Theme: China
Growth is taking a back seat to structural reforms
Near-term downside risks to China’s growth are deepening. Aside from persistently lower lending growth, a combination of shocks will slow GDP growth to 8.2 per cent in 2021 and further to 5.2 per cent in 2022. Some steps will probably be taken to partially offset the slowdown, but the overall official focus will be on limiting structural risks. We will thus hardly see any major shift in current policies. Despite challenges to growth, the USD/CNY exchange rate will likely remain resilient, ending 2021 at around 6.40 with room for modest declines towards 6.30 by end-2022.
Downside risks to China’s growth go beyond the problems created by more restrictive lending. While favourable base effects are fading from annual growth figures, the pullback in economic momentum has been deeper than expected. Yet the government’s focus remains on reforming policies to mitigate structural risks as China nears a significant Communist party congress in 2022. While the direction of the reforms and the reasoning behind them are familiar, their speed and scale in some places have resulted in some painful consequences. Policymakers are steering between a need to help sustain the economy and concerns that too extensive an arsenal of supportive tools might undo some of the successes achieved in their reform work.
We thus expect modest stimulus measures that may help somewhat but will not be enough to generate a strong rebound. Base effects from depressed GDP growth in 2020 will provide enough of a buffer for 2021 GDP to rise by 8.2 per cent year-on-year, but lingering problems will then pull down the growth rate to 5.2 per cent in 2022.
A combination of shocks
A combination of shocks is now evident in monthly activity indicators. The official manufacturing PMI continues to slump, with the production sub-index at its lowest except at the onset of the pandemic and during the 2008-2009 global financial crisis. Hard-to-predict supply chain issues are clouding the outlook. Meanwhile, recurring domestic infection waves are dampening the recovery in the services sector.
The persistent deterioration in the credit impulse (i.e. lending) reflects the caution of policymakers in relying on more debt creation to engineer a growth rebound. Growth in aggregate credit continues to head lower. Aside from a modest pullback in bank loans, the expansion of local government bond issuance has dropped to an estimated 13 per cent year-on-year in September, from almost 21 per cent at the end of 2020. Aside from lower bond issuance this year, following large-scale issuance in 2020, local governments have also been more cautious about tapping the onshore government bond market. Provincial authorities have struggled to find revenue-generating infrastructure projects. Part of the deleveraging drive has been aimed specifically at instilling financial discipline among local and provincial governments. The effect has been to exacerbate the tightness in financial conditions from this direction as well.
In an attempt to provide some easing in fiscal constraints given the current situation, Beijing has instructed local governments to sell the remaining quotas of special bonds by end-November. About CNY 1.14 trillion of this year’s CNY 3.65 trillion quota had yet to be sold by October. In our view, the incoming bond supply will warrant more liquidity injections from the central bank, but declining fiscal efficiency and rising input prices will likely dampen the impact on infrastructure investment.
China is holding on to its zero-tolerance policy towards COVID-19
Since declaring victory against the virus in September 2020, China has continuously refined its “internal and external” pandemic policies with the aim of eliminating all domestic transmission. The latest infection wave, which started in mid-October, had spread to 20 of 31 mainland provinces as of early November. Although the Delta variant has shown brief periods of zero domestic transmission, authorities are showing no signs of abandoning the current strategy. A combination of strict international border controls, widespread testing, quarantining of arriving travellers and targeted lockdowns at the slightest outbreak has been successful in containing local outbreaks within four to six weeks of confirmation of the first case.
Although this strategy is obviously dampening the economic recovery, the government continues to view widespread transmission as even more costly. The authorities continue to develop and refine methods for limiting transmission, like minimising geographical restrictions after each new outbreak. Yet households remain cautious. The travel and retail sectors are still sensitive to outbreaks. And since this domestic strategy is regarded as successful, imported transmission is seen as the big threat and there is popular support for maintaining tight border controls. Thus, it is likely that extensive quarantine requirements for international travellers will persist for another 12 months. Chinese organisers of the upcoming Winter Olympics in February have decided to hold the Games in an isolated bubble around Beijing. Organisers, competitors and other participants will have no contact with local residents.
Balancing the coal market
Amidst the surge in global energy prices, China’s government is trying to balance the domestic coal market. Regulations promoting cleaner energy have led to lower imports of coal and crude oil in the last year.
However, weather conditions and other factors have disrupted the supply of renewable energy. This has created energy shortages, leading to a jump in domestic coal prices and to power rationing in September and October. Since authorities prioritise stabilising energy supply to households, energy-intensive sectors like steel, cement and aluminium are forced to reduce their production. The government has also taken steps to raise domestic coal production in order to offset energy shortages and lower coal imports. Tighter market monitoring and regulation have recently pushed down domestic coal prices again. Even so, the recent energy crunch illustrates how coal-dependent the economy remains. China has a great need to balance and stabilise its energy supply even as it pursues its environmental targets. This will mean power rationing will become more common in the foreseeable future. Short-term steps are being taken to help companies weather the crisis: for example, deferring payment of Q4 taxes for three months for specific small and medium manufacturing enterprises, as a way of offsetting high energy prices.
Property sector challenges to persist
The challenges of the property sector will persist in 2022. Although worries of contagion beyond this sector have eased, risk appetite for China’s offshore bond markets remains weak. As long as authorities hold on to the “three red line policies” for lending to the property sector, we expect developers’ liquidity challenges to persist especially for weaker-rated names. Controls on pre-selling activities, as well as government land auctions, remain in place. Growth of mortgage loans continues to decline. Although authorities have signalled marginal easing in mortgage processing, this will not be enough to completely offset tightening factors. In particular, low-rated developers rely heavily on off- balance sheet financing. Default risks remain high, with some USD 84 billion of debt maturing in onshore and offshore markets in the next 18 months.
Despite growth headwinds, the yuan will remain resilient. Even though the Federal Reserve is starting to normalise US monetary policy, we expect USD/CNY to trade around 6.40 by end-2021, with modest declines to 6.30 by end-2022. External balances are strong, with the trade surplus beating expectations. Bond inflows will pick up with the inclusion of Chinese government bonds (CGBs) in the FTSE World Government Bond Index (WGBI). With the trade-weighted RMB Index for the yuan now above 100, we believe the authorities will continue to limit USD/CNY downturns with state- owned banks propping up purchases of the dollar in the onshore market as needed.