China defies the gloom

• Chinese GDP for Q1 came in at 6.4%, defying bearish expectations
• There is a risk that stronger manufacturing growth is due to a frontloading effect ahead of tax cuts in April, and therefore could soon unwind
• We still expect recent credit growth to lead to a pick-up in real activity in coming quarters so there is upside risk to our 6.3% GDP forecast for this year

First quarter GDP surprised to the upside in China, with real GDP growth unchanged from the end of 2018 at 6.4% year-on-year (y/y). Given the weakness in high frequency data for the first two months of 2019, this came as a surprise to most economists, and it looks like the economy was bailed out by a strong turnaround in March.

If we were to sound a note of caution, it would be to note that GDP was supported by an acceleration in the manufacturing sector, which offset slowdowns elsewhere in the economy. There is a risk that this is a frontloading effect triggered by the April tax cuts and so unwinds next month.

Overall though, this month’s data should still serve to ease fears over China’s impact on the global economy, even if imports are still weak.

Industrial strength is encouraging but difficult to explain

GDP was not the only data to surprise this month; industrial production in particular blew expectations out of the water, growing 8.5% y/y compared to 5.3% for the combined January-February period and the strongest since 2014. Fixed investment also accelerated to 6.5% from 6.1% previously – though despite the pick-up in industrial production, manufacturing investment actually slowed.

Retail sales though slowed in real terms, and while exports bounced back in March they were still weaker for the quarter as a whole and imports are yet to return to expansion.

For us the difficulty lies in reconciling weak domestic demand as evidenced by contracting imports with the story told by surging industrial production. Credit data has been strong but it is too soon to expect it to show up in activity data, particularly as lending to the real economy seemed to slow in January and February and only picked up in March.

Either imports or industrial production must therefore be “wrong” in their signal on domestic demand. For weak imports to be consistent with strong domestic demand this would suggest that China has managed to shift supply chains onshore. While this is an ongoing theme as China moves up the value chain, it seems doubtful that it could prompt such a sudden and dramatic disconnect given that the two were much more closely related until this month.

Brace for whiplash next month

The alternative explanation then is that something is amiss in the industrial production data. It is curious, for example, that industrial production should be so strong and yet manufacturing investment should slow. The implied increase in capacity utilisation would be expected to see capacity expansion under normal circumstances – that it has not suggests manufacturers do not see this as a sustainable increase in production.

Adding to this, we note that the manufacturing purchasing managers’ indices (PMIs) this month pointed to inventory building, with the return to expansion driven by higher stocks of inputs and finished goods. We would suggest two potential triggers for this behaviour; the first is the end of holiday disruptions to production, essentially “catch up” by manufacturers. The 5.3% print for January-February was very weak and so some bounceback seemed inevitable.

The second factor could be the cut to VAT effective at the start of April. This provided manufacturers with an incentive to frontload orders and production, to enable them to offset the older, higher VAT rate as an expense against future profits, taxed at the lower rate.

As may be apparent, we are somewhat sceptical of the sudden spring in China’s step, and see a strong possibility that some of this strength in production is undone next month. All the same, this is a stronger-than-expected GDP print. We still expect the strong credit data to result in a pick-up in growth in the second and third quarters, so there is some upside risk to our expectation of 6.3% growth for 2019.