China outlook - Q2 2021

After a stellar run in 2020, the Chinese market recently saw a substantial market correction. In this piece, we highlight several macro and policy developments that are key to forming our outlook on the Chinese economy over the coming quarter.

1. China reported its Q1 2021 GDP and March’s monthly economic data. Overall, a strong GDP quarter in line with consensus expectations while March’s monthly economic data was more of mixed bag. The onshore market reaction has been subdued. The 18.5% Q1 GDP print is the highest y/y growth since China started recording GDP data back in 1992 – although the data is skewed due to an easy comparable in Q1 2020, which saw a -6.8% GDP slump from the onset of the pandemic-related lockdowns. On a sequential q/q basis, Q1 2021 GDP growth improved by a more modest 0.6%, reflecting a tapering of China’s sharp V-shaped recovery. 

March’s monthly economic data such as industrial production came in below expectations, driven by weaker cement, steel and electricity production. Fixed asset investments also slightly missed due mostly to a contraction in the auto manufacturing sector although investments to the property and infrastructure sectors continued to be strong.

The bright point from the monthly data is reflected in a pickup in consumption spending as measured by retail sales. It’s reasonable to assume that the consumption pickup is starting to gain steam after temporary travel restrictions over the Lunar New Year dampened spending.

As inflationary fears pick up with a corresponding rebound in economic activity, the spokesperson for the National Bureau of Statistics allayed these concerns – shrugging off inflation pressures and expects consumer prices (CPI) for the rest of the year to hold stead and trend at normalized levels. The recent spike in CPI has been driven primarily by elevated gasoline and diesel prices while a sharp drop in pork and grain prices have acted as a countervailing force.     

Q1 GPD y/y: 18.3% vs cons 18.5%

Mar Industrial Production y/y: 14.1% vs cons 18.0%

Mar Retail Sales y/y: 34.2% vs cons 28.0%

YTD Fixed Asset Investments y/y: 25.6% vs cons 26.0% 

2. China’s economic recovery to normalize ahead of other economies

China’s outperformance in 2020 relative to other major economies took place for three reasons: effective virus containment, policy stimulus, and pandemic driven demand for Chinese exports. By the same token, this means China’s economic rebound may normalize ahead of other economies. Firstly, vaccinations in China may have a comparatively smaller impact on domestic economic activity in China. Secondly, credit growth – an important driver of China’s growth -  is expected to continue softening due to the slowing government bond issuances led by fiscal consolidation and deleveraging initiatives. Finally, while Chinese exports should benefit from the consumption boom in the US, pandemic driven demand for Chinese produced medical equipment and work-from-home electronics may decline as vaccinations continue to accelerate in the US and Europe – this may moderate China’s rapid export growth.

3. Subdued inflationary pressures mean the PBoC is unlikely to raise rates

Reflationary pressures in China are picking up but are likely to remain subdued in the near term. Consumer price inflation returned to positive territory in March but remains low, rising from -0.2% YoY in February to +0.4% YoY. Most of the increase was the result of a surge in fuel price inflation of +11.5% YoY. As economic activity, especially consumer spending and service demand, normalize, this may lead to a moderate recovery in the pricing environment going ahead. In terms of yields, while the 10y US Treasury Yield rose more than 70 bps since the beginning of this year, the Chinese 10yr Treasury yield has picked up just 1.5 bps remain range-bound between 3-3.5%. Nonetheless, the rise in US Treasury yields has led to a strong rotation from growth to value and cyclical stocks within China since the beginning of the year.

The PBoC is unlikely to raise interest rates in the near-term. While China’s GDP rebounded strongly in 4Q2020, the recovery has been uneven, with SMEs and the service sector still lagging. These sectors would be hit hard by a sharp tightening of monetary policy. Services are also more labor intensive than manufacturing, and SMEs account for around 80% of China’s urban employment. The PBoC will look out for signs of improvement in the labor market and recovery in household income growth to support household spending before contemplating hiking interest rates.

4. Chinese debt issues over COVID-19 may be overblown

The COVID-19 policy stimulus led to a spike in Chinese debt as Chinese non-financial debt as a percentage of GDP jumped 23% to 281% in 2020, but we think existing debt issues may be overblown. In fact, China’s fiscal stimulus so far in 2020 has been much less when compared to other economies worldwide. Most countries have spent almost double on fiscal support in 2020 than in 2009, whereas the Chinese government have only spent around 4% of its GDP to support its economy in 2020 compared to 8% in 2009. While global debt to GDP in the first three quarters of 2020 rose by 33%, China’s debt to GPD increased by just 26%.

5. Chinese government steps up its de-leveraging initiatives 

The Chinese government has ramped up its de-leveraging initiatives and fiscal tightening measures. In particular, the highly levered real estate sector has experienced significant pressure to delever due to the property loan caps imposed on banks last year and the recently enacted “three red lines” campaign¹ - regulatory policies to constrain real estate investment. The de-leveraging of China’s real estate sector highlights the worry that China could repeat Japan’s mistake in the 1990s of not reining in excessive credit and shutting down insolvent borrowers quickly enough, causing long term damage to the economy.

High debt implies that the interest repayment burden may crowd out credit support for the real economy. In recent years, despite the decline in average lending rates, the interest repayment burden in China has been equivalent to 14%-15% of GDP or 40%- 60% of TSF. This constrains interest rate policy significantly, as policy rates may be lowered or stay very low for too long to facilitate debt repayment, as has happened in high-debt advanced economies since the GFC. As such, rationing credit to the real estate sector is part of a wider initiative to channel lending to other, more productive areas of the economy such as technology, green economy, and consumption related projects.

6. Credit growth to slow 

Credit growth is likely to slow in 2021. Broad credit growth, as measured by outstanding TSF, edged up by just 13.3% YoY in Feb, lower than last October’s peak of 13.7% but still high compared to 2019. However, looking at total credit, China's total credit grew by CNY3.34 trillion in March and CNY10.24 trillion in 1Q21, down CNY873 billion from 1Q20. The difference comes from a decline in shadow banking activities, including trust loans, entrusted loans, and less fund raising from corporate bonds and stocks. This shows that China is amid a deleveraging reform and credit growth is likely to slow in 2021.

7. Systemic Risks: COVID-19 and Geopolitical Tensions

COVID-19 continues to be a risk to China’s domestic growth and economic re-opening. China has effectively curbed infection numbers since March last year, but there have been instances of local outbreaks, most recently in Yunnan province. We think the risk of COVID-19 to China’s economy is minimal given the Chinese government’s strong record in stifling local outbreaks through utilizing efficient contact tracing and strict lockdown measures. In addition, the Chinese government has ramped up its vaccine rollout in recent weeks, with the government setting a goal of vaccinating 40% of its 1.4 billion people by the end of June.

Geopolitical tensions, especially with the US, are an evident economic, political, technological risk for China going forward. We expect the Biden administration to take a more multi-lateral approach to counter any Chinese action that could affect US interests, and geopolitical frictions in HK and Taiwan are especially sensitive. Continued de-coupling in the technology and financial sector is also expected. That being said, China remains the world’s largest manufacturing hub, with the pandemic cementing its primacy in global supply chains. A couple of other mitigating factors to US-China geopolitical risks, are Beijing policy maker’s current drive for self-sufficiency via the government’s push towards growing domestic demand and cultivating indigenous innovation and China’s continued engagement with its APAC partners through the Regional Comprehensive Economic Partnership (RCEP).

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

^1Chinese regulators are assessing developers’ financing based on the following three criteria: (1) liability-to-asset ratio of less than 70% (excluding advance receipts); (2) net gearing ratio of less than 100%; (3) cash-to-short-term debt ratio of more than 1x. 

David Chao

Global Market Strategist, Asia Pacific ex Japan

Adrian Tong

Investment Thought Leadership, Asia Pacific ex Japan

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