China’s Economy: Slowing Not Contracting

That China’s economy is slowing shouldn’t come as a surprise to investors. Even a one-party government that depends on growth for its political legitimacy has been signaling that. Policy has been aimed at managing both the cyclical and structural slowdowns so they are orderly (i.e., not politically destabilizing), ensuring the so-called soft, not hard landing.

The latest measure of factory activity underlines how the weakness of demand in the developed economies is hitting exporters. The flash (preliminary) HSBC purchasing managers’ index (PMI) for March, which is weighted towards export-dependent small- and medium-sized manufacturers, fell for the fifth consecutive month, to 48.1, from February’s 49.6. Any number below 50 signals contraction. The official PMI, which captures more activity at large and state-owned enterprises, will likely come in higher, at it customarily does.

For policymakers, the question is whether the lack of demand for the output of factories can be alleviated by making more credit available. As the U.S. Federal Reserve has found out since the 2008 global financial crisis, if underlying demand is nonexistent, it doesn’t matter how cheap the central bank makes credit. Even if pumping credit into the economy is deemed necessary–and the People’s Bank of China has been doing that of late after tightening lending and reining in the property market over the previous 18 months–Beijing’s policymakers have crude monetary tools at best. They can cut banks’ reserve ratio requirements (the capital banks have to keep in reserve against potential bad debts), or they can cut interest rates.

They are constrained on both fronts. Persistent worries about how hard banks could be hit by loans to property developers and local governments turning sour demand that an adequate capital cushion is maintained. Reserve requirements are being relaxed only selectively, such as for the Agricultural Bank of China, the country’s third largest  lender and which has just reported its first drop in quarterly profit since its stock market listing two years ago (via Bloomberg). Persistent inflation concerns, again highlighted by the PMI figures, limit the scope for interest rate cuts.

Government-created demand looks the more likely alternative, despite the potential long-term costs (price distortions, misallocation of capital and unsustainable build-up of debt), and yet further delay to the necessary rebalancing of the economy. Yet fixed-asset investment has been the go-to GDP machine. The massive transport infrastructure plan approved by the State Council on Wednesday is starting to look like the outline of a new stimulus plan.

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