China's GDP growth decelerates to 7.5% in Q2

Chinas' GDP growth downshifted to 7.5% year-on-year (y/y) in the second quarter (Q2), down from 7.7% y/y in Q1. China's GDP has now come under 8% for five straight quarters, a clear sign of distress. With the Q2 deceleration, China's year-to-date growth has dropped off to 7.6% y/y. Decomposition of the quarterly GDP shows that the deceleration has been primarily caused by the external sector, with net exports' contribution to GDP growth coming down to 0.1 percentage point for the first half, from 1.1 percentage points in the first quarter. Consumption's contribution to GDP growth also pulled back, by 0.87 percentage point. In contrast, capital formation's contribution rose quite sharply to 4.11 percentage points, from a miserly 2.3 percentage points in Q1. However, the considerable rise of capital formation's contribution to GDP growth is hard to explain. Fixed-asset investment (FAI) growth has actually been decelerating in the second quarter, in nominal and real terms. Nominal FAI growth has pulled back to 20.1% y/y as of June, a 12-month low, from 20.9% y/y as of the end of Q1. Meanwhile, the inventory cycle has also been quite negative since March, based on the purchasing managers' index (PMI) inventory data.

On the industrial production side, output growth in the second quarter just experienced a brief and modest rebound, followed by another marked deceleration. After rebounding to more than 9% for the first two months of Q2 – following a sharp downslide to 8.9% in March, industrial production growth dropped back to 8.9% again in June, led by the slump of the light industrial sector. Again, the power consumption data are not that aligned with industrial production, although this time around it was the power consumption data which have far outperformed industrial production. Overall industrial power demand rose nearly 5.7% on the year in June, compared with 3.2% y/y in March, a big discrepancy considering that industrial production growth came in at the same 8.9% for both months. Light industry output growth in June, at 7.9%, is much weaker than in March, although power consumption last month held up at 4.33% y/y – compared with a more than 13% plunge in March.

Given that power consumption has been one main component of the so-called Li Keqiang economic index, the reversal of the power consumption and industrial production data trend (power consumption normally is much weaker than output growth in bad times) in the second quarter has rendered that index almost irrelevant for cross-checking purposes.

Outlook and implications

The Q2 downshift is well expected, as the data release had already been overshadowed by the worst trade data since the global financial crisis, a suspension of sector PMI release which has raised suspicion of severe sector distresses, and, much earlier, a mini-financial crisis in the interbank market. The rather sharp growth deceleration and the recent financial market turmoil indicate that risks have been building on both the financial and real goods sector. The liquidity crunch has exposed the extreme vulnerability of the financial system linked with excessive leveraging through shadow banking, while the GDP data indicate the economy is facing the risk of slowing to a stalling speed.

For the real economy, the risk continues to build on the exports front and construction sector. June shipments have contracted by 3.1% y/y, the sharpest fall since November 2009, after the bloated trade with Hong Kong collapsed into negative-growth territory – from more than 90% earlier this year. On the domestic front, the rebound of the construction sector has started flattening out. Infrastructure construction growth in June was already nearly four percentage points lower than in March, and real estate investment growth has pulled back to 20.3% y/y, after two straight months of deceleration. The construction sector could see still more headwinds coming forth in the second half, if there is no marked change in policy course.

Growth has probably already touched the down limit of the government, but the chance for big fiscal stimuli for infrastructure is low, although the government has recently reiterated support for key infrastructure project construction. For housing construction, there is a rumour that equity financing for real estate developers could be loosened up slightly going forward. Nonetheless, the main focus of the government's macro management going forward looks to be still on consolidation. One main policy thrust this time around, as sketched out in a financial sector consolidation framework earlier this month, is restructuring and realignment of financial resources, with a focus on the reining-in of shadow banking activities. The realignment of financial resources, if implemented successfully, could hopefully not just defuse the financial market bomb, but also provide some liquidity boost to the real economy. Nonetheless, the pay-off from such financial consolidation efforts will most likely show up in the medium and long term, even if implemented successfully. In the near term, the downside risk for growth has become much more elevated now than a few months ago.

Given that uncertainties remain huge in the domestic construction sector and with external demand, IHS Global Insight expects China's growth could slip even further to below 7.5% in the second half, and whole-year growth might come in just around the targeted 7.5% or even lower. For the medium term, upside will be restrained by capacity overhang and high leveraging. The financial market's systemic fragility may also render China vulnerable to the shocks from advanced economies' exit from quantitative easing. With that, we have raised the probability for China having a hard landing over the next three years to 25%, from 20%.