China's Big Decisions

China is facing some critical choices that could shape its economic growth and affect global financial markets for years to come.

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February 8, 2019

In the face of mounting external pressures and softening domestic demand, China is dealing with some very difficult policy decisions ahead. Escalation of the U.S.-China trade war, concerns about the fate of the private sector and the direction of economic reforms weighed on financial markets in 2018 and are set to continue to dominate investor sentiment. What the world’s second largest economy chooses to do in the next few months could impact both its future growth outlook and global financial stability for years to come. In this report, J.P. Morgan Research explores the key issues China is dealing with for the rest of the year and beyond.

What's Next for U.S.-China Trade Talks?

The escalation of U.S.-China trade tensions was one of the most significant developments for the global economy in 2018 and will likely remain in the spotlight throughout 2019. Currently, about half of China’s exports to the U.S. ($250 billion) and 85% of U.S. exports to China ($110 billion) are subject to different levels of penalty tariffs, ranging between 5% and 25%. Bilateral negotiations have been constructive since the G20 summit, increasing the chances of a partial agreement, but J.P. Morgan Research remains cautious longer term.

"In the long run, the U.S.-China relationship is unlikely to go back to the old days. We expect the competition between the two economic superpowers, in areas of trade, technology, and geopolitical influence to become a new normal,” said J.P. Morgan Chief China Economist and Head of China Equity Strategy, Haibin Zhu.

The trade dispute has also accelerated corporate strategy and long-term planning of supply chain locations. China’s manufacturing sector accounts for a huge proportion of emerging market (EM) Asia’s low-income production capacity, but neighboring Vietnam, India and Bangladesh are starting to gain some market share. Some of this reallocation of capacity is welcome, as China is striving to upgrade its manufacturing capabilities and attempts to move away from being the world’s factory floor. But how China navigates the U.S. relationship as it implements its hi-tech dominance plan, “Made in China 2025”, will continue to impact corporate strategy and planning.

“Whether a deal is reached or not, the U.S.-China relationship has changed fundamentally. While a tariff war would have a more immediate impact that could accelerate the pace of relocation, conflict in non-tariff areas still increases uncertainty in the trade and business environment and may continue to support the relocation trend in the long run,” said Zhu.

Group 4 Created with Sketch. In the long run, the U.S.-China relationship is unlikely to go back to the old days. We expect the competition between the two economic superpowers, in areas of trade, technology and geopolitical influence will become a new normal. Haibin Zhu Chief China Economist and Head of China Equity Strategy, J.P. Morgan

Is China’s Economic Growth Sustainable?

There is a wide consensus that China will lower its growth target to a 6%-6.5% range this year from “around 6.5%” in 2018. China has emphasized that its economy is facing headwinds and near-term economic pressure is coming from both internal and external fronts. Domestically, investment demand could weaken across the board (manufacturing, real estate and infrastructure investment) in 2019. By contrast, the services and consumer sectors seem to be holding up better. Except for auto sales, consumption growth has been relatively stable and tax cuts for households have partially offset drags such as slower wage growth and weaker house price inflation. Externally, uncertainty surrounding bilateral negotiations between the U.S. and China and their long-term relationship could hit export growth and reduce the incentive to invest. In an effort to combat the slowing economy, Chinese authorities made a flurry of policy announcements in early 2019 including tax cuts, monetary policy loosening and plans to support public spending.

China is expected to lower its growth
target this year to a range of

“We think the biggest risk near term is rising unemployment. To balance different policy objectives, the government will need not only to improve counter-cyclical policies, but also to promote structural reforms. Structural reform is critical to restore productivity-driven, sustainable long-run growth, in our view,” said Zhu.

Will Tax Cuts Provide a Necessary Boost?

Tax cuts in China will likely be at the center of Beijing’s fight against its slowing economy. Tax and fee reductions are expected to total around 2 trillion yuan ($300 billion) or 2% of GDP this year, boosting GDP growth by 0.46 percentage points, according to J.P. Morgan Research estimates. While the Chinese government previously favored spending on infrastructure as a fiscal stimulus, that led to a sharp rise in local government and state-owned enterprise debt — which Beijing has been trying to keep under control.

“The major fiscal effort will be tax cuts this year, instead of the infrastructure spending it relied on in the past. The government has grasped the problem and is adopting a different style of fiscal stimulus: tax cuts, for both households and corporations,” said Zhu.

Tax and fee reductions are
expected to total around
or 2% of GDP this year,
boosting GDP growth by
0.46 % points

“We expect further corporate tax cuts in 2019 and a further VAT reduction averaging 2 percentage points which would reduce the tax burden by around 700 billion yuan, or 0.7% of GDP,” Zhu added.

But the impact on growth could still be modest, amounting to around 1.2% of GDP according to J.P. Morgan Research. This is for two main reasons: first, the actual size of the tax cuts may be smaller than headline numbers due to more vigorous tax collection or to problems in policy implementation. Second, tax cuts have an indirect impact on the economy by increasing the capacity for households to spend and corporates to invest. During a business downturn, consumers tend to spend less and investment appetite eases, so a meaningful boost to growth takes longer.

Can China Count on the Consumer?

Retail sales in China slowed in the second half of last year, creating perceptions of a broad-based slowing in China's consumption. But this disappointing data was driven largely by weaker auto sales and the expiration of a tax break, confusing the picture according to J.P. Morgan Research.

“Excluding auto sales, nominal retail sales growth largely held steady, rising 10.6% in the first 11 months of 2018, compared to 11.2% in 2017. The message is similar for retail sales volume: the slowdown is mainly attributable to the decline in auto sales,” said Zhu.

China retail sales

Source: J.P. Morgan (% year-on-year, three month moving average)

Apart from the weaker than expected data, long-term structural factors support China’s growing consumption, as its share in GDP is still much lower in China than the world average. China’s demographic trends and government policies also support the consumption story and with trade frictions likely to remain in place for the foreseeable future, the domestic market is becoming more important for China’s production. Recent policy measures such as tax cuts for individuals and corporations, as well as import tariff reductions will benefit consumers, but the outlook for the consumer is not without its challenges.

“Consumption is susceptible to labor market conditions. A tariff war could squeeze industrial profits and deter investment and hiring, not to mention possibly further drive the relocation of the global supply chain as uncertainty lingers,” said Zhu.

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