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Taiwan tensions add impetus to decoupling

Taiwan has dominated the headlines this week, with Nancy Pelosi’s visit triggering Chinese military drills and restrictions on cross-strait trade. These moves appear largely symbolic. China’s bans on exports of natural sand and imports of some Taiwanese food products are of little economic significance. And while the military drills are causing some disruption to shipping and air traffic, that should quickly fade provided the drills end on Sunday as scheduled.

China’s response appears calibrated to signal displeasure at Pelosi’s visit while limiting the economic fallout. We recently examined the ramifications of different ways that China might try to force its will on Taiwan, ranging from a blockade or seizure of an outlying island, all the way to a full-scale invasion. One key takeaway was that in almost all cases it would come at a significant economic cost to China, which would see its access to Taiwanese semiconductors disrupted and commercial ties with the West curtailed. That may be a cost China’s leadership is willing to bear at some point in the future. But so far, there appears to be little appetite for an economic fight.

But Pelosi’s visit could still have lasting consequences. Even if China takes little further retaliatory action in the near term and current tensions ease, the visit probably has increased the urgency in the minds of Chinese officials of efforts to prepare for future escalation. It has also further hardened views against China in the West, increasing the likelihood of continued moves to limit the country’s access to foreign technology.

For China’s leadership, a pressing task now is to become more self-sufficient in key goods so as to make the economy more resilient to any future Western sanctions. That is easier said than done. China has been trying to cut its reliance on foreign semiconductors for over a decade but the imported share of its chip consumption has barely budged. Technological progress is hard to dictate from above and state subsidies intended to support strategic sectors are often misused, as the recent spate of arrests in China’s domestic chip industry highlight.

Nonetheless, there are many parts of the economy where the barriers to reducing dependence on Western allies are lower. Take iron ore, for example, where the government plans to ramp up domestic production, boost mining capacity in more friendly countries and curb consumption via the use of recycled steel. We argued last year that China’s dependence on Australian iron is likely to decline significantly this decade.

Even if they succeed in a narrow sense, policy-driven efforts to boost self-sufficiency will come at a cost. In the case of iron ore, steel mills will pay a premium given the lower efficiency of domestic mining. More generally, efforts to skew the market in favour of local firms are negative for productivity growth, a problem we discussed here.

One economic vulnerability that a shift toward supply chain self-sufficiency can’t address is China’s continued dependence on foreign demand, which drives 15% of GDP. In the event of a major cross-Strait crisis, a sizeable share of this demand could be cut off. Although many countries would side with China – China’s foreign ministry says it has received messages of support about Pelosi’s visit from more than 100 countries – these tend to be small emerging economies. The developed economies that drive final demand for Chinese exports are largely united in favour of Taiwan – the G7 nations, which generate 45% of global GDP, have condemned the military drills. And our work on decoupling suggests that two thirds of Chinese exports go to countries that align with the US.

The week ahead

The key focus will remain the Taiwan Strait and any further steps that China might take. Military exercises are scheduled to end on Sunday. It’s a busy week for data. The key releases are trade (have exports remained so strong?) and credit (further acceleration or fizzling out?).


Data Previews

Trade (Jul.) Sun. 7th Aug.

Forecasts

Time (China)

Previous

Consensus

Capital Economics

Exports (USD, % y/y)

-

(+17.9%)

(+14.2%)

(+17.0%)

Imports (USD, % y/y)

-

(+1.0%)

(+4.0%)

(+3.0%)

Trade Balance (USD)

-

+98bn

+88bn

+97bn

Exports still holding up, for now

Export volumes rebounded strongly in June as shipping bottlenecks eased, while import volumes resumed their downward trend. (See Chart 1.)

Most signs point to a drop-off in global demand for Chinese-made goods recently. And yet the number of containers passing through Chinese ports kept rising last month, suggesting that easing shipping bottlenecks coupled with sizeable backlogs kept export volumes elevated in July. As for imports, we think they will have remained depressed amid continued weakness in the construction sector.

Further ahead, the strength of exports is unlikely to be sustained. Once backlogs are cleared, weaker demand will become a major drag. Cross-strait tensions are also a threat to trade flows given that Taiwan is China’s fifth-largest trading partner and that escalation could have wider implications for China’s trade with the West. But for now at least, Chinese policymakers have shown little appetite for an economic fight over Taiwan.

Chart 1: Goods Trade ($bn, seas. adj., 2010 prices)

chart001-69.png

Sources: CEIC, Refinitiv, Capital Economics

FX Reserves (Jul.) Sun. 7th Aug.

Forecasts

Time (China)

Previous

Consensus

Capital Economics

Foreign Exchange Reserves

-

$3,071bn

$3,051bn

$3,065bn

Taiwan tensions threaten to reawaken outflow pressures

The PBOC has largely refrained from direct FX market intervention in recent years, although it did purchase small amounts around the turn of the year to slow the renminbi’s rise. (See Chart 2.) It then sold a small amount in April and May in response to a sharp weakening of the currency. In June, it held back from intervening directly.

We think the PBOC stayed on the sidelines in July. Outflows from Chinese equities remained small. And the drop back in US yields probably tempered outflows from onshore bonds. Most importantly, there were few signs of much downward pressure on the renminbi that would warrant intervention. As such, valuation effects will have been the main driver of changes to the value of the reserves.

The renminbi could come under renewed pressure in the coming weeks if investors respond to mounting tensions in the Taiwan Strait by stepping up outflows from Chinese assets.

Chart 2: Net FX Purchases & CNY-CHN Spread

chart002-48.png

Sources: CEIC, Refinitiv, Capital Economics

Net New Bank Loans, M2, AFRE (Jul.) 9th – 15th Aug.

Forecasts

Time (China)

Previous

Consensus

Capital Economics

Net New Bank Loans (RMB)

-

+2805bn

+1,200bn

+1,100bn

M2 (% y/y)

-

(+11.4%)

(+11.2%)

(+11.4%)

Aggregate Financing “AFRE” (RMB)

-

+5173bn

+1,500bn

+850bn

Mortgage boycotts held back credit growth

Credit growth continued to rebound in June thanks to a big helping hand from government bond issuance. (See Chart 3.) But we think this acceleration stalled in July.

Government bond issuance dropped back last month, after the annual special bond quota was largely exhausted by end-June. Corporate bond issuance has also softened in recent weeks. And although policymakers have loosened quantitative controls on bank loans, the recent glut of liquidity in the interbank market suggests banks aren’t making use of this additional room to lend. The mortgage boycotts have probably played role, with potential homebuyers turning more cautious and banks tightening mortgage approvals. At best, we think year-on-year growth in bank loans and broad credit will have held steady.

Chart 3: Broad Credit & Government Bonds
(outstanding, % y/y)

chart003-33.png

Sources: CEIC, Capital Economics

CPI, PPI (Jul.) Wed. 10th Aug.

Forecasts

Time (China)

Previous

Consensus

Capital Economics

CPI (% y/y)

09.30

(+2.5%)

(+2.8%)

(+2.9%)

PPI (% y/y)

09.30

(+6.1%)

(+4.9%)

(+5.1%)

Underlying inflation remains low

We think consumer price inflation rose in July and is now scraping against 3%, which is usually the PBOC’s preferred ceiling. Retail prices of pork have continued to increase, reflecting higher costs for feed. On our forecasts, even though retail fuel price inflation was little changed in July, this pushed headline inflation to a 27-month high.

That is still very low by global standards. And core inflation is likely to have remained low and stable at about 1% thanks in part to continued slack in demand. We think headline inflation is close to a peak and will drop back over the coming quarters.

Meanwhile, factory gate prices are probably now falling again for the first time since January on lower raw material prices. (See Chart 4.) Base effects will also pull the headline rate lower.

Chart 4: Producer Prices & PMI Output Prices

chart004-26.png

Sources: CEIC, S&P Global, Capital Economics


Economic Diary & Forecasts

Upcoming Events and Data Releases

Date

Country

Release/Indicator/Event

Time (China)

Previous*

Median*

CE Forecasts*

August

Sun 7th

image005-9.png

Chn

Trade Balance (Jul., USD)

-

+97.9bn

+88.1bn

+97.0bn

 image005-9.png

Chn

Exports (Jul., USD)

-

(+17.9%)

(+14.2%)

(+17.0%)

 image005-9.png

Chn

Imports (Jul., USD)

-

(+1.0%)

(+4.0%)

(+3.0%)

 image005-9.png

Chn

Foreign Exchange Reserves (Jul., USD)

-

+3071bn

+3051bn

+3065bn

Wed 10th

image005-9.png

Chn

Consumer Prices (Jul.)

(09.30)

(+2.5%)

(+2.8%)

(+2.9%)

 image005-9.png

Chn

Producer Prices (Jul.)

(09.30)

(+6.1%)

(+4.9%)

(+5.1%)

Fri 12th

image006-8.png

HK

GDP (Q2, Fin., q/q(y/y))

(16.30)

+0.9%(-1.4%)

-

+0.9%(-1.4%)

Also expected during this period:

9th – 15th

image005-9.png

Chn

Aggregate Financing “AFRE” (Jul., RMB)

-

+5173bn

+1500b

+850b

 image005-9.png

Chn

Net New Lending (Jul., RMB)

-

+2806bn

+1200b

+1100b

 image005-9.png

Chn

M2 Money Supply (Jul.)

-

(+11.4%)

(+11.2%)

(+11.4%)

11th – 18th

image005-9.png

Chn

Foreign Direct Investment (Jul., RMB)

-

(+17.4%)

-

-

Selected future data releases and events:

August

Mon 15th

image005-9.png

Chn

1-Year Medium-Term Lending Facility (MLF) Auction

 image005-9.png

Chn

Home Prices (70 Cities, Jul.)

 image005-9.png

Chn

Spending and Activity data (Jul.)

Wed 17th

image006-8.png

HK

Unemployment Rate (Jul.)

Fri 19th

image005-9.png

Chn

Foreign Exchange Net Settlement and Receipts (Jul.)

Main Economic & Market Forecasts

%q/q annualised (%y/y), unless stated

Latest

Q3 2022

Q4 2022

Q1 2023

Q2 2023

2021

2022f

2023f

2024f

Official GDP

-2.6(+0.4)*

(+4.7)

(+5.3)

(+4.8)

(+8.5)

(+8.1)

(+4.0)

(+5.5)

(+4.5)

GDP (CE CAP-derived estimates)

-2.8(-4.2)*

(+3.2)

(+3.1)

(+2.2)

(+6.1)

(+9.0)

(0.0)

(+4.0)

(+4.0)

Consumer Prices

(+2.5)**

(+2.3)

(+1.5)

(+1.7)

(+0.9)

(+0.9)

(+2.0)

(+1.0)

(+1.0)

Producer Prices

(+6.1)**

(+3.8)

(+0.5)

(+0.5)

(-1.0)

(+8.1)

(+5.0)

(0.0)

(+0.5)

Broad Credit (AFRE)

(+10.8)**

(+11.7)

(+12.2)

(+12.0)

(+11.7)

(+10.3)

(+11.1)

(+10.1)

(+9.2)

Exports (US$)

(+17.9)**

(+3.6)

(-2.2)

(-7.9)

(-12.2)

(+29.9)

(+6.5)

(-10.5)

(-4.0)

Imports (US$)

(+1.0)**

(-3.1)

(-4.2)

(+6.1)

(-0.8)

(+30.1)

(+0.5)

(0.0)

(+1.5)

RMB/$

6.75

6.90

7.00

7.00

7.00

6.37

7.00

7.00

7.00

7-day PBOC reverse repo %

2.10

2.10

2.10

2.10

2.10

2.20

2.10

2.10

2.10

1-year Loan Prime Rate (LPR) %

3.70

3.70

3.70

3.70

3.70

3.80

3.70

3.70

3.70

1-year MLF Rate %

2.85

2.85

2.85

2.85

2.85

2.95

2.85

2.85

2.85

10-year Government Bond Yield %

2.72

2.60

2.40

2.40

2.40

2.78

2.40

2.40

2.40

RRR (major banks) %

11.25

11.00

11.00

11.00

11.00

11.50

11.00

11.00

11.00

CSI 300 Index

4,117

4,180

4,250

4,188

4,125

4,940

4,250

4,000

4,150

Hong Kong GDP

(-1.4)*

(+2.2)

(+5.6)

(+8.3)

(+10.1)

(+6.3)

(+0.5)

(+6.0)

(+1.5)

Hang Seng Index

20,192

20,340

20,500

20,225

19,950

23,398

20,500

19,400

20,300

Sources: Bloomberg, CEIC, Capital Economics *Q2; **Jun.; End of period


Julian Evans-Pritchard, Senior China Economist, julian.evans-pritchard@capitaleconomics.com
Zichun Huang, China Economist, zichun.huang@capitaleconomics.com