CHINA’S GDP growth slowed to 7.3 percent in the third quarter from 7.5 percent in the second.

The deceleration was less than what the market had expected, despite a more visible slowdown in industrial production growth from 8.9 percent to 8 percent over the same period. Given that official data showed a deceleration in service sector growth, the discrepancy then implied that construction and industrial production of small businesses (not captured in the monthly industrial output) improved markedly. While construction may have indeed improved on the support of social housing and infrastructure amidst larger decline in property sales, we do not have evidence showing improvement in small scale industrial enterprises.

While we will need more evidence to reconcile the growth data, the better-than-expected GDP reading in the third quarter and the reported robust employment mean that market expectation of further and bigger policy easing in the near future may be dampened.

Property weakness remained though construction improved

Property activity stayed weak but saw some sequential improvement in September. Despite the relaxation of purchase restrictions in all cities outside Tier 1s, property sales declined by another 10.3 percent year-on-year in September, although this was due in part to a high base effect.

The recent relaxation of mortgage lending rules seems to have helped to improve market sentiment and sales through the first three weeks of October. We expect more positive property sales data in October and the fourth quarter, which may help to narrow the decline in overall residential sales from about 10 percent year-to-date to under 5 percent for 2014 as a whole.

Nevertheless, we do not expect underlying starts and construction activity to pick-up visibly in the months ahead. Given the inventory overhang (especially in most tier 3 cities) and the fundamental shift in China’s property supply/demand balance and outlook for the sector as a while, we expect developers to continue focusing on improving sales whilst cutting back on land purchasing and new starts activity, to improve their cash flow situation and lower their financial gearing.

The resultant deceleration of construction activity is thus expected to further dent domestic demand and GDP growth in coming quarters. 

The negative impact of property downturn

The negative impact of the ongoing property downturn is being felt not only in heavy industry production, but also in manufacturing investment, both of which have weakened.

In contrast, thanks to ongoing policy support, infrastructure investment held solid. Nevertheless, policy support for investment so far has not fully offset the negative drag from China’s ongoing property downturn.

The ongoing property downturn has also started to affect consumption too. While overall retail sales remained resilient, sales of automobiles and construction & decoration materials all slowed in the third quarter. Of these, only auto sales showed signs of improvement in September. Meanwhile, there were also signs of improvement in catering sales, perhaps as a result of the fading base effect.  

Employment &
financial risk

Investors have often asked us what might trigger government policy support and what form that support may take. Based on our understanding, labor market conditions and financial risk are the two most important variables in the government’s current policy reaction function, in the absence of inflationary pressures.

These considerations will largely influence the path and nature of policy support in the coming year.

On the job market front, the authorities reported robust growth in both new employment and wage. While the more rapid growth of China’s labor-intensive services sector has been flagged by the government as a key factor, we think that intensified government support for infrastructure and social housing construction, and the lack of labor shedding in heavy industry sectors so far are likely also important reasons.

On financial risk, there seems to be a broad consensus within the government that excessive monetary easing and policy support, akin to what was implemented post-global financial crisis, would further exacerbate imbalances in the economy and add to financial risks already accumulated. This explains why the government has so far refrained from using more aggressive policy easing measures or signals, such as a reserve requirement ratio or benchmark interest rate cut. Instead, they have been relying more heavily on various lower profile easing measures.

That said, we also think that the government is aware of the potential downside risks that a sharp economic slowdown could pose to both China’s labor market and financial system. In particular, the recent financial deterioration in the property, mining, metals and commodities, and local government sectors, brought about by the ongoing property downturn, would not have gone unnoticed. While some of the debt in these sectors would have been borrowed via the shadow banking market, ultimately the final burden may still fall largely on China’s banks.

Separately, with excess capacity in many heavy industry and mining sectors exposed to the property downturn, the job market could well come under fresh downward pressures as such capacity is forced into retirement or restructuring.

In light of the above, despite still-resilient labor market conditions and the government’s tolerance for property sector adjustment, which could facilitate a much-needed rebalancing in the economy, it is also in the government’s interest to keep the adjustment process as smooth and as manageable as possible.  

Policy support intensified in the past month but more is expected

In response to the property downturn and August’s weak economic activity, China’s government has further intensified policy support over the past month.

While we expect the recent property easing measures to support sales in October and the fourth quarter and have a positive knock-on impact on infrastructure investment, we think the impact of monetary easing so far will be limited. Liquidity easing measures taken in recent months has been designed more to ensure that sufficient liquidity remains in the system, given the recent reductions in foreign exchange inflows, deteriorating cash flows in the economy, and rising debt servicing burdens.

We expect the government to adopt additional policy support by launching additional infrastructure projects that should provide large spillover effects for the rest of the economy, funded not only by the central government and policy banks, but also by the “crowding in” of corporate balance sheets via public-private partnership schemes.

The government may also further ease property policies, with cuts to property transaction taxes and fees, lower mortgage down payment requirements, and another targeted mortgage rate cut.

Chinese authorities will likely broaden monetary easing measures, including a benchmark interest rate cut to shore up business confidence and more effectively lower financing costs, and further relaxation of supply-side credit constraints.