moderating economy through tax cuts, and by boosting liquidity in the financial system. There have been more ambitious government policies, such as accelerated market opening, further protection for intellectual property and increased promotion of regional free trade, have also been implemented, along with other efforts to stabilize the economy.
Base case (75% probability) - Moderate growth
We remain cautiously optimistic about China in our base case scenario, keeping in the clear risk of further escalation in US trade tariffs, which could cause a considerable downside risk to the country's growth in the short to medium term.
However, with both the monetary policy and fiscal policy remaining supportive of economic growth, we do not expect a financial crisis to erupt, though concerns about leverage in the economy could re-emerge as local government debt loads have risen mildly to support infrastructure projects to cushion the economic slowdown.
In our base case, we expect China's debt-to-GDP ratio is likely to rise again after stabilising in 2017 and 2018. This shift will provide near-term policy relief, but we note that rising leverage also exacerbates longer-term debt sustainability risks as the economy continues to slow. This scenario assumers equity markets returning between 5% to 8%, while the Yuan will remain in a range between 7.0-7.4 in 2020.
Downside scenario (20% probability) - Sharp slowdown
We give 20% weighting to a scenario which assumes the latest round of US tariff hikes will put additional pressure on the Chinese economy and cause a sharper slowdown. In this scenario, we expect the Trump administration will impose investment restrictions and 10–25% tariffs on all Chinese imports (over USD 500bn annually) before 2020.
If this threat is carried out, China would experience a much sharper slowdown than our base case. GDP growth could fall to around 5% for at least two quarters, with the current account balance deteriorating sharply due to an export slowdown. The yuan could depreciate sharply and USDCNY could rise to over 7.5 within a quarter alongside a steep decline in official FX reserves, but it would also depend on the extent of the economic slowdown in the US and the rest of the world. Equity market could be expected to return -15% to -20% in such a scenario.
However, Chinese GDP growth of 5% would not constitute an end to the global business cycle, nor would it derail markets to the same extent as a Federal Reserve-induced US recession or a global trade war would. But such a slowdown would certainly not go unnoticed by Asian and global markets.
This would also mean that energy commodities and industrial metals would also suffer major price declines as many of them are bought mainly by Chinese companies (in aggregate, about 50% of all global industrial metals go to China).
Upside scenario (5% probability) - Stable GDP growth
We only give a 5% weighting to our upside scenario which assumes a stable growth of 6.6–6.8%, which would be a big positive surprise, especially if other economic targets, such as deleveraging and transitioning to a consumption-driven economic model, continue to be met.
This would enable the Chinese current account balance to rise back above USD 100bn. In such a scenario, commodities and risk assets, especially those in Asia and emerging markets (EMs) more broadly, would appreciate considerably.
Overall we believe we will continue to see a moderate growth in China which should meet the lower end of expectations and consensus. A moderate economic slowdown in the country could be a healthy and necessary side effect of reducing leverage and transitioning to a more sustainable growth model.
Head of Investment Research