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CHINA: FIRST IN. FIRST OUT. WHERE TO NOW?

Yolanda Naudé
Investment Strategist and Portfolio Manager

 

The Chinese Communist Party – the founding and only governing party in China – celebrated its centenary on the 1st of July this year. Yet, from an economic perspective, was there reason to celebrate?

FIRST IN AND OUT

Although there are still a myriad of pertinent unanswered questions about the origin of the COVID-19 virus, which is still wreaking havoc in many parts of the world, what we do know is that the Chinese economy went into the COVID-19-induced global recession first and emerged from it earlier than any other major world economy.

While the United States (US), Japan and the eurozone economies shrank by 3.5%, 4.7% and 6.7% respectively during 2020, China was the only major economy that was able to post positive, real economic growth. The Chinese economy grew by 2.3% last year during a very distinct and sharp V-shaped economic recovery – present when economic growth dips rapidly, but then rebounds at the same pace.

CHINA: QUARTERLY AND ANNUAL REAL ECONOMIC GROWTH

Source: Refinitiv Datastream

A MONETARY AND FISCAL BOOST

China’s strong containment efforts have kept the virus largely under control, and were supplemented by significant fiscal stimulation, more than double the 2008/9 pace, measured as a percentage of the size of gross domestic product (GDP). This, coupled with remarkable monetary support, was sufficient to ensure a very large expansion in the second quarter of 2020, which offset the steep contraction during the first quarter of 2020.

In addition, short-term interest rates and the reserve ratio requirement for banks were cut in the wake of the COVID-19 storm. Meanwhile, money supply growth and total social financing – a broad measure of aggregate credit and liquidity in the Chinese domestic financial system – shot up and grew at rates last seen five years ago during the previous recovery phase. On the fiscal side, swift policy actions helped mitigate the economic impact of the crisis. These included targeted tax and fiscal relief measures for the most-affected firms, increased government spending on infrastructure investment, with a focus on their public health emergency management system. Overall, this contributed more than two percentage points to economic growth last year.

Another major contributor to growth last year came from the export sector, as Chinese companies, particularly those that operate in the medical and technology sectors, benefitted from a strong COVID-19-related and work-from-home demand surge in 2020.

UNBALANCED GROWTH

Although many of China’s major economic sectors have already fully recovered to pre-COVID levels, domestic demand has lagged, mainly due to income growth that has fallen behind the recovery in nominal GDP. Other contributing factors to the relatively weak consumption recovery thus far include renewed COVID-19 related mobility restrictions, slow recovery of consumer confidence and the lingering elevation of household savings rates.

Consumption growth is generally aligned with household income growth, which has been on a structurally downward trend since China’s working age population peaked nearly 10 years ago. From a cyclical perspective, demand growth in China has been moving from the goods sector (buying things) to the services sector (doing things) in recent quarters. What’s more, China’s services’ Purchasing Manager Index (PMI) has been inversely correlated with China’s new COVID-19 cases.

During 2020, China was successful in containing domestic COVID-19 cases. Yet, unless they can speed up their vaccination programme, they are likely to be at a disadvantage during this year and the next, relative to countries like the US and the United Kingdom (UK) which have already successfully vaccinated a significant proportion of their populations. At the time of writing, China was administering about 2.5 million vaccines per day, with the aim of having 80% of their population vaccinated by the end of 2021. This would be a fantastic achievement, not least because the outlook for consumer spending in China in the second half of 2021 relies heavily on China’s ability to prevent significant flare-ups, particularly of the aggressive Delta virus variant. Such prevention is vital to avoid the rather draconian lockdown measures which have previously been implemented in China, given their zero-tolerance policy on COVID-19.

WHERE TO FROM HERE?

There are clear signals that China’s economic growth has peaked and is slowing down. Impulse indicators, expressed as a percentage of the size of the economy, are particularly useful when analysing growth momentum in China. These indicators have proven valuable in suggesting turning points in the Chinese economic cycle.

Source: Bank Credit Analyst Chart Explorer

As per the graph above, both China’s broad money and total social financing (TSF) impulses peaked late in 2020, with downward momentum since continuing unabated as Beijing continued to tighten policy. There is typically a six-to-nine-month lag between the impulse indicators rolling over and real economic growth peaking, which suggests that actual economic growth numbers should be slowing down further as we progress through the second half of the year. We are not, however, expecting a hard landing for China. In fact, real economic output growth is likely to be between 8% and 9% in 2021, the highest in a decade. For 2022, however, we do expect much more muted growth of around 5% as the economy normalises further in a, hopefully, post-COVID world.

Thus far in 2021, the US and Europe have embarked on renewed and sizeable fiscal stimulus programmes to further support their economic recoveries. Conversely, in China, fiscal policy is likely to be a drag on growth in 2021 as the government aims to reign in their government debt-to-GDP ratio which has increased from 54% in 2018 to nearly 70% in 2020. Thus far this year, the Chinese authorities have embarked on marginally more monetary stimulus with the recent reduction in banks’ reserve ratio requirements, but we don’t expect significant monetary support at this stage.

DEBT REMAINS A CHALLENGE

Going forward, the exceptional fiscal policy stimulus and COVID support of last year should be replaced by a renewed focus on macroprudential measures – aimed at ensuring financial stability – to reign in China’s escalating debt levels. This process has started, with the government constraining further credit since the start of the year to the already-highly-leveraged real estate industry via their “Three Red Lines” policy, which aims to reduce leverage, improve debt coverage and increase liquidity of companies operating in that sector. This is in an attempt to ensure stability in this prominent economic sector. Financial de-risking – terminating or restricting risky business relationships – is also required in the non-financial corporate and banking sectors. This strategy is well-advised with corporate debt now more than 100% of GDP, and credit quality likely having deteriorated amid the exceptional COVID-induced policy support which kept weak companies in business for longer than usual.

REBALANCING REQUIRED

In our view, one of the main economic challenges for China over the next 12 to 18 months is to continue with their support of the economy, while also ensuring financial stability. One of the ways in which they could possibly reach both these goals is to support the shift from a mostly government-led, infrastructure-investment-driven support model during COVID-19, towards a household or private-demand support model which should speed up economic rebalancing and ensure a more sustainable economic future.

CHINESE EQUITIES IN CONTEXT

From an asset class perspective, Chinese equities currently constitute about 35% of the MSCI Emerging Markets (Equity) Index, with the other major emerging country stock markets represented in this index being Taiwan (at a 14% weight), South Korea (at 13%) and India (at 10%). South African stocks comprise 3.5% of this emerging markets equity index, in line with Russia and Saudi Arabia, each at about 3% weight.

PEREGRINE’S NEW FUND

In our recently launched Peregrine Emerging Market Equity Fund, in which we blend active stock selection with emerging market exchange traded fund equity exposure, we are slightly underweight in China, with the active manager in the fund currently favouring stocks in Greece, Indonesia, Mexico and Egypt.