Can China’s pro-growth push reassure markets?

Key takeaways

• China’s slowing economy and risk of deflation increase the likelihood of additional stimulus being announced this month
• Foreign investors are looking for measures that support weak consumer demand and address ongoing real estate problems
• It is not yet clear whether China’s authorities will deliver a stimulus package that convinces markets
• We remain underweight Chinese sovereign debt and the yuan, and we are reviewing our Chinese equity positions.

After China’s rapid reopening from its zero-Covid policy, economic activity has disappointed markets. Second quarter data show domestic consumption growth slowing, despite high savings and rebounding income. We expect China’s leadership to launch a broader pro-growth package later this month. If that convinces markets that Beijing can deliver reflation, China’s equities may see a boost.

The case for the renewed pro-growth government push is clear. China’s second quarter (Q2) economic growth rose 6.3% compared with the same period a year earlier. But that jump is flattered because a year ago Shanghai, China’s biggest city, was in lockdown. The latest figure creates a downside risk to our 5.5% growth forecast for 2023, as we expected a Q2 rate above 7%. More alarmingly, the economy got closer to outright deflation with consumer price inflation decelerating to 0% and producer prices dropping 5.4% in June compared with a year earlier. Growth in commercial banks’ lending to households also slowed in June, with the growth rate in lending around half that of broad money supply, showing that easing monetary policy is not being transmitted effectively to consumers. Worse, private sector capital expenditure effectively stopped in June, despite a solid year-to-date rise in its public sector equivalent.

China has already made some changes to support the economy. After the People’s Bank of China (PBoC) cut onshore benchmark rates by 10 basis points last month, the authorities extended measures designed to encourage banks to lend to property developers. On 12 July, Premier Li Qiang met technology company leaders and praised them as essential to China’s future growth. A macroeconomic policy body under China’s State Council then echoed this message. The comments follow the fines levied on Ant Group Co. and Tencent Holdings on 7 July, and potentially signal an end to a regulatory crackdown and the resumption of approvals for China’s tech platforms to list private companies.

Yet markets’ relatively tepid responses to these developments show that investors remain doubtful about the impact of the government’s growth initiatives, a more predictable future path for regulation, or the economy’s long-term prospects. We believe that deleveraging in the private sector will keep China on the path to easing policy, and a meeting of the Chinese Communist Party’s 25-member Politburo at the end of July should provide more details. Few economists expect a ‘bazooka’ style reflationary policy similar to China’s response to the financial crisis in 2008, but any announcement could prove crucial for market sentiment.

Few economists expect a ‘bazooka’ style reflationary policy… but any announcement could prove crucial for market sentiment

Consumers hold the key

Countering deflation depends primarily on stabilising the real estate market where transactions are slowing after a brief respite in the first quarter. An estimated two-thirds of China’s consumer wealth is tied up in real estate. Property sector turmoil in 2021 and 2022 continues to weigh on borrowing demand as consumers worry whether developers will complete projects, and about prices.

Markets are also worried about the deflationary effects of debt-fuelled industrial overcapacity, and they would welcome a direct boost to consumer demand. Unlike the consumer handouts offered by economies including the US and across the eurozone through Covid, China’s post-pandemic stimulus mostly supported the country’s industry and local governments to encourage infrastructure investment. Some experts suggest the focus now needs to change. “The target of our stimulus should shift from investment to consumption, which can more directly correspond to our actual economic bottlenecks and weaknesses,” said an economic advisor to the PBoC this month.

Markets are also worried about the deflationary effects of debt-fuelled industrial overcapacity

Given local government’s role in delivering social services and healthcare, stabilising their finances is also key to boosting consumer demand. Fragility in the real estate sector is beginning to pressure the revenues that local governments receive from the sale of land use rights. This is especially clear in cash-strapped regions such as Guizhou and Yunnan.

The Chinese economy therefore needs a range of growth measures to reassure households. A package combining looser real estate restrictions for the largest cities, consumption vouchers, fiscal boosts for local governments, and a monetary policy cut of at least 25 basis points in the reserve requirement ratio (RRR) may be enough. Ideally, this would then be followed by fundamental reform of national housing policy to make it easier for households to own properties while letting markets determine land allocations.

The Chinese economy therefore needs a range of growth measures to reassure households

Binary risk

Unfortunately for investors, it is unclear whether Chinese authorities will deliver such a convincing package. In our view, economic constraints to delivering such stimulus are manageable. While system-wide leverage has risen, low inflation and a high current account surplus allow for more fiscal action, and the path of regulation can be changed depending on what is politically expedient. Historically however, Beijing’s record implementing pro-growth policy is mixed. Moreover, a growing focus on national security, including technology investments to compete with the US, could hamper effective policy, as it emphasises control and stability of these sectors over broader growth and market concerns. For these reasons, we see July’s Politburo meeting as a real binary risk.

From an investment perspective, negative market sentiment could continue to weigh on the Chinese yuan. Yet while we expect the currency to remain weak against a range of currencies going forward, there are signs that the PBoC is defending the yuan from further weakness against the US dollar. Our expectation is that the USDCNY rate will remain around 7.2 a year from now. We took profit on our Chinese government bond positions in December 2022. While Chinese sovereign debt continues to offer some diversification within a portfolio, other sovereign debt now offers better yield opportunities.

Better performance catalysts could include bolder-than-expected economic stimulus, signs of stabilisation in the property market, and an improvement in the negative earnings revision trend so far this year
Chinese equities have underperformed other equities markets so far this year with the MSCI China All Share index falling 1% in yuan terms. Despite weak performance, we do not see evidence that investors are withdrawing money from Chinese index-tracking funds. Better performance catalysts could include bolder-than-expected economic stimulus, signs of stabilisation in the property market, and an improvement in the negative earnings revision trend so far this year. In the absence of a convincing stimulus package from the Politburo, or better news on economic growth, relief may prove short-lived. There is still scope for foreign investor flows to weaken; we keep our overweight positioning in Chinese equities under review.

Author: Homin Lee – Senior Macro Strategist

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