China Expects a ‘Tough Economic Battle’ in 2019 as Debt Legacy and Trade Standoff Bite

China lowered its goal for economic growth and announced a major tax cut, as policymakers seek to pull off a gradual deceleration while grappling with a debt legacy and the trade standoff with the U.S.

The gross domestic product growth target released Tuesday morning in Premier Li Keqiang’s annual work report to the National People’s Congress was set at a range of 6 to 6.5 percent for 2019. The shift to a band from the previous practice of using a point figure gives policy makers room for maneuver and compares with last year’s “about” 6.5 percent goal.

The lower bound of the GDP target would be the slowest pace of economic growth in almost three decades, a consequence of China’s long deceleration as policy makers prioritize reining in debt risks, cleaning up the environment and alleviating poverty. Warning of a “tough economic battle ahead,” Li announced tax cuts worth 2 trillion yuan ($298 billion) for the year.

“These targets accommodate structural deceleration but not cyclical, which means that policy makers will need to flex their muscles to stimulate the economy,” said Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis SA in Hong Kong. “It’s good news for the market in the short term; bad news for China in the medium term as more leverage will need to be piled up.”

What Our Economists Say… “There are two particularly positive developments in Tuesday’s announcement: wide-ranging tax cuts, particularly reductions in value-added taxes, and a signal for targeted monetary support for the economy rather than a flood of liquidity,” wrote David Qu and Chang Shu in a note. “The range signals the top leadership’s pragmatism in accepting a mild slowdown.”

Chinese stocks continued rising on Tuesday, after climbing to their highest level since June on Monday as signs of progress in trade talks buoyed investors. Other Asian indexes fell after the S&P 500 Index dropped the most in a month.

Economists surveyed by Bloomberg see output growth slowing to 6.2 percent this year from 6.6 percent in 2018, before easing further in 2020 and 2021. The report pledged to keep China’s leverage ratio “basically stable” in 2019. Policy makers are trying to rekindle lending to the private sector while avoiding an accelerated run-up in debt, with the total debt pile now approaching 300 percent of GDP.

Unlike in previous years, there were no targets for retail sales growth or fixed-asset investment in the reports.

In his speech, Li said the government would “improve the exchange rate mechanism,” phrasing which was missing from the 2018 and 2017 reports. He also pledged to keep the currency “generally stable and at an adaptive and balanced level.”

A cut of 3 percentage points to the top bracket of value-added tax was announced in a move aimed at benefiting the manufacturing sector. That plan was reported by Bloomberg News on Monday. In addition, a 1 percentage point cut to the 10 percent VAT bracket was announced. Combined, the VAT cuts are equivalent to as much as 800 billion yuan and will boost corporate earnings, according to Morgan Stanley.

The target budget deficit for 2019 was set at 2.8 percent of GDP, versus last year’s goal of 2.6 percent. The report pledged a “noticeable decrease” in the tax burdens of major industries, with the total of reductions in tax and social security fees coming to 2 trillion yuan.

The more modest growth target paired with further targeted stimulus measures typifies the government’s attempt to steady the economy after a bruising 2018 and marks a shift from last year’s edition when the emphasis was on reining in financial risks and trimming budget outlays. Maintaining employment was given a higher priority than last year.

The report reiterated that monetary policy will remain “prudent,” while fiscal policy will be “proactive, stronger, and more effective.” Further cuts to the required reserves ratio for smaller banks are planned, according to the work report.

The U.S. and China are close to a trade deal that could lift most or all U.S. tariffs as long as Beijing follows through on pledges ranging from better protecting intellectual-property rights to buying a significant amount of American products. While that would remove one cloud hanging over the economy, debt risks and signs of weakening consumption at home remain.

“China will face a graver and more complicated environment as well as risks and challenges that are greater in number and size,” Li said. “China must be fully prepared for a tough struggle.”

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