China’s economy begins 2018 facing what its own leaders call three years of “critical battles.”
Those fights to tackle domestic debt, poverty and pollution pose a hat-trick of risks to the world’s No. 2 economy even before higher interest rates and trade war threats from the U.S. are taken into account.
While the nation is starting from a position of strength, with full-year growth in 2017 poised for its first acceleration since 2010, the expansion is seen slowing in 2018.
As a result, the government of Xi Jinping is signaling that it’s sanguine about more modest economic performance, if progress on the top risk — financial fragility — can be made.
“Significant economic imbalances continue to create downside risk to the outlook for 2018,” said Rajiv Biswas, chief Asia-Pacific economist at IHS Markit in Singapore. “Risks to the Chinese economy will remain among the key risks to the global growth outlook in 2018, with the Asia Pacific region particularly vulnerable to the shock waves from a slowdown.”
Those waves haven’t materialized, and in fact economic activity is holding up. The official manufacturing purchasing managers index was at 51.6 in December, signaling improving conditions. New export manufacturing orders also climbed to a six month high, according to a sub-index.
The Caixin manufacturing purchasing managers index, which is more representative of smaller firms, also showed strong momentum with a reading of 51.5 in December, beating all estimates.
However, figures “likely are overstating momentum, particularly in construction,” according to a report by Freya Beamish, chief Asia economist at Pantheon Macroeconomics Ltd in Newcastle, U.K. “The profit story appears to be deteriorating, as input price rises continue to slow.”
Forecasters see expansion slowing to 6.5 percent — the slowest pace since 1990 — this year, the following are among areas they flag as having the potential to trip up economic growth or spur market turbulence.
The Communist Party recently renewed its pledge to prevent and control financial risk, calling it a pivotal challenge for the next three years. As the financial system opens further to foreign firms, a debt-to-GDP ratio that’s heading toward more than 320 percent by 2022 stands as the main danger.
“Even its own propaganda machine admits that this is such a serious problem that Beijing doesn’t expect there to be any solution in anything less than three years,” said Pauline Loong, managing director at research firm Asia-Analytica in Hong Kong. “Financial instability is the core problem. Solve that and you ease pressure on capital outflows, complications from deleveraging, weaknesses in smaller banks.”
The tightening of financial and environmental regulations to help curb debt may cause tremors in 2018 that slow housing and infrastructure construction, according to Frederic Neumann, co-head of Asian economics research at HSBC Holdings Plc in Hong Kong.
“A sharper-than-expected slowdown in construction could thus weigh on broader activity with emerging sectors not yet vigorous enough to provide a sufficient cushion,” said Neumann. “The biggest fault line running through the Chinese economy is the construction sector.”
U.S. President Donald Trump’s recent national security strategy speech was a “tee up” for a turn toward protectionism, says David Loevinger, a former China specialist at the U.S. Treasury Department.
“On the menu for 2018: lots of red meat for the base, and that means bashing imports,” said Loevinger, now an analyst at TCW Group Inc. in Los Angeles. “Since nationalistic populism is as irresistible in China, Chinese politicians will feel compelled to retaliate.”
If the U.S. Federal Reserve raises interest rates more than markets expect and tax cuts build on underlying 3.2 percent growth, the dollar may get a second wind that puts the yuan and capital outflows under pressure again, according to George Magnus, an associate at Oxford University’s China Centre and former adviser at UBS Group AG.
“If the Fed starts hiking and the dollar goes on a bull run, that would cause big problems,” says Christopher Balding, an associate professor at the HSBC School of Business at Peking University in Shenzhen.
Should tension between the U.S. and North Korea escalate into a more significant confrontation, there will be profound and far-reaching consequences not just for China’s economy but that of the entire Asia-Pacific region, says Zhu Ning, deputy director of the National Institute of Financial Research at Tsinghua University in Beijing.