Chinese Growth Sinks to Three-Year Low in Q2

June Snapshot

The June data are a mixed bag, with most indicators coming down further with the exception of investment and housing sales.

• Fixed-asset investment growth picked up to a three-month high of 20.4% year-on-year (y/y), up from 20.1% y/y in the previous month, as infrastructure investment improves. That is in line with the pick-up of bank lending, as well as a sharp increase in government expenditure in June.
• Industrial production growth pulled back again: growth was down to 9.5% y/y, from a 9.6% y/y increase in May, although still stronger than April, when China's growth slowdown suddenly accelerated. However, power production growth dropped to zero, the slowest since the global financial crisis if excluding months with Lunar New Year holidays, adding to concerns about the veracity of the headline output data.
• Housing construction continues to slide, although housing sales are improving. The floor space of residential units sold is still down, although the pace of fall has narrowed for four straight months. However, the fall of new housing starts accelerated—June's decline almost doubled the pace of the drop in the previous month.
• Retail sales growth is down: growth came in at just 13.7% y/y, the slowest since March 2009. Households look to have become more reluctant to spend as expectations of income and employment dims. Employment growth so far has budged very little, but local media has started reporting wage cuts and disguised redundancies in some of the most heavily hit sectors.

The H1 Report Card

With industrial production growth remaining subdued in June, China's GDP growth for the second quarter came in at just 7.6%, the worst in almost three years. This brought first-half (H1) growth to 7.8%: primary and tertiary sector growth accelerated compared with the first quarter, while secondary industry growth slumped from 9.1% in the first quarter to 8.3% in the first half. The downslide as of the second quarter represents a less vicious downturn compared with the global financial crisis if measured by peak-to-trough deceleration, but nearly as bad as in the Asian financial crisis. The length of consecutive quarterly GDP growth deceleration is even longer than in the slide following the Asian financial crisis—six straight quarters of deceleration as opposed to five. Domestic macro control and weakening external demand are the causes of the slowdown, but it is policy miscalculation and larger-than-anticipated shock from the Eurozone which have caused the stalling in the second quarter.

The composition of growth has shifted a lot in the second quarter as private consumption weakens and government spending starts picking up momentum. National Bureau of Statistics data show that final consumption's contribution to GDP growth retreated to 57.7% in the first half, down sharply from 76% in the first quarter, and capital formation's contribution increased to 49.4% by the end of the second quarter, up from 33.4% in the first quarter. In the meantime, net exports' contribution share to GDP remained negative, at -7.1%, although improving slightly from -9.4% recorded in the first quarter. Translated into percentage-point terms, final consumption contributed 4.5 percentage points to the 7.8% growth in the first half, investment 3.9 percentage points, and exports -0.6 percentage point.

Outlook and Implications

That growth has slowed to a three-year low, just a touch above the government's 7.5% growth target, has come within expectations given the quite weak industrial production numbers in April and May. What is more dismal than the growth situation is China's inability to absorb slower growth. A 7.8% growth in the first half already feels quite hard in terms of impact, inflicting huge pain: a downward spiral of producer prices, surging manufacturers' inventories, plunging profits, bankruptcies and pay cuts. "As a large developing economy, China needs to maintain a certain speed of growth," said the Chinese premier this week. Indeed, speed is essential for China, an economy which is basically built on the discount-store model of high turnover and low margin, and which outperforms based on size, scale and speed. Before China makes a successful transition to a luxury-store model of low turnover and high margin, proper growth is still critical, and 7.5% growth will still be a luxury which China cannot afford to have yet.

The cave-in of consumption in the second quarter is a sign that slowdown is transmitting from the business to the household sector. To stop the vicious cycle of slowdown, the government is acting more proactively again, which will be one key factor driving upticks in growth in the second half. There are some burgeoning signs of potential upturn down the road: increased bank lending, more aggressive fundraising by local government investment platforms, increased infrastructure construction, and a thawing housing market—all influenced by the visible hand of the government. Looking forward, China will continue to push ahead with its "mini-stimuli", which might include another rate cut, continued reduction of reserve requirement ratios, tax incentives and more proactive credit policies. The government should have adequate tools to revive the economy to a growth rate exceeding the 7.5% growth target. But the long-term stabilisation of the Chinese economy is left to the invisible hand of the market. That in turn depends on whether the government can conduct reforms to unleash mighty market forces that will boost demand and productivity, just as it has done after the Asian financial crisis. Without that, businesses might need to prepare for a relatively protracted period of slowdown and probably more volatilities down the road.