Focus
July 30, 2021 | 12:55
Where is China’s Economic Policy Headed?
Where is China’s Economic Policy Headed? |
Financial markets were focused on China’s regulatory policies this week, but there are more fundamental changes afoot on the policy front. With the world’s leading central banks setting the stage for eventual tightening, China looks to be bucking the trend. This was highlighted by the People’s Bank of China’s (PBoC) unexpected cut of the reserve requirement ratio (RRR)—a key monetary policy tool—for all banks by 50 bps on July 9 [1]. In our view, such a decision isn’t surprising when one digs a little deeper into the Middle Kingdom’s current economic situation. Moreover, we suspect that China’s authorities may need to provide a little more fiscal and monetary stimulus in the coming quarters due to five key developments: (1) the economic recovery has been mainly driven by external demand, (2) the pandemic has intensified the divide between the stronger coastal and weaker inner provinces, (3) the country’s numerous small banks remain under pressure, (4) inflationary pressures remain moderate, and (5) relatively little fiscal or monetary support was provided when the pandemic began. An Uneven Economic RecoveryThe composition of the economic recovery has become more concerning (Table 1). Headline real GDP’s seemingly impressive 12.7% y/y rise in H1/21 was powered by a 38.6% y/y surge in merchandise exports (U.S. dollar terms). Even when measured in terms of the two-year average growth rate to adjust for distortions caused by the low base of comparison in 2020, both results are solid (roughly 5.5% and 15%). However, domestic demand has been more subdued, which could prove problematic if global demand for goods rolls over (as demand for services revives). Both fixed asset investment and retail sales posted relatively sluggish growth rates of around 5% and 4% in H1/21 (again on a 2-year basis). A breakdown of fixed asset investment shows that real estate development (+10%) continues to lead the way, while manufacturing (+5%) lags behind it. Notably, infrastructure spending has been soft (+2.5%). |
Similar to many developed economies since the pandemic began, Chinese consumers remain keen on spending heavily on housing. This may explain why property prices have picked up steam despite tighter financing conditions (Chart 1). At the beginning of the year, mortgages were capped at 32.5% of a large bank’s total loans with overall lending to the property sector capped at 40%. Note that the decision to restrict the flow of credit to the housing sector is multifaceted as the authorities are keen to keep housing affordable, prevent a housing bubble, and channel more funds to struggling small and medium-sized enterprises (SMEs) and the manufacturing sector. The latter is being driven by Beijing’s desire to upgrade its technological capabilities to reduce its reliance on foreign suppliers, as part of its rebranded “dual-circulation” strategy. The Inter-Regional Divide WidensAlthough it’s difficult to precisely quantify given the lack of comprehensive high-frequency data, there is increasing anecdotal evidence (e.g., diverging consumer spending and house price trends) that the divide between the more-developed coastal regions versus the less-developed inner provinces (and higher-tier versus lower-tier cities) has risen during the pandemic. This divergence helps explain why some highly-leveraged property developers are encountering financial difficulties and are likely to continue making front-page news. High-tech manufacturing hubs (Guangdong, Zhejiang, Jiangsu and Shanghai), which are mainly located on the coast, have benefited from the boom in exports (Map 1). In contrast, the pandemic, which has curbed tourism, has taken a toll on the inner provinces. However, there are other non-pandemic developments at work such as the long-running urbanization drive and the ongoing downsizing of largely state-owned heavy industry in the northern rust belt (e.g., Liaoning, Jilin and Heilongjiang). Furthermore, the country’s decarbonization drive could begin to weigh on the inner provinces (e.g., Shanxi, Inner Mongolia, Shaanxi, Hebei, Henan) that have a heavy concentration of high-pollutant industries (e.g., steel, cement, and coal). To mitigate this risk, the authorities have begun to let more non-financial state-owned enterprises fail (i.e., default on debt) in an effort to break the longstanding belief of the ‘implicit government guarantee’ to increase market discipline and overall financial stability. Small Banks Still in the Line of FireAt the same time, pressure on China’s 4,000+ small city and rural banks remains intense. Their pre-pandemic struggles were highlighted by the high-profile troubles experienced by three banks in mid-2019 (Baoshang Bank, Bank of Jinzhou and HengFeng Bank). Although the authorities do not provide a comprehensive breakdown of the banking sector’s total problem loans (non-performing loans, special-mentioned loans, off-balance sheet exposures and loans benefiting from regulatory forbearance/deferred payments), the city and rural banks are facing a higher degree of pressure on asset quality (Chart 2). These banks are generally located outside China’s major economic hubs but are also more exposed to SMEs, which historically have a high failure rate. |
Another source of pressure bearing down on the smaller banks is their heavy dependence on interbank funding given limited deposit bases, which is mainly supplied by the country’s four massive state-owned financial institutions. This explains why the PBoC cut the RRR for both large banks and small banks as pressure on systemwide funding has been rising and is highlighted by the aggregated bank loan/deposit ratio breaching 75% since Q4/20 (Chart 3), which had long been considered a critical level of liquidity risk. The increase has been largely driven by sluggish growth in deposits rather than a pickup in loans. |
Limited Inflation PressureThe inflation picture does not appear overly threatening as headline CPI only recently crept back into the black, rising 1.1% y/y in June (Chart 4). Like the rest of the world, current pressures are being largely driven by cost-push factors, namely higher commodity prices, not demand-pull factors (i.e., higher incomes). Thus, the rapid rise in PPI for industrial products (+8.8% y/y in June) is unlikely to translate into significantly higher CPI as occurred in the last large episode when PPI surged in 2017. One might rightly question why Beijing has become so vocal about the strength in base metal prices, which has resulted in the release of strategic state reserves of aluminum, copper and zinc. We believe Beijing’s anti-inflation rhetoric and measures have more to do with preventing smaller downstream firms (i.e., SMEs) from being squeezed (as they cannot pass on higher input prices) from the country’s array of wholesalers and traders who play a key role in the distribution of metals by large producers. |
Plenty of Policy Space Still AvailableChinese policymakers still have plenty of firepower at their disposal, unlike many developed economies, as they refrained from easing fiscal and monetary policies significantly in their initial response to the pandemic in early 2020 (Chart 5). The rather conservative approach to the health crisis reflects a number of factors, namely: (1) confidence that COVID-19 can be contained domestically; (2) the commitment to lowering financial stability risks; and (3) the traditional reliance on household savings/family support during times of trouble. This explains why Beijing has chosen to provide limited direct payments to the unemployed like in the West and instead has focused fiscal support (5% of 2019 GDP) to help hard-hit small SMEs. The monetary policy response has been even more restrained. Beyond the banks’ average RRR cuts of 150 bps in total since end-2019, the de facto policy rate (1-year loan prime rate—the key rate that the majority of a bank’s lending is linked to) has been reduced by just 30 bps (Chart 6). Key Takeaway: Although China has been able to limit the impact of the pandemic from a human tragedy perspective, both businesses and consumers remain cautious, which is taking an economic toll. Thus, authorities may need to introduce more fiscal or monetary stimulus to help fortify the economic recovery. We think that Beijing is likely to lean more heavily on fiscal policy given ongoing concerns of excessive financial leverage. |
Endnote:[1] The reserve requirement ratio is the share of total deposits that a commercial bank is required to place at the central bank as reserves as opposed to being lent out. [^] |