The headquarters of the Asian Infrastructure Investment Bank in Beijing, China. Picture: REUTERS
The headquarters of the Asian Infrastructure Investment Bank in Beijing, China. Picture: REUTERS

China’s economy begins 2018 facing what its own leaders call three years of "critical battles".

Those fights to tackle domestic debt, poverty and pollution pose a hat-trick of risks to the world’s second-largest economy even before higher interest rates and trade war threats from the US are taken into account.

While the nation is starting from a position of strength, with full-year growth in 2017 poised for its first acceleration since 2010, the expansion is expected to slow in 2018.

As a result, the government of Xi Jinping is signalling it is sanguine about more modest economic performance, if progress on the top risk — financial fragility — can be made.

"Significant economic imbalances continue to create downside risk to the outlook for 2018," said Rajiv Biswas, chief Asia-Pacific economist at IHS Markit in Singapore. "Risks to the Chinese economy will remain among the key risks to the global growth outlook in 2018, with the Asia Pacific region particularly vulnerable to the shock waves from a slowdown."

Those waves haven’t materialised, and in fact economic activity is holding up. The official manufacturing purchasing managers index was at 51.6 in December, signalling improving conditions. New export orders also climbed to a six-month high, according to a subindex.

Still forecasters see expansion slowing to 6.5% — the slowest pace since 1990 — in 2018.

The following are among areas they flag as having the potential to trip up economic growth or spur market turbulence.

Financial risks

The Communist Party recently renewed its pledge to prevent and control financial risk, calling it a pivotal challenge for the next three years. As the financial system opens further to foreign firms, a debt-to-GDP ratio that’s heading towards more than 320% by 2022 stands as the main danger.

"Even its own propaganda machine admits that this is such a serious problem that Beijing doesn’t expect there to be any solution in anything less than three years," said Pauline Loong, MD at research firm Asia-Analytica in Hong Kong. "Financial instability is the core problem. Solve that and you ease pressure on capital outflows, complications from deleveraging, weaknesses in smaller banks."

Construction slowdown

The tightening of financial and environmental regulations to help curb debt may cause tremors in 2018 that slow housing and infrastructure construction, according to Frederic Neumann, co-head of Asian economics research at HSBC Holdings in Hong Kong.

"A sharper than expected slowdown in construction could thus weigh on broader activity with emerging sectors not yet vigorous enough to provide a sufficient cushion," said Neumann. "The biggest fault line running through the Chinese economy is the construction sector."

Trade brawl

US President Donald Trump’s recent national security strategy speech was a "tee up" for a turn towards protectionism, says David Loevinger, a former China specialist at the US Treasury Department.

"On the menu for 2018: lots of red meat for the base, and that means bashing imports," said Loevinger, now an analyst at TCW Group in Los Angeles. "Since nationalistic populism is as irresistible in China, Chinese politicians will feel compelled to retaliate."

The US is seeking allies to challenge China’s trade tactics

Tax cuts

If the US Federal Reserve raises interest rates more than markets expect and tax cuts build on underlying 3.2% growth, the dollar may get a second wind that puts the yuan and capital outflows under pressure again, says George Magnus, an associate at Oxford University’s China Centre and former adviser at UBS Group.

"If the Fed starts hiking and the dollar goes on a bull run, that would cause big problems," added Christopher Balding, an associate professor at the HSBC School of Business at Peking University in Shenzhen.

China sees Trump’s tax cut as a risk to its currency and a chance for reform

North Korea

Should tension between the US and North Korea escalate into a more significant confrontation, there will be profound and far-reaching consequences not just for China’s economy but that of the entire Asia-Pacific region, says Zhu Ning, deputy director of the National Institute of Financial Research at Tsinghua University in Beijing.