SUMMARY
- China’s Q1 GDP beat analyst expectations with 4.5% y/y growth; while growth remains driven by the service sector, manufacturing activity is gradually gaining momentum.
- Household spending is recovering, fueled by gains in employment and income; improved household finances also bode well for a further stabilization of property sector activity.
- While the report is a strong positive, there are still points of caution for the outlook, particularly the subdued level of private investment and the temptation for the authorities to eventually withdraw stimulus amid concern over debt risks.
We flagged in our preview note yesterday that, based on the recent flow of data, China’s Q1 GDP was likely to come in on the high side of expectations. It did indeed, with growth of 4.5% y/y, compared to the Bloomberg consensus of 3.4% y/y. As important, the March activity data show promising signs of strength for household demand.
A few initial takeaways on the data:
Services continue to drive the recovery. The service sector component of GDP grew by 5.4% y/y, compared to 3.3% y/y for industry. On a monthly basis in March, the service sector production index rose 9.1% y/y, an acceleration from 5.5% y/y in January/February, compared to the more modest pickup in manufacturing production, which grew by 4.2% y/y growth in March from 2.4% y/y in Jan-Feb. A services-driven rebound means fewer spillovers for global demand than an industry-led one, but the gradual firming up of manufacturing activity is still welcome for China’s recovery as well as for global growth in an environment where advanced economies are expected to slow.
The fundamentals for household consumption and for property demand are improving with employment gains. Nominal retail sales grew by 10.6% y/y in March. Retail sales of catering services (a proxy for dining out) grew 26.3% y/y, but retail sales of goods (9.1% y/y) also showed important signs of health. Those high growth rates need some context. There were large base effects from March 2022, when Omicron led to a wave of lockdowns in major cities in China; the March 2023 retail sales of goods are still only 6.8% above March 2021 levels, showing that the degree of “revenge spending” in China is still modest. One should also note that China’s retail sales data include some spending by firms, so they aren’t a pure picture of household spending.
Still, the fundamentals for household finances are clearly strengthening. Data from China’s quarterly household survey show real consumption and income growing by 3.8% y/y and 4% y/y in Q1, respectively – below the pre-pandemic trend but a nice initial rebound from the wrecked Covid economy of late 2022. The nationwide urban unemployment rate fell to 5.3% in March, from 5.6% in February; employment gains are crucial for the consumption outlook given limited direct support for consumption from the Chinese government. While youth unemployment remains an economic and social concern, rising back up to 19.6% in March (just below the historical peak of 19.9% in July 2022), it is as much of a structural as cyclical phenomenon. Property activity also showed further signs of a recovery in March, though from a low base from 2022.
We have been relatively cautious about the strength of China’s recovery this year – particularly in terms of the spillovers to global demand – given headwinds for household spending (recovering income and employment), firms (deleveraging pressures and uncertain investment appetite) and local governments (strained finances from the real estate downturn). The Q1 data don’t erase those headwinds but the recovery is clearly gaining strength and is in better shape than we expected based on January/February data. Households are a particular bright spot.
Still, there are still several points of caution or uncertainty regarding the outlook in coming quarters:
First, private investment remains subdued. Animal spirits in the private sector have not fully awakened. Fixed asset investment grew 5.1% y/y year-to-date in March, but state firms increased their investment by 10% while private investment remained flat at only 0.6% growth. Some private firms face deleveraging pressures from debt incurred during the pandemic, and some are responding to the weak outlook for exports.
Second, the potential for stimulus withdrawal is a watchpoint given Beijing’s concern over financial risks. In Q1, new bank lending that reached an all-time high (see our write-up HERE). The authorities have leaned on banks to support firms, including small and medium-sized enterprises hit hard by the pandemic.
This dependence on credit growth and state-driven investment is a potential vulnerability for the outlook, given that Xi Jinping remains intensely focused on avoiding systemic financial risks. Beijing set a relatively unambitious growth target for the year (“around 5%”) for a reason – to avoid exacerbating these risks any more than necessary. Thus, if policymakers become confident that their growth target and social/employment goals are reasonably assured, they are likely to step up risk control efforts in H2, potentially including more aggressive efforts to address debts of local governments and their affiliated SOEs.
Third, some of the factors that contributed to Q1 growth are likely to recede. Pent-up demand for services will eventually wane. Strong export performance in March also seems unlikely to last given the expected slowdown in advanced economies and the fact that Chinese exporters may also have been clearing a backlog of orders from early in the year when factories were still closed from Covid disruptions. Finally, while construction activity has also been strong, new construction orders fell back abruptly in the March PMI data suggesting a temporary boost as Covid ended and the weather improved.
A final point, more of a puzzle than a major point of caution, is the discrepancy between strong growth in activity and subdued inflation; core CPI was only 0.7% y/y in March, which seemed to nod to subdued demand. The divergence between activity and inflation is likely due to growth in production capacity – in particular, workers returning from Covid and holiday furloughs – outstripping demand. Thus far there are no indications that labor market conditions are tightening to the extent that China is danger of overheating, but we’ll be looking into this divergence further.
