Below are initial takeaways from China’s July activity data and surprise PBOC rate cut, which I also discussed in a short video recorded this morning (link HERE).
In a note on Monday that previewed the July activity data (link HERE), I argued that given downward pressures on the economy, including a new round of financial distress in the property sector, China’s authorities are at risk of falling further behind the curve in their campaign to stabilize growth and confidence. Events over the last 24 hours reaffirm that view: while PBOC surprised the market with rate cuts, the depth of weakness in the July data underscore just how much work there is to do to put this recovery on a solid footing.
The July data but they were exceedingly weak virtually across the board – several series, including retail sales, came in below the bottom range of analyst forecasts. The economy continued to suffer from soft demand and weak confidence:
- Households spent on services in July but not on goods, especially durables like appliances and autos; retail sales of goods grew only 1% y/y in July. On a sequential basis, retail sales and fixed asset investment both fell month-over-month. Within investment, private sector investment was still negative through July (-0.5% y/y ytd, vs. -0.2 in June).
- The surveyed unemployment rate rose slightly, to 5.3% from 5.2%. Perhaps most striking was the absence of data on youth unemployment in July (21% in June), one of the most hotly debated issues on the economy right now and a highly sensitive issue for the leadership. The authorities announced they will suspend publishing unemployment data by age while they ‘revise the methodology’ – a move that undermines the campaign to boost government credibility at a time when confidence in policymakers is weak.
- The property sector remained a major drag on growth, with property investment at -8.5% y/y ytd vs. -7.9% in June. Property sales by volume (accounting for a recent data revision) fell by -24% y/y, only a slight narrowing from the rate in June. And of course, this does not reflect the likely hit to confidence in property stemming from deepening problems at Country Garden, the largest developer.
- Industrial production grew 3.7% y/y in July, compared to 4.4% in June, and this was sustained in part by an increase in steel production (10%+ y/y across several categories) despite concerns about overcapacity. IP was flat on a month-over-month basis. Poor weather in China likely contributed to some of the weakness here and in investment. The statistical authorities were keen to highlight strong numbers for production and investment in new growth drivers such as electric vehicles, which are indeed impressive but do not compensate for the broader weakness in domestic demand.
The best thing that one can say about the July data is that it does not reflect the impact of ongoing stimulus measures. These have been modest to date, but August and especially September and October will see an acceleration of infrastructure investment after a slowdown in recent months. Beijing is directing local governments to complete their issuance of special bonds to finance infrastructure by end-September. An important watchpoint is how much financial support PBOC will provide through the policy banks to support these projects given strained local government finances. Expectations center on an amount of roughly RMB 500bn in such support.
But if July data do not reflect recent stimulus, they also do not yet show the potential ripple effects from woes at Country Garden as well as Zhongrong Trust (see our preview report yesterday, link HERE, for a short overview). Country Garden is a major concern, as a default threatens to worsen the vicious cycle underway in property: weak household confidence in private developers’ ability to deliver apartments hurts sales, which in turn further undermines private developers’ liquidity and creditworthiness. While China signaled at the Politburo meeting that local governments will loosen demand-side policies, stabilizing developers’ financing is becoming increasingly urgent. Full bailouts are still verboten for Beijing but potential financial support for Country Garden and peers is another key watchpoint in coming weeks.
With this backdrop, PBOC’s surprise rate cuts are welcome but much more needs to be done across a range of policy areas. PBOC cut the one-year MLF rate, which is the basis for the loan prime rate, by 15 bps, the most since a 20 bps cut in 2020. However, this cut only partially offsets the impact of deflation on real borrowing rates for the manufacturing sector, which have risen sharply in the last year (see chart). While the surprise cut signals a more proactive stance by PBOC, concerns over the exchange rate and financial risks are likely to limit the scope for more aggressive moves, at least in the near term. Moreover, monetary easing – even if fairly robust – will likely have limited effectiveness in boosting demand in an environment of fragile confidence. Fiscal stimulus and stabilization of the property sector will be key.
Below are short answers to questions from clients today:
- What is the outlook for growth in H2? While my basecase is that China will still be able to hit its 5% GDP growth target, two weeks ago I would have said the risk is 20% and now it is at least 30%. Note that the above refers to the rate that China will report, not actual growth, which will be lower.
- Why is Beijing so reluctant to stimulate? This is one of the more important and interesting questions on China, one that we have discussed in many reports. The short version is: Xi Jinping is determined to avoid taking measures for short-term expediency that undermine his long-term vision. That means directives to try to avoid exacerbating financial risks and to shift from old growth drivers (such as property) to new growth drivers (such as clean tech and advanced manufacturing). The problem is that there aren’t readily available stimulus tools that are attractive to Beijing that would support near-term demand while linking to these longer-term goals. I, and more importantly many influential economists in China, believe Beijing can and should do more fiscal stimulus focused on households to boost consumption. But China’s leadership remains averse: it believes money not spent on investments for the future (and Xi’s strategic priorities) is wasted; it wants to conserve fiscal capacity as a backstop for local government debt and the costs of an aging population; and it is reluctant to establish a precedent of “handouts to households” that it believes China cannot afford. For more on the politics of stimulus, see my July trip report (link HERE).
- Won’t pressures on growth force Beijing’s hand? Yes, to a degree. Recent measures to ease housing and cut interest rates are to some extent already a capitulation in the face of weak growth. I think it would take a lot – the prospect of a financial crisis and/or social instability – to force Beijing to bring out the “bazooka” (very aggressive monetary easing and/or major expansion of fiscal stimulus). More likely is that Beijing will progressively increase the number and scale of mostly targeted measures in Q3 and Q4 as necessary to try to secure the 5% growth target or close to it.
A note on exchange rate weakness and the risks of China selling Treasuries
The offshore yuan (CNH) closed near its weakest level ever against the dollar on Tuesday, at 7.32 USDCNH and the onshore CNY is also close to multi-year lows. That weakness is fueling some concern that China could be forced to sell its holdings of Treasuries to stabilize the currency, with potential risks for US rates.
While I don’t dismiss this possibility, I lean towards the view of the Council on Foreign Relations’ Brad Setser, the guru of China’s intervention and reserve practices, who explained in a twitter feed [link HERE] why Chinese authorities likely have sufficient liquidity to obviate the need for major UST sales. He points to sources of liquidity including FX deposits, income from foreign asset holdings, the assets of China’s state banks and sovereign wealth funds, and the support on a flow basis from China’s large current account deficit. This is of course not the last word on this issue but his take is where my priors are.
As far as the exchange rate pressures on the RMB more broadly, my basic views are as follows
- PBOC will be very anxious to avoid a repeat of the 2015-2016 cycle, when expectations of depreciation fed capital outflows, adding to currency weakness in a dangerous vicious cycle. Without being complacent about the risks of an accident, I view PBOC as having the will and capacity to avoid runaway depreciation. The main risk would be if property/trust/local government debt issues start to raise acute concerns over financial stability.
- PBOC will be more concerned with managing the pace of depreciation than defending a given level. Overnight the PBOC appears to have intervened to prevent CNY from breaching 7.30. However, I believe that ultimately the central bank does not want to waste ammunition defending a level that might be unsustainable. It will use a variety of tools – including the fixing rate, intervention, and macro prudential measures – to slow periods of rapid depreciation and keep expectations anchored.
- However, there are few near-term catalysts to support sustained appreciation. PBOC’s easing right now is a tug-of-war in terms of impact on the currency: the rate cuts widen interest rate differentials vs. the US (increasing depreciation pressure), but boosting growth and confidence, if effective, would push for appreciation. To date the interest rate effect is ‘winning’, given that rate cuts haven’t been large or effective enough to stabilize growth and expectations — this is the “water torture” for the currency that I described in an earlier note (link HERE). Monday’s rate cut was not so bold as to boost growth expectations – for that, as noted above, we will need to see the impact of infrastructure stimulus and other measures to stabilize expectations.
