The coronavirus outbreak has struck yet another blow to the Chinese economy after the improvement in business confidence since the Phase 1 trade deal with the US was announced in mid-December. How severe the blow may be for the economy will depend not only on the extent and depth of the outbreak itself but also on the government response.
Beijing’s immediate and bold reaction to calm markets with a liquidity injection equivalent to US$170 billion says it all about the pressure for Chinese policymakers to mitigate the impact of the coronavirus outbreak on financial markets, on sentiment, and on the economy more generally.
Many take the example of the SARS (severe acute respiratory syndrome) crisis in 2003 as a benchmark to estimate the impact of the latest outbreak on the Chinese economy and beyond. But the reality is that China is very different from what it was 17 years ago.
First, the service sector, especially service consumption, is China’s key growth engine now, which was not the case in 2003. Based on the SARS experience, the service sector is likely to be more severely affected than the manufacturing sector, especially transportation, which continues to be an important part of the service economy.
The second reason is that investor confidence has already been hit hard by the trade war with the US. The coronavirus outbreak is likely to have a knock-on effect on sentiment and thereby on the consumption of durable goods, as well as private investment.
We cannot forget, either, that both the trade war and the virus outbreak are harming China’s growth trend on a cyclical basis, but over and above a worrisome structural trend, namely that of a fast deceleration. The reasons for structural deceleration are well known and will not change, from an aging population to the end of China’s urbanization process. In other words, the virus outbreak is hitting a weaker economy than was the case with SARS.
Based on the above, and assuming that the peak of the coronavirus outbreak happens in the first quarter – which seems an optimistic assumption – we should expect a rapid deceleration in Chinese economic activity in the first quarter and gradual stabilization for the rest of 2020. This would clearly bring China well below the growth target announced by Premier Li Keqiang a couple of months ago, namely a growth rate much closer to 5% if not lower.
Li’s growth target is not really only his own but actually one needed to ensure the achievement of President Xi Jinping’s very important target of doubling China’s gross domestic product from 2010 to 2020. Given the importance of achieving this objective before the Communist Party of China’s 100th anniversary in 2021, it seems crystal clear that no effort will be spared to achieve a high enough growth target to achieve this goal. This is why we should expect unequivocally lax demand policies from the Chinese government in the next few days, weeks and months.
The bigger the shock now, the larger the policy expansion will be needed to achieve the growth target. Such policy expansion, however, has an important constraint, namely inflation, which might be pushed higher by the limited supply of certain goods. This means that, in the short run, the People’s Bank of China may not be able to use the most visible tool, namely interest-rate cuts, but rather temporary liquidity injection, as has already been announced, and targeted lending and window guidance to steer the cost of funding down.
This is particularly needed for those industries most affected by the coronavirus outbreak, and we are already seeing announcements of targeted PBOC support to such industries. More generally, the exchange rate might be the most effective demand policy to use, and we are already seeing signs of this as the yuan quickly goes back to the psychological barrier of 7 to the dollar (and even more quickly than that in the offshore market).
It would seem difficult for US President Donald Trump to denounce China for current manipulation at such a tough time, so the room is clearly open for more depreciation. Moreover, weaker economic fundamentals and potentially laxer monetary policy will exert downward pressure on the yuan, so it will be hard to argue this is not a market-driven process.
Finally, fiscal policies in the form of targeted subsidies and potentially infrastructure investment may also be used.
As such, we expect quick policy reaction to avoid a sharp correction in growth so that the CPC’s objective of a doubling of GDP in 10 years can be achieved. This means that 2020 growth may still hover around 5.5-5.7%, but at a heavy cost. Debt will continue to pile up, for corporates, for the government and even for households, as they are pushed to consume more durable goods with subsidies and discounts.
More debt for an already highly indebted country like China can only mean lower potential growth down the road. In that regard, one could argue that the negative consequences of the virus outbreak on the Chinese economy may be more medium-term than immediate, and the reason is simply the large stimulus expected to follow, and the unavoidable excessive leverage resulting from it.
Alicia Garcia Herrero is senior research fellow at Bruegel and chief economist for Asia-Pacific at Natixis.