Chinese Q3 Growth Softer than Expected

A Look Back at Q3

The National Bureau of Statistics (NBS) decided to address third-quarter trends by reporting cumulative figures for the first three quarters of the year this morning, a move intended to present a picture of the resilience of the Chinese economy in contrast to the stream of negative news coming from the West. This is true, but somewhat misleading, as the 9% year-on-year (y/y) growth figure reported for the third quarter and 11.4% y/y increase to industrial output for September reveal the much-anticipated deceleration. Trade growth figures reported this morning looked good in dollar terms, but real growth in terms of yuan is clearly falling. Overall domestic conditions may be stronger than prior to the East Asian crisis in 1998, but the external exposure of the Chinese economy since then has risen: exports were equivalent to around 35% of GDP at the end of 2007, compared with 18.5% in 1998. There were two positive notes in the data released: 22% y/y growth in retail sales for the first three quarters of the year (23.2% y/y for September) and a 27.6% y/y increase to fixed asset investment (FAI) spending (29% y/y for September).

Recent measures by the People's Bank of China (PBoC), while falling short of a significant easing of credit controls, would seem to have had a positive impact on bolstering domestic demand, especially investment in recent months. The PBoC cut interest rates twice last month and at the end of September the total of outstanding renminbi-denominated loans rose 14.5% on the year, accelerating from the 14.3% increase recorded in August.

This uptick in lending is a function of having raised lending quotas for loans directed towards small and medium-sized enterprises (SMEs). Interest rate cuts are understood to be more of a discount for the state-owned enterprises (SOEs) that receive the vast majority of bank lending than anything else, while the recent requirement cut was aimed at easing tension in interbank markets, especially in terms of dollar liquidity, which had fallen as a result of PBoC rules requiring commercial banks to top up the required reserves with foreign exchange. This would seem to leave the PBoC with plenty of room to stimulate growth, by easing up on lending quotas and reserve requirements. However, with reports of an increasing volume of loans 90 days past due, and in the context of the broader slowdown, the central bank will be cautious not to throw too much good money into an increasingly uncertain market. Political considerations could, however, win out.

More Neixu, Because Waixu is Fickle

With export demand expected to fall considerably in coming months, the popular media in China has been drowning the airwaves with the effortless idea that neixu (domestic demand) must replace waixu (external demand). Problems quickly arise, however, because there is not much consensus as to where this stimulus should be directed and where it will come from. For example, the combined effects of natural disasters, social strife in the West, and the Olympics have reportedly created a large hole in the central government budget for the current fiscal year. The Ministry of Finance is reported to have dipped into various stabilisation funds to avoid the outward appearance of running up a large deficit this year. For regional and municipal governments, the decline in turnover in local property markets has reduced the flow of related fees and taxes considerably, causing them to delay ambitious industrial development plans in some cases. On the consumer side of the equation, the latest retail sales data may point to a looming adjustment of household spending patterns resulting from lower expectations for income growth. This may also be a function of the crash of China's stock market this year, the effects of which are not discussed enough in the context of transitioning towards neixu-driven growth. The evaporation of close to 18 trillion yuan in market capitalisation must be significant. Various consumer sentiment indexes have posted large declines in recent months, and if household income growth slows along with the broader economy, as one would expect, in the absence of significant tax cuts or subsidies, it is difficult to see where the extra confidence would come from to reverse this trend.

These trends leave three basic choices for the central government: increase the deficit for this and next year; relax lending quotas that have tied the hands of commercial banks; or allow regional governments to issue or back debt to fund various initiatives. The latter of these may be more likely, albeit less advisable.

The Stimulus Package

China's State Council announced over the weekend what is by far the most comprehensive fiscal stimulus package in recent years, signalling an official shift to an expansive fiscal policy stance. Noting increasing global and domestic economic uncertainties, the State Council has announced that the government will adopt more "flexible and prudent" macro economic policy, making commitments to a package of new fiscal, taxation and foreign trade stimulus policies that are expected to be rolled out in the third quarter.

• Fixed-Asset Investment: The State Council has pledged to accelerate the construction of key projects in agriculture, water conservation, energy, transportation, and urban infrastructures, as well as the reconstruction of quake-hit areas in Sichuan, Gansu, and Shaanxi provinces. This marked a significant change in tone from the annual work report of the central government at the national legislature in March this year, where Premier Wen Jiabao simply noted that the country should "maintain a reasonable scale of investment". This is also the first time in the past five years that the government has ever urged local governments to step up investment.
• Export Tax Rebate: Maintaining stable exports growth is another focus of this package, in which the State Council announced that it will increase the export tax rebate rates for such labour-intensive products as textiles and apparels, as well as for the high value-added electrical machinery products. In August the Chinese government raised the export tax rebate rate for textiles and apparels by two percentage points, reversing previous rebate cuts introduced over the last two years.
• Tax: With fiscal revenue growth slowing to only 2.5% y/y in September from 30% y/y for the corresponding month of last year, the government stopped short of offering long-expected tax breaks for personal income tax and personal deposit interest income tax. Nevertheless, the central government has promised to slash the housing transaction tax, although this is framed in the context of "improving people's livelihood" rather than supporting the real estate industry.
• Agriculture and SMEs: Additionally, the Chinese State Council has also called for greater support for the agricultural sector and for SMEs. The support measures will include new plans to increase agricultural subsidies, the expansion of agricultural subsidy coverage, an increase of minimum purchasing prices for grains, and expanded lending to SMEs.

Outlook and Implications

Before the financial crisis in the west took a decisive turn for the worse, policymakers in China were giving serious attention to longer-term structural issues where reform is concerned, and it could be the case that the foundation of domestic growth is solid enough to absorb the effects of short-term adjustments. However, rhetoric about "uncertain factors" coming from the government would seem to indicate that the reform agenda may be scaled back in the name of preserving social stability. There is a risk that the government's short-term measures taken in response to softening growth could actually exacerbate structural problems. In the end, it could also be the case that under the current circumstances less is more where it comes to substantive government action to bolster growth. Thus allowing excess capacity in certain sectors, such as steel and low-end manufacturing, to die away would be a variety of reform in itself. However, the announcement of the State Council's stimulus package (timed to coincide with this latest data release) could well fuel redundant investment sponsored by regional- and municipal-level governments eager to move ahead with their own ambitious development plans. One possible result is another mini-boom in industrial investment in sectors that are risky at this point in China's growth cycle, and where slack capacity is already on the rise.