By Erik Norland
For all the deliberation on the China-U.S. trade dispute, there is scant evidence that the tit-for-tat tariffs are having any significant impact on China's growth. The country's official growth rate did slow down from 6.7% to 6.5% in Q3, but it was just 0.1% below the consensus estimate. The Li Keqiang Index, an alternative barometer of China's economic performance based upon rail freight volumes, electricity consumption and growth in bank loans, shows that growth is much stronger - closer to 9% year on year - although it too has slowed slightly (Figure 1).
Figure 1: So Far So Good, China's Economic Growth is Holding Up Well.
That China's growth has largely shrugged off the trade dispute thus far comes as little surprise for several reasons. First, U.S. tariffs have only just begun to bite - so whatever impact will likely not be fully reflected in China's data for several more months (at the soonest).
Secondly, the proposed tariffs just aren't that big in relation to the size of China's economy, the second largest in the world behind the United States. Ignoring second-round effects, a 10% tariff on $200 billion worth of goods in a $12 trillion economy should only erase about 0.1% or 0.2% from China's growth. Third, China can and is taking actions to offset those negative impacts, however modest.
China's apparent resilience is great news for commodity producers. As we have highlighted in our past research, nearly all commodities, from agricultural goods to metals and energy, have demonstrated significant, lagged responses to fluctuations in Chinese economic growth - especially when using the Li Keqiang proxy measure of GDP. That doesn't mean, however, that those who are long commodities are in the clear. Some of the actions that China is taking to offset any negative impacts from the trade dispute could have negative short and long-term consequences for commodity investors.
Offset #1: Devaluation
In response to both the trade dispute and a general fall in the value of emerging market currencies, China is carefully managing its currency downward. Its State Administration of Foreign Exchange doesn't want a sudden, destabilizing devaluation nor does it want China to lose competitiveness. As such, China's currency has slipped, bit by bit, nearly 10% versus the U.S. dollar (USD) since the start of April (Figure 2). Intentionally or not, a 10% devaluation just about perfectly offsets the impact of higher U.S. tariffs.
Figure 2: A Careful Devaluation.
A modest, progressive devaluation poses little danger to the Chinese economy. It's not enough to significantly boost inflation and it's slow enough to discourage a destabilizing capital flight. Moreover, it has the salutary impact of slightly augmenting China's competitiveness without attracting the ire of foreign leaders. That said, a weaker renminbi (RMB) is, at the margin, not great news for commodity producers, who might see some slowing in demand growth as China's consumers will have to pay slightly higher prices.
Offset #2: Ever Greater Leverage
If China's economy begins to slow in earnest, the main reason won't be the trade war; it will be debt. China's overall debt burden stabilized relative to GDP in 2017, mainly owing to a surge in growth, but it began climbing again at an alarming pace in Q1 2018. In Q1, GDP grew by 6.7% but debt rose by twice as much, taking China's leverage ratio to 261.2% from 255.7% in Q4 2017 (Figure 3).
In the short term, increases in debt issuance are great news for the economy: one entity's deficit spending is income or investment for somebody else. It adds to GDP. At higher levels of debt, additional borrowing mainly serves to refinance existing loans and stimulates less growth than it might in a lower leverage environment.
Figure 3: Debt Stabilization is Over: Time to Lever Up Again!
China's policies are geared towards maintaining growth by adding ever more leverage. In September, China cut taxes and further increased government spending. Even before these actions, growth in Chinese public debt was already outstripping economic growth, having risen from 45.2% to 47.8% between Q1 2017 and Q1 2018. Presumably, the latest tax and spending measures will accentuate that upward trend.
Recent actions by the People's Bank of China (PBOC) will also encourage increased leverage in the private sector. Since the beginning of 2018, PBOC has cut the reserve requirement ratio three times, from 17% to 14.5%. This could encourage further growth in household debt, which rose from 45.6% to 49.3% of GDP between Q1 2017 and Q1 2018 even before the easing in bank lending requirements took effect (Figure 4).
Figure 4: Let's Get this Party Re-Started.
Chinese non-financial corporations have bucked the trend of increased leverage, with their debt ratios edging slightly lower the past year. Even so, with debts adding up to 164% of GDP, there are many companies in China, especially quasi-state-run enterprises, whose solvency is questionable.
Thus far, China has avoided a "Minsky moment" - a sudden loss of confidence in the ability of borrowers to repay loans that leads to a financial crisis. Indeed, China may not be close to any Minsky moment. Nevertheless, if China doesn't find a way to reduce leverage, such a moment might come, eventually.
Japan experienced such a collapse in confidence in 1990 when its debt levels were at levels like those of China today. The same is true of the United States and the European Union in 2007 and 2008. What differentiates China is that the Japanese, American and European crises began after periods of central bank tightening. With the PBOC easing policy for the moment, no such crisis is on the immediate horizon.
So long as inflation remains subdued, the PBOC can probably avoid taking measures that will provoke a loss of confidence in the financial system. That said, further increases in leverage will ultimately make any future reckoning more damaging. Moreover, a loss of confidence could potentially happen even if the central bank hasn't tightened policy.
Finally, any future financial crisis will likely be dealt with by devaluing the currency and the deeper the crisis, the bigger the potential future devaluation. Any eventual downturn/devaluation will likely send shock waves through commodity markets and the currencies of commodity exporting countries.
- Chinese growth shrugging off trade war, thus far.
- Offset by 10% drop in renminbi against USD since April.
- Weaker renminbi might dampen Chinese demand for commodities.
- China's Q1 growth in debt was double the GDP rate.
- Debt ratio rose to 261.2% of GDP in Q1 2018 from 255.7 in Q4 2017.
- Household debt rose from 45.6% to 49.3% of GDP from Q1 2017 to Q1 2018.