Morgan Stanley: China Economy's K-Shaped Divergence Deepens, Policy Adjusts Rather Than Pivots

Overview

Morgan Stanley releases latest China macro observation report, pointing out that April-May economic data further confirms the deepening of the 'Dual-Speed Economy' pattern: On one hand, production and exports maintain resilience; on the other, domestic consumption and investment slow significantly. The report argues that this cooling of internal demand is not an abrupt recession, so the policy response will be 'adjustment' rather than 'full pivot'. Institutions expect the government to accelerate the execution of approved budgets, focusing on supporting strategic infrastructure to stabilize short-term growth and serve long-term security goals. Although the second-quarter GDP growth tracker value drops to 4.4%, given the policy support in the second half and falling oil prices, the full-year 4.8% growth goal remains achievable. Meanwhile, the report warns that export surges caused by insufficient domestic absorption may trigger more targeted trade protection measures from the EU.

Core views

Domestic demand exhibits a structural slowdown, but not a systemic recession. Apr-May data shows YoY declines in fixed asset investment (FAI) and retail sales are partially influenced by high base effects and policy direction. Central emphasis on 'correct view of official performance' prompted local governments to shift from new projects to resolving hidden debts, resulting in FAI data revisions. Retail sales negative growth mainly stems from the high base effect of last year's trade-in subsidy; after removing the base effect, the two-year compounded growth rate shows consumption slowed compared to Q1 but did not collapse. Weak labor markets, real estate adjustments, and oil price pressures suppressed spending, while increased export automation limited spillover effects on employment, causing consumer confidence index to fall again. Policy response focuses on 'minor adjustments' and strategic infrastructure. Facing Q2 GDP tracking growth of approx. 4.4%, without intervention, full-year growth might touch the lower bound of 4.5-5% target range. Report believes July Politburo meeting will reiterate accelerating budget execution; currently approx. 60% of annual government bond quota remains unused, 800 billion RMB quasi-fiscal financing tool rollout has acceleration space. Policy support focus clearly points to 'Six Networks' framework: Water network, new power grid, computing power network, new-generation communications, urban underground pipeline networks, and logistics infrastructure. Among them, AI computing power networks, data centers, and smart grids will receive most direct support. Report explicitly states no expectation for major turning point policies regarding private consumption; economy's K-shaped divergence characteristics will persist. External Environment: Refined Trade Frictions and Oil Price Benefits. Due to weaker domestic absorption, more Chinese manufacturing flows to export markets, especially significant share increase in EU market (steel, EVs, batteries, solar, chemicals). EU response may be targeted rather than systematic, including industry tariffs, anti-subsidy investigations, etc. Although China holds countermeasure leverage in rare earths and luxury imports, if Europe narrows high-value manufacturing access, China's export engine may be forced to turn towards low-friction but low-profit markets. On the other hand, with progress in US-Iran peace agreement, Brent crude is expected to fall to $80/barrel in Q4 2026, improving China's terms of trade and indirectly supporting exports and global investment cycle.

Analysis framework

Report adopts 'Dual-Speed Economy' analysis framework, judging the true position of the economic cycle by splitting production/export vs. domestic consumption/investment data performance. In policy deduction, combines local government behavior patterns (debt resolution prioritized over new starts) and fiscal tool usage progress (bond quotas, policy bank bond issuance), assessing timing and intensity of policy support. In external impact analysis, uses industry chain transmission logic, linking oil price changes to terms of trade and export competitiveness, combining geopolitics (US-Iran relations) to predict marginal impact of commodity price trends on macroeconomy.

Methodology notes

• Macroeconomic framework

  Dual-Speed Economy Analysis (Two-Speed Economy)

  Refers to the phenomenon of significant divergence in growth rates between different sectors or areas within an economy. This article uses it to explain why strong exports coexist with weak domestic demand, and the impact of this divergence on policy formulation (minor adjustments rather than broad stimulus).

• Industry/Industrial Analysis FrameworkSupply-demand framework

  Supply-Demand Mismatch and Trade Friction

  Analyzes strong domestic supply capacity but insufficient domestic absorption, leading to excess capacity turning to exports, subsequently triggering protectionist reactions from trading partners (e.g., EU). This is the core logic for understanding current external risks.

• Macroeconomic framework

  Fiscal Pulse and Policy Lags

  By tracking government bond quota utilization rate and policy bank bond issuance progress, judge the actual pace of fiscal policy implementation and its pull effect on economic growth, rather than just looking at policy statements.

Key data

• Q2 GDP Tracking Growth Rate~4.4%Current second-quarter tracker value, lower than first-half average
• Full-Year GDP Growth Forecast4.8%Morgan Stanley baseline scenario forecast, H2 expected to rebound to 4.8-4.9%
• Unused Government Bond Quota~60%Annual quota remaining ratio, showing fiscal space still exists
• Quasi-Fiscal Financing Tool Scale800 billion RMBQuasi-fiscal tool used for infrastructure construction, currently rollout is slow
• Brent Crude Price Forecast$80/barrelExpected to stabilize from Q4 2026, beneficial for reducing imported costs

Impact & implications

For investors, this means the policy bottom has appeared but intensity is moderate; do not expect broad-based stimulus similar to 2020. Beneficial directions should align with 'strategic security' and 'new quality productive forces', such as grid renovation, computing infrastructure, etc. Export chain enterprises need to be wary of risks of EU targeted trade barriers, especially high-value-added manufacturing. Falling oil prices will ease cost pressure on midstream manufacturing enterprises and indirectly benefit export competitiveness. Overall market style may continue to show structural divergence rather than universal rally.

Risks

• Domestic demand slowdown exceeds expectations, leading to policy adjustments being insufficient to stabilize growth
• EU adopts stricter targeted trade protection measures, impacting China's high-value manufacturing exports
• Geopolitical conflicts (e.g., Middle East situation) cause oil prices to fail to fall as scheduled or even surge
• Real estate market adjustment depth exceeds expectations, further suppressing household wealth effect and consumption

What to watch

• July Politburo meeting's stance on fiscal policy intensity
• Monthly data on government bond issuance and usage progress
• Progress of EU trade investigations on specific industries (EVs, steel, etc.)
• Progress of US-Iran peace agreement negotiations and international oil price trends