WE have had two big surprises in the past several months. One was the dramatic July decline in new loans and total social financing. Then, in August, industrial production growth plunged to a post-global-financial-crisis low of 6.9 percent, falling from 9 percent in July and 9.2 percent in June.

This is the reality that the Chinese government has to face.

Over the past few months, we have repeatedly warned that the growth target of 7.5 percent set for 2014 would be difficult to achieve. The statistics bureau reported growth of 7.5 percent for the second quarter and 7.4 percent for the first half. As a result, we have decided to return to our original thesis that China’s growth faces structural constraints.

Since 2008-09, the Chinese government has used pro-growth stimuli to close the growth gap between organic, or potential, growth and the growth target because it believed cyclical declines were caused by external shocks. But the GDP growth trajectory in the quarter-on-quarter seasonally adjusted annual rate since the first three months of 2012 seems to suggest that the trough is around 6 percent at this stage. Growth stimuli are able to strengthen growth for a certain period, but we note the marginal effects are declining and diminishing.

Most economists now believe that growth deceleration is because the potential growth rate is lower. Li Yang, vice chairman of the China Academy of Social Science, estimates that potential growth will be 7.8 percent to 8.7 percent in 2011-15, while another prominent economist, Cai Fang, estimates potential growth at 7.5 percent in the same period. We think the difficulty China faces in realizing its potential growth targets has substantially increased.

Demographic change, overinvestment, overcapacity, oversupplied property development, over dependence on exports, unsustainable credit expansion, high pollution and debt-laden local governments are all structural factors that have driven growth to decelerate.

Three factors

What factors would make the growth target more difficult to achieve this year as compared to other years? We believe there are three: the adverse effects of the anti-corruption campaign; the credit crunch because of rising financial risks; and insufficient effective demand because of weakening fixed asset investment, in property in particular.

We have been impressed by President Xi Jinping’s determination to crack down on corruption. The depth and scale of the crackdown is unprecedented. Xi has made it clear that the anti-corruption campaign will continue. Theoretically, the campaign aims to curb the powers of all officials. We believe the government’s administrative efficiency has been substantially affected by this campaign as many programs, development plans and investment projects are put on hold.

The credit crunch has manifested itself in the reluctance of banks to lend, to call back outstanding loans yet to reach maturity and to delay disbursement of promised or approved loans. We believe this is not due to monetary policy tightening. The People’s Bank of China has provided sufficient liquidity to the market, forcing it to issue repos to mop up excessive liquidity over the past months. Commercial banks and financial institutions have become more aware of financial risks since credit expansion began in 2009. Credit growth has also suffered due to corrective policies on shadow banking and on fund-raising through local government financing vehicles.

While export growth seems to have strengthened amid improving external demand, consumption growth continues to be lackluster due to the anti-corruption campaign. But fixed asset investment is the decisive factor in effective demand. The residential property sector, in particular, has been in a downtrend, suffering from negative sales and price growth.

Even assuming industrial production growth rebounds to 8.5 percent in September — which looks difficult — we expect third-quarter GDP growth to moderate to 7.1 percent, year-on-year, from 7.5 percent in the second quarter, or drop to 7 percent on a quarterly seasonally adjusted basis, from 8.2 percent in the second quarter. Thus, achieving this year’s 7.5 percent growth target becomes increasingly challenging.

Policy reaction

So, what should the government do? The market seems to be confused. Premier Li Keqiang did not satisfy market expectations in his speech at the Summer Davos in Tianjin on September 9. Li made it clear that the current growth performance was within the target range and his government would not resort to short-term growth stimuli despite growth decelerating. On the other hand, the China Banking Regulatory Commission adopted a new resolution stipulating that banks’ monthly deposit deviation ratio must not exceed 3 percent. The new regulation is to prevent commercial banks from competing for deposits at the end of every month and quarter. However, the regulation is commonly understood to lead to an increase in commercial bank funding costs and, possibly, to loans contraction.

Will the central bank cut interest rates? Yes and no. We believe the People’s Bank of China would like the interest rate, in general, to go down. Inflation at only 2.2 percent in the first eight months is far below the government’s ceiling of 3.5 percent. From our observations, the central bank is aiming to lower the interest rate through open market operations. It will look to maintain liquidity and open new credit lines for the top five banks to borrow 500 billion yuan (US$81.3 billion) through the standing lending facility. It should be seen as a second round of targeted easing. The first round of targeted easing of 1 trillion yuan through pledged supplementary lending was made to China Development Bank.

But contrary to market expectations, the central bank does not plan a specific interest rate cut. On the one hand, the bank does not have an appropriate central bank rate to cut as does the US Federal Reserve, the European Central Bank or the Bank of England. The lending rate has been fully liberalized, even though China’s central bank still decides the benchmark. The one-year deposit benchmark rate at 3 percent is substantially lower than the actual market deposit rate. In the short run, we believe the bank intends to guide the market rate lower by setting a lower repo rate and providing sufficient liquidity in the interbank market.

We think a cut in the required reserve ratio is unlikely for the remainder of this year. Cutting the ratio could excite the stock and capital markets but would not help to regain growth momentum, in our view. On the contrary, cutting the ratio could put the central bank in a dilemma. Every 50 basis point cut in the ratio would permanently release between 500 billion yuan and 600 billion yuan. The central bank would be forced to remove excess interbank market liquidity through repos and issuance of bills.

We don’t expect the government to do a lot more on policy easing or stimuli either. But we do expect the government to do something to stem the downward trend.

Fixed asset investment growth has decelerated by 0.8 percentage point per month on average since the beginning of the year and could hit 10 percent by year’s end if the deceleration rate remains unabated. That will translate into 14.4 percent growth for fixed asset investment for 2014. If that is the case, GDP growth could hit to 6.2 percent.

We expect targeted monetary easing to carry on. The key is to provide sufficient funding supply. We believe monetary and financial authorities will adopt targeted monetary easing to lower funding costs. This explains why the central bank provided 500 billion yuan under its standing lending facility and recently lowered the 14-day repo rate by 20 basis points.

To slow the decelerating pace of property investment, we have seen local governments remove home purchase restrictions, deploy housing provident funds, relax quotas and interest rates on mortgage loans for both first and second-time homebuyers and provide incentives for social housing construction. Meanwhile, the central bank provided 1 trillion yuan in credit lines to China Development Bank. The State Council has urged the Ministry of Finance to mobilize idle fiscal resources to support credit loans.

Retain growth

Some necessary bottom-line holding policy efforts in the rest of the year would help retain growth strength and achieve a rate that could be lower, but closer, to the growth target. In this sense, we expect GDP to grow 7.4 percent in the fourth quarter and we have returned to our original 2014 growth forecast of 7.3 percent. This growth rate should be politically acceptable as policymakers start to manage growth expectations.

For 2015, we expect a lower growth target of about 7 percent. What is the government’s target likely to be? We believe policymakers have learnt their lessons and will become more realistic. Many economists, including us, would prefer to see the government set an ideal growth target range of 6.5 percent to 7.5 percent.