Summary:
- Overall economic sentiment in China remains subdued, with deflationary pressures prominent and property yet to find a bottom; decent headline growth numbers mean that Beijing is unlikely to launch significant stimulus policies in Q3.
- However, a broadly stable macro outlook, and China’s resilience among trade tensions, allows for significant pockets of market and industry optimism, mainly in areas linked to high tech.
- Contacts welcome Beijing’s focus on combatting “involution” in the industrial sector; at the same time, they are skeptical of a broad turnaround in excess capacity this year, given the scale of the problem and Beijing’s commitment to meeting a high growth target.
- While US-China relations remain a major area of uncertainty, contacts are broadly confident in China’s ability to navigate tariffs and other tensions; the upshot is that Beijing is not under heavy pressure to make large concessions to the United States, limiting expectations of major deliverables from a Trump-Xi meeting this fall.
- Drafting is underway for the next Five-Year Plan, which will be previewed at a plenum meeting this fall; the plan will likely maintain a policy focus on promoting high-tech and advanced manufacturing as well as long-term shift towards consumption.
We recently returned from a visit to Shanghai and Beijing for an on-the-ground update on the economy and to prepare for 22V’s investor trip to China (September 14-18). The title of this report does not refer to our own adventures: “Many stories to tell” is instead how one of our longtime contacts described the current economic situation in China, which we found apt. His point was that China’s economy faces numerous challenges – including from debt and deflation, trade tensions, and the ongoing property market contraction. Economic sentiment remains very subdued. Investors looking for negative stories to tell can certainly find them.
At the same time, a broadly stable outlook, combined with investors exploring markets outside the US, is facilitating reasonable optimism about investment themes in China – especially China’s dynamic tech and advanced manufacturing sectors.
The extent to which the positive themes can offset the subdued macro backdrop will depend in part on Beijing’s economic policies. Our view on policy, and generally those of our contacts, continues to lean cautious, at least in the near term. A new “anti-involution” campaign is a signal that Beijing is starting to take the risks of excess capacity and deflation more seriously. However, at the macro level these efforts so far remain piecemeal relative to the scale of the challenges. A plenum meeting this fall to preview the next Five Year Plan (2026-2030) will be an important gauge of the direction of policy, including the seriousness of efforts to boost consumption.
We will further explore these issues during our investor trip in September. In the meantime, below are the main takeaways from our recent meetings.
US-China and Trade Tensions: Quiet Confidence
Contacts welcomed the recent de-escalation of US-China trade tensions and the likelihood of a meeting between President Trump and President Xi Jinping this fall. Few have strong convictions as to what a meeting might produce, given uncertainty as to what Trump aims to achieve with China.
That said, contacts in and outside of government expressed confidence in China’s ability to navigate U.S. trade measures and tensions. This confidence comes from two places. The first is a sense that China has demonstrated sufficient tools of deterrence (especially rare earths) to prevent serious re-escalation by Trump anytime soon. The second source of confidence is in the ability of China’s exporters to cope with U.S. tariffs through nimble investments (targeting other export markets, shifting production to third countries) and through their remarkable cost competitiveness. Exports are getting help from a weak real effective exchange rate due to China’s domestic deflation and the decline in the broad dollar, which has allowed the CNY to stay broadly even with the dollar while depreciating against other currencies (especially the euro).
This relative confidence reinforces our view that a Trump-Xi meeting will have modest economic outcomes. We do not see Beijing as under great pressure to make large concessions to Trump in the hopes of gaining tariff relief. Beijing is certainly open to Chinese enterprises purchasing more from the US, and even investing in the United States, but such decisions would be largely up to the enterprises and be made on commercial terms. Investments would require firms to evaluate the suitability of the political environment in the United States for such projects.
A foreign policy scholar voiced a common view that China’s leadership has come to terms with the notion that high tariffs are simply becoming a permanent feature of U.S. economic policy and will adjust its ambitions accordingly. Hence, Beijing will push for modest tariff relief – particularly reduction in the 20% tariffs that Trump imposed to incentivize cooperation on fentanyl – but may view a Trump-Xi meeting as successful if it improves the overall stability and predictability of the relationship, including on foreign policy issues such as Taiwan. This is less a “grand bargain” than extended truce.
Deflation and Excess Capacity: Rising Urgency, But Not Enough
One cannot escape how inexpensive many things are in China’s largest cities these days (especially services) – indeed, it kept coming up in conversation. While this is great for consumers, it drives home the extent to which deflation is becoming entrenched in household and firm expectations. This is reflected not only in anecdotes but also at the macro level; nominal GDP growth slowed to around 3% in Q2, from over 4% in Q1. If there is a lesson from past deflationary episodes, particularly Japan’s, it is that it is extremely hard to break out of once built into expectations.
Is Beijing taking sufficient notice about the dangers of deflation? Stepped up rhetoric on “anti-involution” (the treadmill of capacity expansion and ruthless price cuts) reflects a rising sense of urgency on overcapacity and the risks it presents for the industrial sector. But the leadership still seems to view deflation as a transitory (and not entirely negative) phenomenon rather than chronic problem that requires bold action. Policymakers are especially resistant to a prescription of sustained, aggressive support to domestic demand.
What to make of recent efforts to address industrial overcapacity? Contacts welcome the renewed focus but are less confident of the outcome of this campaign than what the recent surge in industrial commodity prices would suggest. As we have noted (link HERE), given the scale of excess capacity in affected sectors (solar, autos, batteries, building materials), China’s leadership would need to mandate sharp cuts in manufacturing investment in order to make major progress in restoring pricing power and profit margins across industries. There is not yet political appetite for such a crackdown, which would jeopardize the 5% annual GDP target. Hence, contacts see potential only for a modest improvement in industrial prices in Q3 that is unlikely to last past Q4.
Stimulus: Too Early for Bold Action
Contacts universally expected little in the way of major stimulus to come from the end-July quarterly economic meeting of the Politburo. This is similar to our view (see our preview note HERE). While growth slowed sequentially in Q2, the year-over-year GDP growth rate (5.2%) was above the targeted pace for 2025. The slowdown will need to manifest in year-over-year numbers – likely when the Q3 GDP numbers are printed in mid-October – for the urgency of stimulus to rise.
Beijing has become a bit bolder this year about using fiscal policy to boost domestic demand but continues to worry about exacerbating debt burdens of local governments and depleting policy room for the future. Government spending was a key source of support in H1, but the annual budget is running out of room to maintain this pace of spending for the full year. Most contacts expect a modest increase in the deficit to be announced in early Q4, though some share our expectation (subject to change) that Beijing may muddle through in the final months of the year by supporting spending through project lending by policy banks rather than a formal increase in the deficit ceiling.
Contacts expect the PBOC to lower interest rates in coming months – perhaps waiting for the Fed to cut first – but that the scope for monetary easing is quite small. The two reasons are PBOC’s concerns that cutting interest rates will: (1) increase capital outflows and thus depreciation pressure on the CNY; and (2) pressure banks’ net interest margins, which are already at a historical low and pose a potential risk for long-term financial stability. Given ongoing deflation, small cuts mean that real interest rates will remain high, a continued obstacle for the property sector recovery. Thus, contacts do not entirely dismiss PBOC’s reasons for caution but believe the risks of being too conservative are greater than those of cutting more aggressively.
Equity Markets Surprisingly Hot
While contacts welcomed the recent strong performance of Chinese equities, particularly in Hong Kong, there was some degree of surprise at the degree of the equity market boost given ongoing macro challenges (deflation, property contraction, etc.). They advanced several explanations:
- Speculative enthusiasm over the “anti-involution” campaign (including by domestic investors, who have been buyers of Hong Kong-listed equities through the Stock Connect program)
- Relatively cheap valuations of Chinese equities
- Rebalancing of global portfolio flows away from US markets
There was no clear conviction that equities would be able to extend the recent run, given the muted macro story, but the Chinese authorities continue to view support for the equity market as an important aspect of their efforts to boost broader confidence.
Property: Still Searching for a Clear Bottom
Contacts note that the ongoing double-dip in property prices and other indicators is a test for Beijing’s pledge in September 2024 to “stop the decline and return to stability.” Analysts thus expect a new round of property support measures in Q3 or early Q4 but note that these are likely to remain incremental. A truly comprehensive effort would involve major central government funding of property initiatives, which remains unpalatable for the leadership. Contacts do not expect to see a convincing bottom for the property sector anytime soon and note the ongoing feedback between property price declines and broader deflationary pressures.
Politics: A Parade, Plenum and Plan
The next several months will be political high season. The leadership goes on its beachside retreat to the Beidaihe resort for part of August. On September 3, Xi will preside over a massive military parade to commemorate the 80th anniversary of the end of World War II. Market focus will be on preparations for two events this fall: a Trump-Xi meeting (timing and location still to-be-determined), and a “plenum” meeting – likely in October – of senior Party officials to approve the outline of China’s next Five-Year Plan (2026-2030).
Contacts do not expect the Five-Year Plan to announce major directional changes in China’s economic policy but nonetheless view it as an important roadmap for the next five years. They expect two central themes to be:
- A continued focus on tech and advanced manufacturing. The Plan will lay out the next iteration of Beijing’s innovation and industrial plans, covering priorities such as AI, automation, and biotech.
- Promoting consumption. Contacts expect stepped up efforts to boost domestic household consumption, though note that this is a long-term strategy and will be gradual.
The Plenum will also be a watchpoint for elite politics, including personnel changes and (very) early speculation as to what these might imply for the next major political transition in the fall of 2027.
