China Outlook: Recovery To Fade Into 2024

• With a low CPI inflation profile in the next few years, plus a multi-year hangover in the residential property sector, we could see some incremental policy easing beyond June measure (e.g. RRR cut and further 10bps medium term facility and 1/5yr loan prime rate). Additionally, slow monetary policy normalisation is now no longer likely from late 2023 and through 2024 and a further 20bps of cuts is likely in 2024. 

Our Forecasts

China Two Speed Recovery 

China economic recovery is a tale of two different contributions. Consumer services and tourism have shown a clear benefit from the shift to an endemic COVID policy and this could still have some momentum, both as consumer confidence rebuilds further and as consumption momentum filters into jobs growth and income/consumption in H2. Output has shown less of a pick-up for three reasons. Firstly, the global economic slowdown has trimmed exports growth prospects, while some global supply chains are also being amended to ensure they are less China centric. Secondly, production and output were suppressed less than consumer services by the zero COVID regime in 2021 and 2022 and thus is seeing less of a bounce. Thirdly, the weakness in construction remains, as property developers remain restrained and construction has not started to bounce back. Figure 1 shows this contrast between the manufacturing and non-manufacturing sector.

Figure 1: NBS Manufacturing and Non-Manufacturing (Index) 

Source: Datastream/Continuum Economics

The critical question for the remainder of 2023 and 2024 is whether this two speed recovery will continue, or alternatively, if slowing output and production will act as a drag for consumption and see the recovery fading. For the remainder of 2023, we see a two speed recovery being in place, which can show a continued divergence between consumption and output/production speeds of growth. Pent-up demand post COVID is not satisfied in one or two quarters, but will likely be an influence through 2023 in China. Additionally, some pick-up in employment should be evident, that then feeds through to income and consumption growth. Base effects from 2022 also help as well. Thus, we maintain our forecast of 5.5% GDP growth in 2023.

However, the two speed recovery will likely mean that job growth for the economy as a whole is less than we previously forecast and this will likely curtail the scope of ongoing recovery in 2024. Additionally, the residential property sector rebound in sales is fading, while real estate investment still remains negative. The hangover in the residential property sector will likely last years (here) and the lower ongoing volume of sales relative to 2015-19 will also likely see lagged adverse effects on construction employment and steel/cement production. While the government has tried to ease the pain in the sector, they are not willing to abandon the three red line policies. Some further support could be seen for the sector (see below), but it is likely to be incremental rather than aggressive and this will see the sector being a drag on growth through 2024.

Meanwhile, IMF estimates that local government financing vehicles (LGFVs) had an estimated debt of Yuan56.7trn or 47% of GDP in 2022 and that this would rise to 66% of GDP by 2027. This debt is mainly loans, but includes an estimated Yuan13.5trn of bonds according to S&P Global Ratings. These LGFVs are suffering from the residential property hangover with deterioration in assets and less revenue from land sales/property. Additionally, LGFVs are closely interlinked to state owned enterprises (SOEs); local governments; banks and private companies throughout China. Severe debt problems for weaker LGFVs are a debt problem for the rest of the financial system, but also for China’s economy, as restrained finances for LGFVs mean less local business and infrastructure investment and, hence, less growth momentum. Some weak and stressed LGFVs have been struggling to issue bonds in recent months and paying higher coupons, which can undermine long-term financial stability. 

A default by a major LGFV would probably send shockwaves through refinancing activities of LGFVs, which would spill over to the wider financial markets and the economy. However, a bond default has not occurred recently for a major LGFV and some are focused on a recent loan restructuring as a solution. Zunyi road and bridge construction extended loan repayments by 20 years with no principal repayment for 10 years in a recent agreement. This extend and pretend approach could be a template for other LGFVs in acute distress. Additionally, buying of new issuance by banks could also be officially encouraged. If a crisis were to occur, then the backstop could be a 2015 style debt swap when a huge amount of LGFV debt was swapped into government and local government bonds. Overall, China can avoid a Lehman style moment with LGFV debt, but it will be a drag on the economy. 

Given all these headwinds we further revise down our 2024 GDP growth estimate to 4.5% from 4.9% in May and 5.5% in the March Outlook. Long-term we still see China growth slowing to 4% and then 3%, as the structural headwinds of peak population and labor force undermine income and consumption/production growth (here). We see 3% growth by 2027-28, but a deeper property crisis would bring this forward quickly. While China authorities have been able to stimulate when required in the past, the current residential property hangover is the most difficult in the last 30 years and could cause more adverse effects than our baseline forecasts.

For CPI inflation, the economic recovery should mean that the disinflation phase should be ending into H2 and 2024, as recent weak CPI inflation numbers are a lagged impact of the zero COVID policy in 2022. However, the fading momentum of the recovery will likely mean that inflation is only slow to pick up and we look for 0.8% in 2023 and 1.5% in 2024 for CPI inflation. This is a consequence of too much production capacity and only moderate momentum for consumption. Companies do not have pricing power with consumers or end goods producers. China CPI profile is also being helped by buying Russian oil on a discount, plus the switch from imported LNG gas to domestic coal. Finally, the fall in FAO food prices since H2 2022 is allowing China to control food price raw materials. While we forecast a moderate 5% rise in FAO food prices for the remainder of 2023, this is not enough to produce a major uplift in CPI food prices.

Policy 

China authorities will likely put in place additional policy easing measures, given low inflation and the prospect of the recovery fading in 2024.While the PBOC has previously been slow to cut interest rates, the 10bps June cut in the 7 day reverse repo/MTF and LPR rates is more proactive. A further 25bps RRR cut could be seen to help the banking system in July/August. Additionally, a further 10bps cut in the MTF and 1 & 5yr LPR is likely in Q3, with 5yr helping to lower mortgage rates still further. The PBOC will also likely encourage ongoing low double digit M2 growth, which supports the economy but is not too fast for monetary excess to build up. The property sector hangover, plus the low trajectory of CPI, also suggests that interest rate policy normalization will not now start in 2024 and we now forecast the 7-day policy rate to be reduced by a further 20bps in 2024 to 1.60%.

Further modest fiscal policy stimulation could also be evident for the economy more widely, if growth falters. However, China’s authorities are also reluctant to fuel a rise in government debt/GDP, given that total non-financial sector debt (government/households and corporates) is high for an EM country and now exceeds the U.S. and EZ (here). This will likely mean targeted extra fiscal policy measures, rather than aggressive support for the economy. Indeed, the rise in China total non-financial sector debt since 2007 (Figure 2) has been very large. The U.S. build up before 2008 was followed by a reduction in household debt/GDP and weak growth, while Japan excess debt build up in the 1980s was followed by two lost decades for the Japanese economy. China policymakers have enough influence and tools (here) over the financial system that a Lehman style moment can be avoided. However, the excess debt could act as a further drag on growth and this is a downside risk for growth in the coming years.

Figure 2: Change in Total Non-Financial Sector Debt/GDP Since Q1 2007 (%)

Source: BIS (data to Q3 2022)