Five clusters of support

The Chinese economy could start a mini-cycle recovery from 2020 with reduced external uncertainty and accommodative policy. A new era of urbanization opens up room for countercyclical public investment in city clusters and digital infrastructure, which could sustain productivity growth and lift China to high-income status by 2025.

Our more constructive cyclical outlook rests on the near-term signing of a phase-one deal between China and the US at the trade talks that would signal a trade truce. This is an uncertain "if". However, the stage has been set for normalization of economic growth, which is running well below trend due to the non-linear impact of tariffs with their pervasive transmission channels.

Reflecting this, multiple growth indicators are running at multiyear lows. For example, growth of both industrial inventory and manufacturing first article inspection are at three-year lows, and the personal income tax cut has only translated into higher precautionary savings rather than spending amid increased job market pressures.

Some market views attribute the current growth slowdown to domestic policy tightening. We disagree.

Instead, we think China had been on a soft landing path with slower and healthier growth, after policymakers successively addressed structural growth impediments such as overcapacity and over-leveraging. While the ripple effects of the ongoing financial clean-up have led to "localized credit contractions", putting downward pressure on some subsectors such as infrastructure investment, the faster, broad-based deterioration in industrial production, private investment and consumption, and employment coincided with rising external uncertainty.

Consequently, a "durable" pause in escalations would be conducive to unlock some of the aforementioned deferred private spending. As it is, the positive news flows on trade since early September have led to improved business sentiment not only in China, but also globally. China's November economic data released to date suggest that domestic demand is on the verge of recovery, while global manufacturing purchasing manager's index registered the first uptick in a broad-based manner in seven months.

Meanwhile, fiscal policy will likely remain supportive. We expect China's augmented fiscal deficit, which includes both on-budget and quasi-government spending, to remain elevated at 9.5 percent of GDP in 2020, down slightly from 9.8 percent in 2019. Supporting this, the meeting of the Political Bureau of the Communist Party of China Central Committee on Dec 6, which set the tone for the annual Central Economic Work Conference, was slightly more dovish than the market expected, explicitly stating "to boost infrastructure investment" and "make good use of countercyclical tools".

Against this backdrop, we expect a modest mini-cycle growth upswing in 2020, with real GDP growth bottoming out at 5.9 percent in the fourth quarter of 2019 and picking up to 6.0 percent in the first half of 2020 and 6.1 percent in the second half of 2020, slightly above the consensus view.

In the alternative scenario of tariff escalation, policymakers will likely increase the size of fiscal stimulus and cut policy rates to defend against downside risks, but we do not expect them to engineer a massive stimulus to keep growth above any numerical level (such as 6 percent) at the cost of renewed structural challenges.

In fact, in the context of weakening demographics and slowing globalization, we believe that sustaining productivity growth should be the guiding principle for both countercyclical and longer-term policy in order for China to avoid the middle-income trap.

To this end, we believe China is forging a different urbanization path, focusing on making cities, safer, greener and more livable by embracing structural reforms and a new era of digital technologies.

The Urbanization 2.0 era that we envision is underpinned by three initiatives.

First, we believe super city clusters, knitted together by China's advanced rail system, should continue to reap the benefits of urban agglomeration while alleviating big-city problems. Indeed, China's larger cities are not oversized compared with those in other countries: the US population is concentrated in coastal regions, while the economies of Japan and the United Kingdom are increasingly concentrated on their capitals.

Meanwhile, Urbanization 2.0 will be powered by new technologies such as 5G, big data, the internet of things and artificial intelligence. These should help reduce traffic, crime and pollution, and greatly enhance the quality of urban life and the capacity of the cities of tomorrow.

Finally, land reforms and the wider adoption of smart farming should boost rural labor productivity, enabling more workers to migrate to cities.

On the policy front, the urbanization strategy has been shifting to "promoting hub cities and city clusters as the main medium for growth and development", contrasting with the old urbanization model of regional rebalancing. As evidence of this, countercyclical public investment is placing more emphasis on city cluster connectivity (high-speed commuter rail systems) and urban infrastructure; meanwhile, top-down initiatives, such as the three-year action plan for Yangtze River Delta region's integration, are being implemented to strengthen integration across local administrative boundaries.

By 2030, the five smart super clusters of the Yangtze River Delta region, Beijing-Tianjin-Hebei Area, Greater Bay Area, Mid-Yangtze River Area and the Chengdu-Chongqing Area could each have an average population of 120 million, close to the total population of Japan, and they could account for 75 percent of GDP growth and half of the increase in the urban population. Total factor productivity will likely sustain at 1.6 percent per year through 2030(versus 1.9 percent from 2014 to 2018), the highest among major economies. We thus remain confident that China will attain high-income status by 2025.

The author is chief China economist at Morgan Stanley.

The author contributed this article to China Watch exclusively. The views expressed do not necessarily reflect those of China Watch.

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