A weak second quarter for China’s economy, with GDP growth narrowly avoiding contraction, might mark the low for this cycle (disregarding the pandemic-related dip in Q1 2020). However, even with intense policy support for the economy and less stringent Covid restrictions, any recovery looks set to be gradual at best, leaving 2022 growth short of the official 5.5% target.
At 0.4% year-on-year (YoY), GDP growth in the second quarter of 2022 was down sharply from the already below-target 4.8% in the first quarter. Beijing has already intensified policy easing to boost growth and introduced more flexibility into its zero-Covid policy.
Nonetheless, lockdowns to contain the spread of the virus have continued to hobble business. Other headwinds include the recent mortgage-payment boycott by homebuyers on unfinished houses as developers struggle to stay afloat. At this stage, its impact remains uncertain.
So, we do not expect a V-shaped rebound in growth in the second half of 2022, although we believe the medium-term outlook is improving.
Missing the growth target
Even if GDP were to grow by 5% to 6% in the second half – which we see as an optimistic assumption –full-year growth will likely undershoot the official target significantly (see Exhibit 1). The market consensus for 2022 growth is between 3% and 4%.
In June, there were signs of recovery amid lighter Covid restrictions and macroeconomic policy support.
Notably, industrial output gained 4.0% YoY (up from 0.7% in May) as car and electric equipment production improved. Retail sales rose by 3.1% (after -6.7% in May) boosted by strong car and catering sales. Fixed asset investment grew by 6.0% (versus 4.7% in May) supported by 13% higher infrastructure investment.
Policy stimulus and risk
The policy easing after April’s Politburo meeting and a steady easing of lockdown measures allowed China’s stock market to stage a notable rebound since late April. This recently ended after an Omicron sub-variant caused a flare-up in Covid curbs in a number of cities (Exhibit 2).
In general, Beijing has intensified its policy support since the second quarter by accelerating special local government (LG) bond issuance, increasing tax rebates, pumping more liquidity into the economy and relaxing property policies.
More easing will likely come in the form of new infrastructure spending1 and funding. Infrastructure investment is already showing a robust recovery. Funding will include bringing forward RMB1.5 trillion in special LG bonds from the 2023 quota, easing local government financial vehicle (LGFV) funding conditions and increasing policy bank lending (estimated to be RMB800 billion) to environmental projects.
Unlike in the most of the world, high inflation is less of a problem for China. Headline consumer price inflation has averaged around 2.0% YoY and core inflation has been around 1.5% YoY since 2013.
This allows China to conduct an accommodative monetary policy in the face of global policy tightening. As a result, aggregate financing has recovered (Exhibit 3) and the key DR-007 money market rate has remained well below the People’s Bank of China target of 2.1%.
In our view, the biggest risk to growth is the zero-Covid policy. The resulting uncertainty has hurt production and supply chains, mobility and especially the capital goods and consumer sectors.
Loss of consumer and business confidence and economic disruption are problems monetary easing cannot resolve effectively. Hence, we expect Beijing to intensify its fiscal stimulus to lift aggregate demand directly.
What has changed?
After more than a year of regulatory tightening on the tech and related sectors, this headwind to growth may be abating as investigations into large fintech and e-commerce companies are concluded. Future regulatory reform will likely focus on policy implementation rather than the introduction of new regulation. This should clear much of the policy uncertainty in these sectors.
Further relief could come from the increased flexibility of the zero-Covid approach since June. Lockdowns are now swift and targeted, while quarantine periods have been shortened. Only non-essential services are being suspended, PCR testing in high-risk areas is more frequent and low-risk areas are being reopened more quickly.
This new approach should reduce the broad-based disruption from lockdowns, help protect supply chains and reduce policy uncertainty.
However, with a growing number of homebuyers not making mortgage payments, there is a new risk to growth. This concerns housing units bought on pre-sold terms that are not being completed and delivered to homebuyers by cash-strapped developers.
Since presales significantly increased developers’ leverage, rising the mortgage-payment boycott could create a credit crunch for developers and lead to defaults in offshore US dollar bond markets (where they have borrowed heavily) and more non-performing loans at local banks.
There is a potential contagion risk: rising mortgage delinquency could hurt homebuyer confidence, further suppressing property sales and forcing more developers to suspend projects. This could lead to more mortgage delinquencies, creating a downward spiral of property woes.
What can Beijing do?
To contain systemic risk, Beijing may relax property market policy further, although a wholesale bailout is not expected.
In addition to ample liquidity, it may mobilise local government, SoE and LGFV resources to kick-start suspended projects and preserve public confidence by signalling that housing completion is an overarching priority. State developers may also take over weak developers to remove the bad players and help consolidate the property market.
Recently, regulators have asked the China Construction Bank to set up a fund to buy property projects under construction and convert them into long-term rental apartments. If this practice is implemented more widely, it could amount to a Troubled Asset Relief Program (TARP) of the kind the US government set up after the 2007-08 Global Financial Crisis to purchase toxic assets and stabilise the financial system.
Reallocating to Chinese assets
Macroeconomic crosscurrents may trap government bond yields in a range of 2.8% to 3.0% in coming months, with the upside being constrained by growth concerns and monetary accommodation and the downside by credit risk concerns and the recovering credit impulse.
Policy risk will likely create volatility for Chinese stocks in the short term, but the market has also welcomed domestic good news, especially on a more flexible zero-Covid policy, setting the stage for an eventual recovery.
In our view, the medium-term outlook is clearer for China than for the West, where clouds have started to gather in US (which faces recession) and Europe (which is suffering from its Russian energy dependence).
Thus, in relative terms, the divergence in China’s monetary policy and GDP trends from the West could prompt investors to reallocate assets to China-related assets in due course.
1 As we argued recently, China needs a Keynesian solution to save growth in addition to monetary easing. See “Chi Flash: Saving China’s Economic Growth”, 25 April 2022.