Is China headed for a downward spiral or a more forceful policy response?

After abruptly ending its zero-COVID policy, China bounced back strongly in the first quarter. Economic forecasters promptly upgraded their growth projections beyond the government’s moderate 5% target. Now, that positive sentiment has been replaced with doom and gloom. One weak data point after another has highlighted slowing domestic demand, a weakening currency, deflation, and portfolio outflows. Reports of companies falling behind on debt payments have also weighed on sentiment. Add to this the weak policy response so far to stabilize the economy, and investors are questioning whether the government’s growth target is in danger, and what would a sharp slowdown in China mean for the global economy and markets?

Invesco Fixed Income believes the answer lies somewhere between optimism and doom and gloom. We believe China is at a crossroads – the economy’s direction will likely depend on policies. We think 5% growth is still within reach, and doom and gloom can be avoided. In our view, a revival in sequential growth is possible by the fourth quarter, but it would likely require a rapid deployment of the recently announced reflationary policies. Should they fail to turn around sentiment and economic data, there will likely be a need for more supportive polices. Otherwise, we may enter an alternative universe not seen in China’s recent history, with a downshift in economic activity potentially to the mid-3% to 4% range, further adjustments in asset prices, and more concerns about balance sheets.

Recent developments have dampened growth

The fact that growth fizzled after the first quarter reflects the multi-faceted challenges China faces, many of which have their roots in the property sector. Official efforts begun in 2020 to reduce excesses in the property sector precipitated a vicious cycle, as leveraged property developers experienced financing problems and many committed, and mostly prepaid, housing projects stalled. Household confidence in housing investment sank, exacerbated by the COVID reopening when employment and income outlooks were uncertain. Widespread house price declines ensued, especially in lower-tier cities, where excess supply had been a concern well before COVID.

In addition, the authorities’ crackdown on large platform industries, starting with Alibaba in 2020 and moving to the education sector, undermined confidence and dampened private capital investment and the employment outlook. This came on top of COVID-related scars in the service sector, the largest source of employment. Despite efforts to push credit to the real economy, private investment has not bounced back sufficiently. Weaker global demand for goods hasn’t helped investment in trade-dependent manufacturing, and destocking is still the theme of the day, rather than rebuilding inventory or capacity.

The authorities’ time-tested approach of using infrastructure and local government investment as a countercyclical fiscal policy tool to increase fixed capital investment is also reaching its limits. Land sales represent an estimated 30% of local government revenues.¹ A stalled housing sector means stretched local government budgets when it comes to infrastructure spending, especially after the expensive enforcement of the zero-COVID policy and related health expenditures. If anything, total fiscal outlays shrank in the first half of this year, detracting from growth momentum.

Amid a deteriorating employment and income outlook, households have pulled back from the housing market and housing-related consumption, such as appliances and furnishings, which are estimated to be about 8% to 10% of total consumption.² Other big-ticket purchases, such as automobiles and communication equipment, are also slowing. As a result, retail consumption growth remains below 2019 levels.

Since second-quarter gross domestic product (GDP) growth was reported, each new data point on real economic activity has surprised to the downside, spurring a policy response from the authorities in July on the heels of the Politburo meeting. These measures were focused on household consumption along with housing and private business sentiment, but policymakers refrained from deploying the type of large-scale stimulus that was launched after the global financial crisis.³ In our view, this reflects a recognition of the structural issues facing China’s economy, which can no longer be addressed by creating excessive leverage in the system. 

Until recently, the policy measures were deemed too modest and too late to stabilize market sentiment, especially in the housing sector. However, in early September, the government response shifted from more targeted sector-specific policies to national monetary policy, with cuts to various policy tools, including the loan prime rate, as well as a nationwide reduction in mortgage rates for outstanding loans and the pulling back on several other housing related restrictions.

Why are we optimistic about a modest sequential growth rebound in Q4?

1. Policy response. We think there is more policy response to come. In the latest State Council Meeting in August, the authorities implicitly acknowledged that the 5% growth target could be at risk if they do not “optimize their policies.” We expect the next move to be a cut in the reserve requirement that allows banks to protect their net interest margins from lower mortgage rates and support upcoming bond issuance However, these measures will not likely lead to a general economic boom or a reversal of fortunes for property developers in particular. The housing sector has been designated as overleveraged, and we are about halfway through the authorities’ traditional four- to five-year window for restructuring a sector. Although the housing market’s final form remains uncertain, we expect a more consolidated property sector in the next two to three years and a more sustainable outlook.
2. Bond proceeds. Local governments have been asked to fulfill their remaining bond financing quotas before September and to deploy bond proceeds to local infrastructure spending in the fourth quarter. Even if the level of spending is not as high as it was before, it should put a floor under public investment growth and “crowd-in” other related private sector investment.
3. Sustained tailwinds. As we’ve seen in the rest of the world, the Chinese economy’s post-COVID re-opening and recovery is likely to be a longer process than a one or two quarter-long rebound. We expect sustained tailwinds to emerge over the next three to six quarters from the service sector and general pent-up demand. Already, the service sector, which accounts for more than 63% of the economy, has recovered sharply following the lifting of the zero-COVID policy.⁴ Although households remain cautious in their spending, including in the “revenge sectors” of tourism and travel, we believe there is more room for organic recovery in services consumption in the second half of the year.
4. Green shoots in manufacturing. After the sector’s reopening in the first quarter allowed it to catch up on pent-up demand, it has been weakening since. For the first time since April, we are seeing a better outlook for manufacturing, as new orders have picked up and the inventory depletion cycle may be coming to an end. Although global external demand is still declining, this should put a floor under the recent decline in exports.
5. A quick response. Finally, as happened with the abrupt removal of the zero-COVID policy, when economic hardship hits a severe pain threshold, we have seen the authorities change their response very quickly. We think we are at that inflection point. We remained concerned whether the implementation of these measures will flow through fast enough to turn the tide.