SUMMARY:
- Weak economic activity in data reflects linked problems of anemic demand and weak confidence by firms and households; this holding back private investment and household spending on goods, which are necessary to complement a recovery thus far driven by services and infrastructure investment.
- The most effective solution to this dilemma would be stepped up fiscal support to boost demand, combined with efforts to shore up long-term confidence in China’s outlook; in part for political reasons, Beijing’s policy package will likely be a less effective mix of infrastructure investment (coming in Q3) and only partial steps at restoring “animal spirits” in the private sector.
- The dynamics above are not a complete surprise, and one shouldn’t overreact to one month of data; at the same time, there are few obvious catalysts in the near-term to shift the macro outlook and some risk that these dynamics represent an entrenched malaise.
Our report Tuesday covered initial reactions to China’s April activity data and the implications for stimulus (see HERE). This note adds further reflections, with three main observations.
First, China’s recovery faces a clear demand problem. China’s Q1 GDP and March activity data had showed some promising initial signs that the recovery was gaining ground. The question in April was whether that trend would be sustained or instead reflected the temporary release of demand built up during China’s Covid pivot in the winter. April data now point to the latter, with momentum fading in industrial production and property activity in particular. Consumption looks a bit better but is much stronger in services (dining out, travel, etc.) than in purchases of goods.
Zhiheng Luo, the chief economist at Yuekai Securities, sets the context in an online piece today in Caixin, China’s equivalent of the FT (rough translation below):
There are several important chains in the Chinese economy: the infrastructure chain, the real estate chain, the export chain, and the consumption chain. The infrastructure chain drives the construction industry and upstream raw materials and is an important means for the government to carry out counter-cyclical macro-control. The real estate chain was an important driving force behind the rapid growth of China’s economy in the past. It not only involves the consumption of furniture, home appliances, and home decoration in the post-sales cycle, but also drives upstream industries such as construction, steel, cement, glass, and construction machinery. It is also related to the finance of local governments’ income, which in turn affects fiscal spending capacity. The export chain is related to the manufacturing chain. Strong exports lead to a significant improvement in the profits of industrial companies, while [today] exports are sluggish and profits of industrial companies have declined. The consumption chain usually plays the role of “ballast”, and the volatility of consumption is less than that of investment and exports; the consumption of durable goods in the consumption chain is more important, such as automobiles, which are associated with many upstream and downstream industrial chains.
As Luo notes, the problem right now is that only the “infrastructure chain” and one part of the “consumption chain” – spending on services – are operating smoothly. The real estate chain is jammed, the export chain is slowing, and within the consumption chain durable goods spending has yet to gain traction.
Writing in March (link HERE), I had termed this phenomenon the “missing middle” of China’s recovery: demand was coming mainly from services (due to reopening) and infrastructure stimulus, but without private investment (including real estate) and household spending on goods the recovery would be weak in strength and narrow in scope. April showed us that the “missing middle” has yet to be filled in.
Second, linked to the demand problem is a confidence problem – and the two are self-reinforcing. The fact that private investment and household spending are relatively weak should not be a complete surprise. The most optimistic forecasts for China’s recovery banked on the lifting of Covid restrictions liberating pent-up demand but overlooked the economic scarring from three years of Covid controls and the real estate downturn. Households saw income growth slow during the pandemic (as employment suffered) and their most valuable asset (real estate) fall in value. Firms also incurred debt during the pandemic and now face uncertain demand domestically and externally. Households, firms, and local governments (which depend on land sales to property developers) are in balance sheet repair mode or even outright deleveraging.
Some of this scarring will heal with time. Households should be more willing and able to spend as employment and incomes recover in coming quarters. And deleveraging by firms and households will eventually run its course. But weak confidence is holding back this process. Households are not spending on goods or buying homes in part because of their lack of confidence in the broader outlook, which in turn hurts demand for manufactured goods. Firms are holding back investment and hiring given the anemic recovery at home and slowing external growth. The result is a vicious cycle.
One can see the confidence problem manifested in various sentiment surveys, but also through the economic policy uncertainty index derived from the frequency of references to uncertainty in mainland newspapers. As the chart below shows, uncertainty in the macro outlook remains very high by historical standards.
Third, forceful and effective policy solutions from Beijing are not forthcoming – at least in the near-term. I have seen few expectations in macro commentary in China that Beijing is going to respond aggressively to the weak April data, which is our view as well. We noted that China’s leadership will wait until closer to the end-July quarterly Politburo meeting – which typically sets policies for H2 – before announcing stimulus measures that focus on accelerating infrastructure investment. This will do relatively little to quickly fill in the “missing middle” of private investment and lackluster household spending.
Why is Beijing staying relatively restrained? As we have repeatedly stressed, Beijing’s conservative growth target for this year of “around 5%” underscored that the leadership is satisfied with a gradual recovery and is not seeking a roaring rebound if that requires aggressive stimulus policies that worsen financial risks. The other reason is that from the perspective of China’s leadership, there are few attractive policy prescriptions to accelerate the recovery.
The most effective policy response to the dilemma would be a strong fiscal stimulus to spur demand combined with structural measures to promote confidence in the longer-term outlook. However, China’s leadership remains reluctant to embrace direct fiscal support for consumption for a variety of reasons, including: (1) lack of confidence as to its effectiveness (having never really tried it at scale before); (2) reluctance to set future expectations of government handouts; and (3) concern that while the central government balance sheet looks healthy, it is backstopping heavy contingent liabilities from local governments that will worsen with population aging.
Monetary policy can only play a limited additional role given that liquidity is ample and real rates are relatively low. The problem facing the economy is not the availability of credit but a lack of demand. As we noted yesterday, PBOC’s main role will be to complement infrastructure spending by ensuring sufficient lending capacity. There is some scope for modest rate cuts and possibly even an RRR cut over the next quarter but it will be secondary to infrastructure response.
Aggressive support to the property sector, such as bailing out private developers, would be both very expensive for Beijing and politically unpalatable as Xi stresses the transition to a more conservative and less speculative model for the sector.
That leaves infrastructure stimulus as Beijing’s main demand-side tool this year, despite its limits and drawbacks. Infrastructure investment is already fairly strong (8.3% y/y ytd), particularly given Beijing’s concern over the debt risks for local governments and their affiliated state-owned companies, who undertake most infrastructure investment. Why then double-down with further spending in the second half? Because it provides Chinese policymakers with reasonable assurances as to the impact on output and employment, addresses some important investment priorities (such as extending China’s EV charging network), and supports struggling upstream industries (such as steel) that are hurting from the real estate downturn.
When it comes to efforts to boost longer-term confidence, the constraints are both structural and political. On the structural side, there are few ready policy solutions to address mounting concern over the aging population and what that means for broader growth; other countries have tried and largely failed to lift fertility rates, so Beijing’s best bet is to prepare for the fiscal costs and impact on the labor force.
The challenge is more political when it comes to lifting “animal spirits” and reassuring China’s entrepreneurial class about its future. Xi has taken some steps in recent months, including by signaling the end of the crackdown on private tech companies and making pledges to level the playing field between private firms and SOEs. But some sources of anxiety are simply hard-wired into Xi’s governance style, with its focus on Party control, reliance on state firms as strategic assets, and suspicion of private capital. For example, recent months have seen Xi further tighten the Party’s grip on the financial sector through a political restructuring (link HERE) and an expanding anti-corruption campaign drive that has included the detention of China Renaissance chairman Bao Fan, a prominent figure in the tech scene. The burden is on new premier Li Qiang to prove to the private sector that the political and regulatory environment is improving meaningfully.
What it all means for the outlook:
The analysis above is not meant to be doom-and-gloom. A subdued services-driven recovery was already incorporated into our outlook and to some extent priced in by investors, with domestic equity markets largely treading water since the initial “reopening trade” ended in January. April represents one month of data in a complicated macro environment. Still, there are few obvious catalysts on the horizon to shift the macro view on China, though investors should expect at least a temporary reduction in US-China geopolitical tensions given signs that the two sides are ready to re-engage (link HERE). When it comes to growth, it will be important to see whether the recent fade in momentum represents a setback or a more entrenched malaise, in which case Beijing will be challenged to respond effectively.
