Morgan Stanley: China's Slowing Domestic Demand Spurs Policy Fine-Tuning; Infrastructure to Become Key Focus
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Morgan Stanley: China's Slowing Domestic Demand Spurs Policy Fine-Tuning; Infrastructure to Become Key Focus
The report points out that China's 'dual-speed economy' is intensifying, with domestic demand cooling down but exports remaining robust. It anticipates that Beijing will not make a full-scale shift toward stimulus but instead fine-tune policies by accelerating strategic infrastructure investments.
- China's economy shows dual-speed characteristics: Exports and production remain resilient, while domestic consumption and investment demand have clearly cooled down.
- The slowdown in domestic demand is not a sign of an economic cliff; policy is expected to focus on fine-tuning rather than a full-scale shift.
- Fixed asset investment slowdown is driven by policy, as local governments shift their focus from new projects to resolving implicit debt.
- Weakening consumption is affected by last year's high base, a softening job market, and real estate adjustments, among other factors.
- The decline in crude oil imports mainly reflects reduced non-essential consumption, while industrial activity remains solid supported by coal and power generation.
- Policy responses will focus on speeding up the execution of approved budgets and prioritizing strategic infrastructure construction such as the Six Networks.
- The full-year GDP growth forecast of 4.8% is maintained, with growth expected to rebound to 4.8-4.9% in the second half.
- Strong exports may exacerbate Sino-European trade tensions, but China has countermeasures at its disposal.
Report interpretation
Overview
Morgan Stanley released its latest macroeconomic report, focusing on China's increasingly evident 'dual-speed economy' phenomenon. The report finds that data from April-May confirm further cooling of domestic demand, but this does not signal an abrupt economic downturn. Therefore, Beijing will not adopt a full-scale policy shift but will instead increase the urgency of fine-tuning policies. In the short term, policy priorities will be accelerating the implementation of existing fiscal budgets and strategic infrastructure development. Based on expectations of policy efforts and falling external energy prices, the institution maintains its forecast of 4.8% GDP growth for China this year.
Core views
Slowing Domestic Demand and Intensified Dual-Speed Economy: Data from April-May confirmed the dual-speed divergence in China's economy. On one hand, exports and industrial production remain resilient; on the other hand, both consumption and investment have softened. The slowdown in fixed asset investment (FAI) is partly due to policy guidance, as local governments shift their focus from new projects to resolving implicit debt. On the consumer side, although May's retail sales fell year-on-year due to the high base effect from last year's 'trade-in' program, the two-year compound growth rate still showed weakness, mainly dragged down by a softening labor market, real estate adjustments, and oil price pressures. The spillover effect of exports on employment has also been limited by industrial automation. Structural Divergence from an Oil Perspective: The decline in crude oil imports has raised market concerns about economic activity. The institution believes this primarily reflects consumers cutting back on non-essential fuel use, such as in gasoline cars and aviation. However, overall industrial activity has not collapsed; commercial crude oil inventories, strong coal imports and domestic production, and stable power generation together provide a buffer for industrial fundamentals. Fine-Tuning Policies Rather Than Full-Scale Shift: Facing pressure that second-quarter GDP growth could fall to 4.4%, policymakers need to break away from the complacency seen in the first quarter. The report expects the July Politburo meeting to reiterate the stance of accelerating budget execution. Currently, about 60% of the annual government bond quota remains unused, and the launch of the 800 billion yuan quasi-fiscal infrastructure financing tool also needs to be accelerated. The policy focus will be on strategic infrastructure such as the 'Six Networks' (water conservancy, new power grids, computing networks, next-generation communications, urban underground pipelines, and logistics infrastructure), while major stimulus measures targeting private consumption are unlikely to be introduced. External Trade Friction Risks: Weakened domestic absorption capacity is driving more manufacturing capacity toward exports, and China's share in EU markets for steel, electric vehicles, batteries, and other products has significantly risen. This could trigger Europe to impose targeted tariffs or anti-subsidy investigations. However, considering China's countermeasures in areas like rare earths and luxury goods imports, the likelihood of this escalating into a systemic macroeconomic shock is low.
Analysis framework
The institution mainly follows the analytical framework of 'macro data breakdown - policy intention inference - scenario forecasting.' First, it breaks down macro data into production/export and consumption/investment components to reveal the structural contradictions of the dual-speed economy. Second, combining policy context (such as proper performance evaluation and debt-resolution requirements), it strips away surface data phenomena to explain the real reasons behind fluctuations in fixed asset investment and retail sales data (such as high base effects and statistical distortion). Finally, starting from fiscal space (unused bond quotas, quasi-fiscal tools) and policy preferences (strategic infrastructure), it derives specific paths for policy fine-tuning and, combined with global energy price cycles, forecasts economic trends for the second half of the year.
Methodology notes
Two-Year Compound Growth Rate (2Y CAGR) Analysis
When monthly year-on-year data is distorted by extremely high or low base figures from the previous year (such as last year's subsidy policies), the institution calculates the two-year compound average growth rate to eliminate base effects and more accurately reflect the underlying growth trend of economic indicators.
High-Frequency Alternative Indicator Cross-Validation
In assessing the true heat of industrial activity, the institution does not rely solely on crude oil import volume but cross-validates it with high-frequency data such as commercial crude oil inventories, coal imports, domestic coal production, and power generation to conclude that industrial fundamentals remain solid.
Key data
- Second-Quarter GDP Growth Forecastaround 4.4%Without policy intervention, this could drag down full-year growth
- Full-Year GDP Growth Forecast4.8%The institution maintains a forecast above market consensus
- Second-Half GDP Growth Forecast4.8%-4.9%Policy fine-tuning and falling energy prices will drive a renewed acceleration
- Unused Government Bond Quotaabout 60%Provides visible room for fiscal efforts in the second half
- Quasi-Fiscal Infrastructure Financing Tool Size800 billion yuanCurrently, the rollout remains slow and needs to be accelerated
- Brent Crude Oil Price Forecast (Starting Q4 2026)about $80 per barrelProgress in the US-Iran peace agreement could balance supply and demand, lowering China's energy costs
Impact & implications
The report believes that China's macroeconomic policy will enter a fine-tuning phase characterized by 'emphasizing implementation over slogans.' Due to the lack of large-scale stimulus aimed at private consumption, the economy's 'K-shaped' divergence (strong production, weak consumption) will likely persist in the short term. For the market, the main investment theme should closely revolve around the country's strategic infrastructure construction, especially sectors like AI computing networks, data centers, and smart grids, which will receive direct funding support. Meanwhile, companies going overseas need to watch out for potential targeted trade protection measures from Europe, but overall macro tail risks remain manageable.
Risks
- Domestic demand slows down more than expected, causing full-year economic growth to fall below the 4.5% target lower limit.
- Europe and other overseas markets impose harsh trade protection measures against China's export-oriented industries (such as electric vehicles, batteries, and solar energy).
- Local governments face excessive pressure to resolve implicit debt, further dragging down fixed asset investment and related economic activities.
What to watch
- The July Politburo meeting's statements on fiscal policy implementation progress and the economic outlook for the second half.
- The issuance and usage progress of the annual government bond quota, as well as the implementation status of the 800 billion yuan quasi-fiscal infrastructure financing tool.
- The geopolitical situation between the U.S. and Iran and the global crude oil price trend in the fourth quarter.
- The NBS consumer confidence index and marginal changes in the job market.