CHINA: Taking the pulse of a chaotic pivot

SUMMARY

• Surging Covid-19 infections are putting China’s under-prepared medical system under strain, lowering personal mobility and adding to worker absences; the next two months will remain rocky for the economy and population but the economy should start a gradual recovery around Q2.
• The main near-term risk is that a major spike in fatalities deepens household risk aversion and forces local containment measures to try to slow infections, but the bar is very high for China’s leadership to shift course on the hasty pivot now underway.
• A wild card on the public health side is the potential for the virus to mutate; among other risks, this could lead the US and other countries to impose travel bans on China, exacerbated by distrust over China’s opacity on public health.
• While China’s leadership is re-prioritizing economic development and sending positive messages to markets and the private sector, the rebound in demand next year is likely to be subdued due to economic scarring from the pandemic, constraints on stimulus and slowing exports.

Commentary on China has been playing out on a split screen: media are focused on the increasingly messy pivot underway, while analysts and investors are largely looking past the wave(s) of outbreaks to examine the outlook for an economic recovery in 2023. That bifurcated approach is justified only to an extent: the public health situation is tenuous, and an exceptionally chaotic pivot would worsen the outlook for the recovery.

In this note we provide a short update on both the pivot and signals as to the 2023 macro outlook. Our views haven’t changed appreciably since our note last Friday following the Central Economic Work Conference (please see: Policies and the pivot will support an H2 2023 recovery – but it probably won’t be gangbusters growth, 17 December 2022). China’s rapid pivot implies an economic recovery starting in the spring, but one that we think will be subdued due to: economic scarring from three years of pandemic controls (particularly in terms of household finances); constraints on the scale and effectiveness of stimulus; falling Chinese exports; and a continued if smaller drag from the property sector. We also detailed these themes in a webinar on Monday with guest Houze Song, who leads work on China’s economy at the thinktank MacroPolo (replay available here).

Pivot dynamics

Here is a summary of latest developments with China’s Covid pivot:

• Explosive growth in cases. Reduced testing has made it very difficult to assess daily cases and their growth, but infections are ripping through country. Cases may already have peaked in Beijing, while Shanghai is bracing for a surge. Chinese social media has circulated notes purportedly from a meeting of the National Health Commission – thus far unverified – in which the government estimates that there were 37 million new cases of Covid on Dec. 20 alone, and that cumulatively 18% of the population has been infected thus far.
• Medical resources under strain. Media and anecdotal reports indicate that cities, including Beijing and Shanghai, are suffering from at least sporadic shortages of fever medicine at pharmacies and overcrowding at fever clinics and ICUs. The FT reports that various local governments are requisitioning medicines, face masks and other medical supplies produced by local firms, which threatens to worsen supply constraints for some localities. As we have cautioned, the biggest dangers of strained health systems will come in poorer cities and rural areas, where the current status is hard to assess and the worst may be yet to come.
• Fatalities are growing but numbers are obfuscated. Fatalities are rising well past the official statistics (fewer than 10 deaths this month) but are difficult to track: the authorities have always taken a narrow approach to counting Covid deaths and recently further narrowed their definition to cover only patients who died of pneumonia and respiratory failure (excluding heart attacks and other comorbidities). Thus far fatality rates do not seem to be approaching the very high rates seen in Hong Kong’s outbreak earlier this year.
• Worker shortages. Some manufacturing firms are reporting production constraints due to absent workers. On the whole, we expect disruptions to be shorter in duration than those caused by lockdowns under the zero-Covid policy.
• Local mobility has plunged while inter-provincial travel is starting to revive. Within cities, traffic congestion and subway ridership has plunged due to household risk aversion, sickness, and closures of schools and offices. At the same time, the lifting of controls on inter-provincial travel earlier this month has led to a surge in interest in domestic travel, with airlines now adding destinations previously suspended due to lack of profitability. There is likely to be significant travel for the lunar new year holiday in early January (officially starts 22 January), which could in turn produce a second wave of outbreaks.
• International travel is likely to pick up as the leadership accelerates reopening. Bloomberg is reporting that China may eliminate quarantine requirements for international travelers in January, requiring only three days of monitoring.

Implications:

• Current dynamics, chaotic as they are, are still consistent with a rapid pivot scenario that puts China on course for a subdued economic recovery that starts in Q2. This is clearly the intended path of China’s leadership, which has deemphasized containment in favor of a resumption of economic activity.
• There are still significant risks and uncertainties with the pivot. Should China experience a true public health disaster – with severe strains on the public health system and very high excess mortality – it would likely worsen the economic outlook. Household risk aversion would be more intense and prolonged, while local governments may be forced to retain some containment measures – such as school and workplace closures – for longer as well. These could potentially also push out the timeline for when China’s outbreaks eventually peak, meaning a later recovery. But the bar is very high for China’s leadership – having already done a 180 degree turn on Covid policies since November – to slow down the pivot that it is now promoting.
• There are also wild cards on the public health side. Some public health officials are worried about the potential for Covid-19 to mutate in China. Should a worrying new strain emerge it would of course scramble the outlook, including introducing the potential for countries such as the US to impose travel bans on China; given concerns over China’s lack of transparency, the political pressure to do so even with inconclusive evidence could be intense. Early warning signs would likely come from Hong Kong, Singapore, Japan, Southeast Asia and other countries in the region that will see the initial wave of Chinese visitors.

Macro outlook for 2023: Stimulus vs. constraints

Last week’s Central Economic Work Conference signaled that China’s leadership is intently focused on promoting a recovery for the economy and for confidence in 2023. In the days since, Chinese officials have followed up on that directive with additional pledges to support that goal, including statements by Premier Li Keqiang at a State Council Executive Committee meeting on Thursday and PBOC Governor Yi Gang on Wednesday. For the most part these reiterate themes from the CEWC – including boosting domestic demand through infrastructure and consumption, spurring employment, and promoting the private sector – without much in the way of new announcements.

Pledges to boost growth need to be set against the broader political backdrop and headwinds for the economy:

• While Xi Jinping is clearly reprioritizing economic development, he is doing so through his lens of “high quality” growth that places a strong emphasis on avoiding financial risks and on tackling priorities such as boosting investment in strategically important sectors. He is not about to abandon discipline to, for example, return to the old model of credit-fueled property investment.
• Households’ ability and willingness to consume has been hit hard by weak employment during the pandemic and uncertainty over the future. This will take time to repair. Further, while the CEWC and recent policy statements have stressed boosting consumption, Beijing remains reluctant to take the most direct route by supporting household income, such as through cash transfers. Instead, policies will likely focus on support to employers and providing small-scale consumption subsidies.
• China will step up support for the property sector but is not inclined to bail out private developers en masse and is intent on searching for a new model for the sector; this approach, plus questions over the fundamental demand for property given declining demographic headwinds, suggests property investment will still be negative next year but a smaller drag on growth.
• Total fiscal stimulus, including quasi-fiscal spending, will likely be smaller than in 2022, especially as China’s leadership refocuses attention on local government debt risks.
• Monetary policy is unlikely to be highly expansionary.
• Exports, a key source of support for growth in the last three years, have slowed sharply and will also drag down associated investment by export-oriented manufacturers.

Bloomberg’s consensus forecast for China is still below 5% for next year, indicating we are not alone in our view; 5% growth is only a modest recovery given a low base from this year. That outlook would be consistent with relatively low inflation in China for 2023 as a whole, though there is the potential for a spike in inflation in the early stages of reopening if demand returns more quickly than workers and production. 22V’s portfolio strategy team placed signals from China in the context of the broader global disinflationary outlook in a note earlier today (please see China’s Growth Focus and U.S. Confidence Do Not Change the Disinflation/Slower Economic Activity Trend, 22 December 2022).

It is worth noting that some prominent Chinese economists – including Yao Yang of Peking University, and Zhang Bin of the CF40 think tank – are calling for Beijing to lift its inflation target from 3% to 5% and let the economy run hot next year. Their argument is that growth has been well below potential during the pandemic, and more rapid growth of at least 5.5% is necessary to lift employment and avoid further scarring or long-term malaise. We do not see signs yet that Beijing is gearing up for such a gangbusters push.