U.S. Markets closed

China hints at potential stimulus, but will it follow through? (Part 1)

Senior Credit Analyst

Despite previous strong statements about focusing on reforms, the Chinese government has now made statements that open the door to stimulus in the short term

The past few months have showed a continued slowdown in China’s economy (FXI). This has triggered a global sell-off in emerging markets in general, as China’s demand has fueled a large share of the growth in several emerging markets. The slowdown in China has been compounded by the increased likelihood of an early tapering of quantitative easing in the United States, which has strengthened the dollar at the expense of local currencies, which have seen depreciation rates in the range of 5% to 15% in less than three months.

(Read more: Brazil’s Q2 starts stronger than expected, but can it keep it up until year end?)

Recent weakness likely to get worse

The Chinese government had previously stated that it would pursue short-term monetary policy and focus on the implementation of the reforms. The reforms aim at moving China from an export-led manufacturing economy to an economy driven by internal consumption—in a sense, a self-standing economy fueled by its own domestic demand.

While all that sounds great, the effects will only start to appear in the medium to long term (likely at least a year away), though the Q2 GDP came in at 7.5% and the full-year GDP consensus is now at 7%, which means further slowdown in the second half of the year.

(Read more: Why recession in Brazil is not imminent, but the short term will hurt)

High inflation and real estate prices prevent stimulus

One of the main obstacles to short-term stimulus has been the persistent high inflation increase in China (FXI). Additionally the real estate market has increased significantly, leading many analysts to believe that the real estate bubble may soon pop.

Any short-term stimulus in the form of lower rates or increase in the money supply would only increase inflation and ease credit conditions, which would only further the real estate bubble.

(Read more: China’s Purchasing Managers Index marks continued contraction, more to come)

Read on for the recent statements in Part 2.

More From Market Realist