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China: structurally higher risks but timely policy responses can turn it around

Manu Bhaskaran
Manu Bhaskaran11/30/2022 05:15 PM GMT+08  • 9 min read
China: structurally higher risks but timely policy responses can turn it around
Citizens protesting against Covid restrictions in Beijing, China, on Nov 28 / Photo: Bloomberg
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China is between a rock and a hard place. Economic activity has slowed as surging Covid infections have led to more restrictions on mobility in regions accounting for a quarter of its economic output. Financial stability is also under a cloud as a deflating property sector and a slowing economy degrade the over-leveraged corporate sector’s ability to repay its debts.

And, now, popular resentment against the government has been thrown into the mix, triggering protests that have shaken the consumer and business confidence so essential for economic recovery.

China’s predicament is serious and the risks are real. However, recent history also tells us that Chinese policymakers have a habit of showing up the pessimists. In the past 20 years, Beijing’s technocrats have found ways to patch over what seemed to be dangerous imbalances such as excessive debt and over-investment while maintaining economic growth at a reasonable pace.

Of course, this time is different — measures used to tackle one of today’s problems could aggravate others. Easing Covid restrictions could, for example, allow the economy to bounce back but could also precipitate a surge in Covid infections.

Thus, China’s leaders need to devise creative economic responses to keep its economy steady and to manage political tensions delicately. If this can be done, as we believe, China’s economy should still rebound vigorously next year from its current malaise.

The economy is again buckling under multiple pressures

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The most recent economic data did not make for pleasant reading. Key elements of demand are deteriorating:

• Household consumption remains lacklustre: Retail sales contracted by 0.5% y-o-y in October, down from +2.5% y-o-y growth in September. This is not surprising since unemployment could be dampening confidence. While the surveyed urban unemployment rate of 5.5% in October was unchanged from September, the youth unemployment rate remained elevated at 17.9%. Unless jobs are found for the growing number of college graduates (rising by 820,000 to 11.58 million in 2023) consumer confidence will take a further plunge.

• Fixed asset investment growth edged down to +5.8% y-o-y in the 10 months to October from 5.9% y-o-y in January–September this year. Moreover, despite government efforts to boost the economy with more infrastructure spending, infrastructure investment has failed to accelerate much, growing by 8.7% in January–October y-o-y this year-to-date, roughly the same pace as the earlier period. The real estate sector’s travails persisted with property investment contracting by a faster 8.8% from the earlier 8.0%.

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• Worse still, the one engine of demand that had continued to grow — exports — is now at risk. Exports contracted by 0.5% in October, a turnaround from expansion of 5.7% in September. As global economic prospects darken, China’s exports are likely to contract at an even faster pace in coming months.

So, the prospects for domestic demand remain under a cloud. One indication of this is seen in how business confidence among micro and small companies declined to 45.5% for 4Q2022, the lowest level since 1Q2021, according to a survey jointly conducted by Peking University and fintech firm Ant.

But as demand growth and confidence have slumped, production activities have also followed suit. The purchasing manager index for manufacturing in October fell to 48, its worst level since April while the non-manufacturing index fell to 46.7: In other words, overall economic activity is contracting. Industrial production growth had already dipped to +5.0% in October from September’s 6.3% — and November’s growth will slow even more markedly. Rapid growth in high-technology manufacturing such as new energy vehicles and solar products, slowdowns in other areas is being offset by slowdowns in more traditional areas.

Authorities seem to respond more vigorously In the past few weeks, China’s economic managers have begun to move more aggressively:

Monetary easing underway: Despite its concerns that monetary easing might spur excessive borrowing and lead to capital outflows, the central bank still went ahead with cutting the reserve requirement rate by 25 basis points, effective Dec 5, which should prompt reductions in lending rates. The authorities have also swallowed their concerns that policy easing might allow speculative real estate behaviour to return or that bailing out the sector could create moral hazard problems or add to medium-term debt vulnerabilities. They are planning additional support measures in addition to the 16-point property rescue plan announced on Nov 11. The central bank is reported to be planning to provide a further CNY200 billion ($35.3 billion) in new loan quotas to commercial banks to support developers that have missed residential project construction deadlines. The state-owned banks have also announced more than CNY220 billion in credit lines for real estate developers on Nov 23, almost certainly at the behest of the policymakers.

• Support for the industrial sector: The Ministry of Industry and Information Technology, along with two other ministries, issued 17 support measures for the industrial sector on Nov 21. Details of the measures are vague; they appear to cover a broad range of industries but remain incremental in nature.

• Support for infrastructure construction: The National Development and Reform Commission is urging local governments to accelerate infrastructure projects. The agency asked local governments to undertake preparatory work for new projects to “build a good foundation for expanding effective investments next year.”

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• Fiscal support for local governments: The Ministry of Finance announced on Nov 10 the allocation of several central government funds from the 2023 budget to local governments ahead of time. The allocation was meant to support local government spending, particularly in poverty alleviation, water conservation, and employment support.

So, the good news is that policy measures have become less piecemeal and more substantive. Whether they pave the way for a general economic recovery is, however, moot.

But can these support measures achieve their desired result?

The most important policy measure that the Chinese economy needs today is a better approach to managing the Covid pandemic. This is yet to happen, although there are some hopeful signs. On Nov 11, the government issued a 20-point package of measures designed to make Covid restrictions less onerous on ordinary folks and less damaging to economic activity.

However, the surge in Covid infections has thrown the easing strategy into disarray. For example, no sooner had the authorities announced that the major manufacturing hub of Zhengzhou would relax Covid restrictions than they had to re-issue a revised set of restrictions affecting hundreds of buildings in the city and reversing much of the benefits of the earlier easing.

China is caught in a bind. Relaxation of Covid management is desperately needed for the economy to recover. But the consequences could be dire for a country where too low a proportion of senior citizens have received the booster jabs needed to protect them from the highly infectious Omicron virus — and where intensive care capacity remains very low.

However, failure to spur the economy would almost certainly aggravate other stress points in China such as the real estate sector. For instance, unless underlying demand for housing recovers, no amount of interest rate cuts will stabilise that critical sector.

High frequency data for November highlight the potential dangers if policy is not sufficiently responsive. Subway ridership in China’s 29 major cities fell 22% last week from the previous week. Air traffic is also weakening, with domestic flights averaging around 3,800 the week before, falling by close to 60% over the same period last year.

With the localities suffering some form of Covid-related lockdown and other restrictions now covering more than 25% of China’s GDP (according to an estimate by Nomura), compared to around 21% in April, there is reason to believe that economic conditions can only worsen.

So, what can be done?

The recent protests are an additional concern. Even though the unrest appears to have died down, the underlying resentment has not gone away. Chinese leaders know that suppressing expressions of dissent through censorship and massive deployment of police personnel can work only for a short while. They have to tackle the public dissatisfaction with Covid management practices and do more to stimulate demand.

Thus, this political threat to the leadership may be just what is needed for more decisive measures to be taken. Leaders have hesitated to adapt their policies, fearful of losing face or because they have become too wedded to old-but-outdated approaches. Now under the greatest political pressure they have faced in 30 years, China’s leaders are more likely to start doing what they should have done some time ago:

• They are already pressing more elderly citizens to be vaccinated and ramping up hospital and intensive care capacity.

• The next test is whether they can overcome nationalist sentiments and allow the use of foreign-produced mRNA vaccines which are deemed to be more effective than China’s home-grown ones.

• They should then move away from their rigid approach to the pandemic. Instead of widespread lockdowns and harsh restrictions on whole neighbourhoods, a more targeted set of controls can help control the spread of the virus without inflicting the kind of harm to the economy China is currently seeing.

• The authorities should disband the highly unpopular “white coats”, enforcers of Covid regulations employed by local governments but whose thuggish treatment of ordinary Chinese explain a lot of the public anger that fuelled the recent protests.

• A shift in policy thinking is needed so as to make stimulus measures more effective. First, direct cash transfers to households should be more widely used. These are more likely to be effective in boosting demand but policymakers have not been willing to deploy them thus far, for no clear reason. Second, the top leadership needs to better incentivise local officials. Many of them fear approving tenders and contracts for infrastructure projects because of the harsh crackdown on corruption. The corruption investigators sent out by the central government need to be more targeted in their approach so that this fear is assuaged.

The bottom line: Policy change is coming and should stabilise the economy

The political and economic threats to China’s well-being are now blindingly evident to policymakers. We think the most likely outcome is a recalibration away from rigid enforcement of Covid measures and a more expansive set of economic stimulus measures. That should result in a rebound in economic activity in 2023 after what is sure to be a very poor 4Q2022. If executed well, without further political ructions, this snap-back in economic growth could be very sharp, especially given the low base this year.

A rebound in China, the second largest economy in the world, will provide a welcome relief for export-oriented economies in Asia in 2023, when the US and Europe are likely to perform weakly. It is certainly going to be a bumpy ride in China, but there is reason to be hopeful.

Manu Bhaskaran is CEO of Centennial Asia Advisors

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