Can the Chinese economy withstand a contraction in manufacturing activity? – The diplomat

Pacific Money

Beware of over-reliance on manufacturing data when forecasting China’s economic health.

With its manufacturing purchasing managers index (PMI) falling below the inflection point of 50.0 units in December 2018, Chinese manufacturing activity entered a phase of contraction for the first time since mid-2016. Data released spooked Chinese stock markets, with Shanghai Composite Index rising 1.2% fall. Observers were quick to assert that the specter of a prolonged economic slowdown now hangs over China. The forecasts inspired mainly by the manufacturing PMI, however, omit important drivers of economic growth.

It should be noted, for example, that in November 2018, the Chinese services PMI jumped up at a five-month high. While services PMI data for December 2018 has yet to be released, China’s non-manufacturing PMI – which includes the service sector and others such as construction, water supply, supply in electricity and gas, etc. rising at a level of 53.8. It is important to note that the services sector, which the manufacturing PMI does not take into account, now plays an increasingly important role in the Chinese economy – 61.3% of GDP growth in the third quarter. from 2018 was attributed to the tertiary sector. As such, the manufacturing PMI is hardly representative of the Chinese economy as a whole. It is therefore not surprising that China’s overall PMI – which includes all sectors – has fallen at 52.6 in December 2018 against 52.8 the previous month, and is still above the 50.0 point mark which means a contraction in activities.

The ultimate question, then, is whether growth in the service sector can exceed or adequately cushion the expected contraction in manufacturing output. In the near term, China’s outlook is indeed uncertain, in large part due to the ongoing trade dispute with the United States.

The weakening in China’s manufacturing sector is attributable to the uncertainty created by US President Donald Trump’s ongoing trade war. If the two sides fail to come to an agreement by the March deadline, U.S. tariffs will cover all Chinese exports to the country. Since intermediate goods constitute a majority trade between the two, this will likely put more downward pressure on China’s manufacturing PMI. In such a scenario, an expansion of the services sector is unlikely to sufficiently alleviate the resulting deflationary pressures, and the stimuli provided by the Chinese government are likely to be ineffective and lead to a misallocation of resources.

Alternatively, if China comes to an agreement with the United States, it will have a better chance of avoiding a precipitous slowdown by allocating resources to the service sector, even if the manufacturing sector shows modest contractions. However, no miracle can be expected from the Chinese economy in 2019.

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In the medium and long term, on the other hand, appreciating the role of services in the Chinese economy will lead to the conclusion that a prolonged slowdown is not a given. China has an undeniably remarkable track record in the proliferation of market-driven innovations, especially in the service sector, as evidenced by the experiences of Baidu, Alibaba and Tencent. Given the size of the Chinese market, the accompanying abundance of consumer data, and what famous venture capitalist Kai-Fu Lee calls “gladiatorial competition” among Chinese companies, the service sector should become the main source of productivity in the economy.

It is important to note that this component of the economy will be relatively isolated from the deteriorating international environment facing China. While the West’s animosity towards China’s industrial policies will certainly prove to be an obstacle to its progress in scientific innovations in fields such as semiconductors and robotics, it can hardly stifle companies that seek to respond to more specific consumer preferences. As such, China’s service sector will be relatively free from the multiple burdens typically encountered by the manufacturing sector.

Certainly, China faces a number of obstacles to sustaining its economic growth and breaking out of the middle-income trap in the medium and long term. An aging population and unsuccessful attempts to raise the birth rate can hamper potential consumer spending. Debt and financial risk threaten to destabilize the economy and introduce deflationary pressures. On the other hand, while it may bode badly for performance in 2019, a decline in the manufacturing PMI does not quite spell the end of the Chinese economy. Observers need to pay more attention to trends in services PMI data and household consumer spending in order to map China’s trajectory.

Uday Khanapurkar is a research assistant at the Institute of Chinese Studies, New Delhi. He is the author of “The Pursuit of Prosperity: Exploring China’s Economic Dependence on India as a Deterrent to Conflict”.


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