Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.
2018 was a tumultuous year for the Chinese economy, marking a dramatic shift in both economic conditions and sentiment. The year started on a confident note as China’s equity markets advanced and the country’s tech champions reached dizzying new valuations. Economic friction between China and the United States began to worsen in the first quarter, culminating in the imposition of tariffs by the U.S. on Chinese goods. China responded in kind by issuing a matching set of tariffs on U.S. imports. The initial tariffs applied by both sides affected a relatively small subset of goods and were not enough to disrupt the otherwise heady domestic sentiment. The prevailing mood was that China was “not afraid of a trade war,” and it was well prepared to weather a protracted economic struggle with the U.S.
In the early months of 2018, policymakers also began to declare victory in the country’s deleveraging campaign. Ramping up in 2016, the campaign had succeeded in stabilizing China’s debt-to-gross domestic product (GDP) ratio and taming many of the wilder corners of the shadow banking system. A widespread view at the time was that deleveraging was not a significant drag on economic growth, despite indications that financial conditions were beginning to tighten sharply.
On the political front, China’s “new era” was made official via the removal of presidential term limits and the unanimous reelection of President Xi Jinping in March. The consolidation of power by Xi Jinping over the past several years has corresponded with a move to emphasize the primacy of the Communist Party across all policymaking domains. Moves to liberalize certain parts of the economy have contrasted sharply with greater intervention in other areas. A sign of the times, private enterprises are increasingly adding party members to their boards of directors and establishing party cells within their corporate structures to maintain good relations with Beijing. Nowhere is the uncomfortable balance between the state and the market more apparent than in China’s strategic technology campaign, where government funds and policy support are influencing a wide swathe of industries.
China’s economy began to slow as the year progressed. The negative impact of the deleveraging campaign began to emerge via two channels: a precipitous drop in local government infrastructure financing and an acute financing crunch affecting many private sector firms. Policymakers responded quickly to both problems with new initiatives, but it will take months to determine the effectiveness of these efforts.
While the economy decelerated moderately throughout the year, domestic economic sentiment turned negative more quickly. During a fall visit to China, I was struck by how pessimistic many local economists were about the country’s economic prospects and how much this contrasted with the optimism at the beginning of the year. China’s equity markets closely mirrored the souring sentiment. The Shanghai and Shenzhen Stock Exchange Composite Indices peaked in late January and then declined through much of the year.
Equity markets reacted sharply to concerns about the economy, the slowing growth of corporate profits, and a series of dramatic escalations in tensions between China and the U.S. These escalations included the imposition of U.S. sanctions on the ZTE Corporation in April; the breakdown of trade talks in May; the imposition of new tariffs in July, August, and September; the Bloomberg Supermicro hack story in October; and the arrest of Huawei executive Meng Wanzhou in December. More so than the direct impact of tariffs, Chinese investors appeared to be rattled by the prospect of a long-term shift towards a more contentious relationship with the U.S. By the end of the year, China earned the ignominious award of the world’s worst performing major stock market.
Despite the undeniable challenges China is facing, there are important positive trends underway that risk being overshadowed by all the negative headlines. First, the effect of the trade war has been exaggerated and the actual economic impact has been limited so far. China’s exports grew robustly throughout the year and while the growth may be driven in part by accelerated orders (to avoid anticipated U.S. tariffs), it also reflects China’s increasingly diverse trade relationships. Underpinned by initiatives like the Belt and Road, Chinese exports to emerging and frontier markets are expanding rapidly. The U.S. and China may ultimately come to an agreement to end the trade war, but the long-term trend is for greater economic decoupling between the two countries. Paradoxically, this decoupling may ultimately lead to a more balanced and sustainable U.S.-China economic relationship in the future.
Second, Chinese policymakers have avoided a return to the old pattern of debt-fueled stimulus and aggressive intervention in the markets. Despite a significant correction in the stock market and a general economic slowdown, stimulus efforts have been modest and targeted, and credit growth continues to moderate. China’s focus on reducing financial risks is not being abandoned in order to boost short-term growth. The country continues to open its capital markets to foreign investors and has been rewarded with a steady inflow of capital throughout the year. Policymakers have addressed acute risks in the equity market, such as pledged share lending, and have not repeated the aggressive interventions seen in 2016.
Third, China’s private sector is facing a difficult period, but it remains the country’s most important economic engine. By their own admission, China’s communist leaders acknowledge that the private sector is responsible for “more than 50% of tax revenue, 60% of GDP, 70% of technological innovation, 80% of urban employment, and 90% of new jobs and new firms.”1 Policymakers engineered an abrupt course correction in the fourth quarter of 2018 when it became apparent that a series of policies, most notably the deleveraging campaign, was having a disproportionate impact on private enterprises. The reversal did much to highlight that despite concerns about the growing role of the state in the economy, the private sector has not been forgotten in the Xi Jinping Era and policymakers are reactive to its needs.
China experienced a volatile and bruising 2018 and new challenges will emerge in in 2019. However, the avalanche of negative news can often obscure important long-term developments that will shape the country’s economy for years to come.Nicholas Borst,
- The Shanghai Stock Exchange Composite Index (SSE) is a capitalization-weighted index that tracks the performance of A-shares and B-shares listed on the Shanghai Stock Exchange. Index code: SHCOMP.
- The Shenzhen Stock Exchange Composite Index (SZSE) is a capitalization-weighted index that tracks the performance of A-shares and B-shares listed on the Shenzhen Stock Exchange. Index code: SZCOMP.
- It is not possible to invest directly in an index.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- As of December 31, 2018 the Seafarer Funds owned no shares in the entities referenced in this commentary.
- “Xinhua Headlines: Chinese vice premier analyzes economic, financial hot issues,” Xinhua News, 19 October 2018.