Is China at a turning point?

Authors: Alex Wolf, Julia Wang, Timothy Fung, Yuxuan Tang, Weiheng Chen

 

After decades of historic economic development, China’s economy is facing structural challenges – the confluence of which have no clear historical precedent. The economic model is facing rapid change as the paradigm moves away from growth led by real estate and construction, and into uncharted territory. Amid this transition, the debt burden continues to mount for local governments and state-owned enterprises (SOEs), with weak confidence and overcapacity pushing prices downwards – leading to outright deflation. This transition is not linear, and policymakers are more constrained than in the past which limits stimulus efforts in the near-term. 

 

Our key calls:  Even as markets have rallied, we continue to take a neutral view on Chinese equities until more policy support is delivered and signs of genuine reflation emerge. On FX, we recommend hedging against Chinese Yuan (CNH) depreciation due to still high interest rate differential against the U.S., downside risks to the near-term growth, and an uncertain export outlook which could continue to pressure the currency. On growth we continue to take a slightly below consensus view expecting full GDP growth to be in 4.0-4.5% range.

Amid this uncertain backdrop a number of questions have emerged, both about the near term outlook, as well as the long-term trajectory. Below we address the top questions we encounter from investors.

 

Why is real estate so important?

Investors trying to understand what is going on in China’s economy need to start with the property sector. Since the global financial crisis, property construction emerged to become the key driver of the economic cycle – at its peak accounting for nearly 30% of economic activity.

As a result the sector grew to become what was one of the world’s single largest sectors and sources of wealth. But like so many past trajectories in other economies, bubbles and imbalances built up over time.

There were three main areas of concern – the debt burden of property developers, bubble-like prices, and substantial excess supply of properties. All of those are now unwinding. Property developers have technically defaulted on around 70% of U.S. dollar debt, property sales and new starts are collapsing, and prices are beginning to decline, though they likely have further to go.

In some ways it was an economic inevitability. No bubble can go on forever, and unwinding these excesses would have had to happen at some point. The economic impact is hard to overstate – based on a paper from Rogoff, Kenneth and Yang¹, it is estimated that a 20% fall in real estate activity could lead to a 5-10% fall in GDP. Current data is showing a 60% drop in real estate activity, resulting in a potentially more substantial GDP impact. In short, this is creating a significant drag on the economy, and there are no other growth “engines” big enough to fill this gap.

Why is deflation a concern?

Weak demand emanating from the property sector is putting pressure on prices, resulting in three straight quarters of outright deflation.

This is impactful through a number of channels. Deflation makes it harder for local governments and SOEs to service their debt, causing strain on infrastructure development and stimulus financing. There is also the risk of deflation becoming more psychologically entrenched – for example there is a risk that consumers or businesses delay purchases or investments on the rationale that prices could be lower in the future. This can cause prices to fall further, and the deflationary cycle can become difficult to break – consider Japan’s ‘lost decades’.

These negative pressures are causing considerable uncertainty over the future path of growth, leading to overall weaker confidence resulting in consumers and businesses alike cutting back on spending and investment. 

What about the international environment?

A more challenging international backdrop is also having an effect on foreign investment into China. While it is difficult to pinpoint a specific driver, the trend of foreign investments, both direct and portfolio-based, has clearly turned against China – with both now heading backwards. It is challenging to extrapolate on just one quarter, but this will likely be a trend to watch. 

Amid the sluggish growth outlook, does the NPC mark a turning point? 

The highly influential National People’s Congress (NPC) officially wrapped up on March 11th. Historically this event has been all about the GDP growth target and the policy setup to support it – but this year it turned out a little bit differently. While the GDP growth target of “around 5%” is in line with expectations, policymakers only promised modest stimulus, which appeared to disappoint the market. There is also a clear de-emphasis on the pace of economic growth in favor of “quality growth” as measured by whether the type of growth is consistent with the long-term economic transition.  

What are the government’s long-term priorities?

The government work report listed ten priorities, but really there are just three major ones. The first is innovation in science and technology, or what is now being termed “new productive forces” – meaning manufacturing upgrades, innovation and the support of emerging industries and technologies. The second is higher education reform. The third recognizes that “growth is not solid” and focuses on stabilizing domestic consumption and investing in essential infrastructure.

What’s different for policy going forward?

The result is a clear paradigm shift in policymaking – a de-emphasis of near-term, numeric growth targets, and the associated toolkit usually deployed to get there. Instead, the focus is on implementing a new vision for economic growth. Major questions persist, however, about whether China’s science and technology capabilities can match its aspirations. Throughout history, countries at middle-income status (like China is now) have aspired to reach high-income through the development of advanced technologies. Few have done it, and even fewer have reached such capabilities through aggressive industrial policy – market-based reforms were critical as well.

What does this policy direction mean for the economy?

While the long-term policy priorities are quite clear, in the near-term, the lack of a policy backstop means there is some downside risk to the growth target. This is particularly the case because the housing market is still unstable and confidence is low. Our GDP assumption for this year is 4.0-4.5%, while the market consensus is at 4.6%. Most economist assumptions incorporate a steady stream of fiscal policy support, which may be smaller or delivered later than expected. Certainly, this also opens up another possibility of some policy fine-tuning around mid-year, potentially towards more support in the second half. 

Why has stimulus not been delivered?

This has been the top question from investors over the last two years. While there is likely a mix of reasons, in our view the key comes down to the paradigm shift in policymaking, as discussed above. This is motivated by the decision to move away from the old growth model (property and high leverage) to a new growth model that is less reliant on debt and more driven by advanced industries. This is the fundamental thinking behind the de-emphasizing of near-term GDP growth, and the general reluctance to resort to traditional monetary and fiscal tools.

There are objective constraints too. High U.S. interest rates constrain how much and how quickly the People’s Bank of China (PBoC) can cut policy rates in China. As a result, real interest rates have increased as inflation falls. Local governments have already taken on a lot of debt, and their balance sheets have been significantly impaired as a result of the property market correction, as their main source of revenue from land sales has declined. That means they are not in a position to direct fiscal stimulus like in the past.

The currency is another constraint, as cutting rates too aggressively or expanding money supply dramatically could cause depreciation pressures that add a further, and unwanted, complication. Over the last decade there has been a lot of criticism of the RMB 4 trillion stimulus package during the Global Financial Crisis, with many citing capital mis-allocation and low returns. Thus, large stimulus packages tend to have a bad reputation.

Many international investors have also asked why China has not implemented any direct stimulus for the household sector. Such policy is perceived to be unsustainable, and policymakers prefer to use fiscal space for investment, rather than consumption. Certainly attitudes can change, but policies such as direct household transfers are unprecedented in China’s case.

Over the next few months, some of these constraints may ease, which opens up the possibility for more supportive policies in the second half. A weaker-than-expected first half and persistent deflation concerns may also induce more willingness to ease. For example, once we have more clarity about the path of U.S. interest rates, the PBoC may feel more confident about lowering interest rates. Meanwhile, the central government has indicated that it can conduct more bond issuances. As the fiscal baton moves back to the central government, fiscal policy may become more proactive again.

The bottom line is that the government is trying to engineer a transition to a new economic model, and that transition is not a smooth linear path. The risk is that the government does too little for too long, and new high-tech industries fail to materialize or are too small to drive overall growth. 

Equities are up significantly from lows – is this the start of a new bull market?

Chinese equities have bounced from the lows in February – with onshore CSI300 up around 13% and MSCI China up around 12%. Many investors are asking if this is sustainable – and pondering what is in fact needed to fuel a sustained market rally. Overall we remain neutral. In the near-term, we think much of the rally was led by a narrowing of the valuation gap with the rest of the world. After the rally, the CSI300 trades at 13x price-to-earnings (P/E) compared to 14x for the MSCI All-Country World ex-U.S., meaning there isn’t a significant valuation discount. Additionally, the tone from the NPC was conservative, and the de-emphasis on near-term numeric growth targets may be interpreted by equity investors to mean a lack of pro-growth policy support in the near future.

For sustained equity upside, we are watching two policy areas as potential catalysts. The first is a comprehensive plan to address the property sector, particularly one that tackles the loss in confidence towards developer pre-sales, as well as stabilizing developer finances and attempting to prevent further defaults. Restoring faith in the property sector can help augur a broader improvement in confidence and help the economy find momentum once again.

The second policy area to watch is demand-side stimulus, and specifically measures that are focused on stimulating domestic consumption and broad aggregate demand. So far, most stimulus has been directed at the supply side, which has increased manufacturing capacity but done little to stimulate broader demand or alleviate deflation. Little stimulus has been directed at households. With demand falling short of supply, more stimulus is needed to rejuvenate the economic cycle and prevent economic malaise from becoming embedded. There are certainly constraints, and China no longer has the policy space it had in 2009, 2012, or 2015 when it last launched rounds of significant stimulus. However, there is still some scope, and to do nothing could present a larger growth risk. 

At the end of January we expected the offshore market to experience a tactical rebound, as fund managers mostly agreed that China seemed to have found valuation support, and that positioning was short. But so far the conviction level of a structural turnaround remains low. We continue to believe that China equity markets have likely found the bottom (Hang Seng Index 15,000-15,500/ MSCI China 50-51/ CSI300 3,100-3,200), but it could remain a range bound market until we see more progress on the policies outlined above. Our longer-term preference is still with the onshore China market, given its policy tilt and domestic ownership profile.

What about the currency risk?

There are limited bullish catalysts for the currency. CNH has historically had a strong beta to equity risk sentiment, and with near-term policy support falling short the pass-through to FX will likely be muted. Policy narratives towards the currency has been largely unchanged according to the language in the Work Report, i.e. maintain CNH stability at reasonable levels. Intervention measures in the offshore market during the NPC also remained largely in line with what the PBoC has been doing over the past 6 months, keeping USDCNH around 7.20.

The PBoC will likely keep monetary policies accommodative, meaning the negative interest rate differential against the USD will likely remain in place, presenting the opportunity of hedging the currency or for carry. While proactive interventions could put a cap on how high USDCNH can go, downside risks to near-term growth, an uncertain export outlook and geopolitical overhangs will likely continue to pressure the currency, leading to our cautious view on CNH exposure.

Is there a silver lining to the economic slowdown? Can consumption continue expanding as a driver of growth?

Interestingly, despite the headwinds from property, consumer demand has been stable. The Chinese New Year holiday data turned out better than expected, especially for travel. The longer-term trajectory will likely depend on income growth and productivity trends, which are unclear, but there could be one overlooked silver lining from the property slowdown.

China has historically spent a lot of money on housing. Up to 14% of GDP was spent on housing in 2022 and over 80% of purchases were for a second home or more, in other words speculative or investment purchases. Such significant spending on “additional” housing was absorbing a lot of capital and pushing up the overall savings rate and reducing spending on other items. A reallocation away from spending on excess properties could allow more capital to be spent on consumption or productive investments elsewhere. Note, this would be a shift in spending patterns, but does not necessarily have an impact on aggregate growth. Nonetheless, it can support specific sectors such as tourism and other consumer goods.

This is a reason why research on the wealth effect of housing in China is inconclusive. It is clear in countries like the U.S. that a drop in house prices leads to weaker consumption through the wealth effect, but the evidence with China is less clear. This is largely because rising house prices often made homes seem more attractive, and due to rising down payment requirements for second homes, it drove an ever increasing amount of savings going into property investments. With a cooler housing outlook, savings could be reallocated towards consumption or other investments despite the headwinds from a substantial housing downturn. For these reasons, we continue to stress that selectivity is key, as some sectors can remain resilient despite the broader downturn.

What do China’s economic challenges mean for the rest of the world?

There is good news and bad news as far as the global economy is concerned. On the one hand, China’s combination of expanding manufacturing capacity and weakening domestic demand could lead to new trade frictions. China’s trade surplus in manufactured goods now exceeds 2% of global GDP, which is some of the largest seen in history. If China continues to achieve growth targets on the back of expanding advanced manufacturing while also focusing on self-sufficiency and reduced imports of key components, this could lead to a new round of trade frictions.

On the other hand, this mismatch between China’s manufacturing capacity and China’s demand is lowering China’s export prices and driving some of the disinflation being seen around the world. Although deflation is a problem for domestic policymakers, exporting deflation to other countries supports the “soft landing” narrative and could help policymakers who want to bring rates down from elevated levels.

In terms of the overall growth impact, China’s growth, especially since 2013, has mattered less than commonly believed. GDP linkages to the U.S. and Europe are minimal, although corporate revenue linkages are a bit higher, but concentrated in a few sectors.

How can I think about China in my portfolio?

We continue to stress a focus on sizing when it comes to China exposure. There is a place for a China allocation in a portfolio, especially for the diversification benefits, but it’s important to keep in mind China makes up around 2-3% of a globally-diversified equity benchmark. Many global investors built up significant “overweights” over the past few years and we continue to recommend increasing regional diversification by adding Japan and India and maintaining a neutral exposure to China relative to the benchmark.

¹Rogoff, Kenneth, and Yuanchen Yang. 2021. “Has China’s Housing Production Peaked?” China and the World Economy 21 (1): 1-31. Data as of December 2021.

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Index definitions

The MSCI All-country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The index consists of 23 developed market country indexes and 24 emerging market country indices.

The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 740 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.

The CSI 300 (China A-shares index) is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.

The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong. The components of the index are divided into four subindices: Commerce and Industry, Finance, Utilities, and Properties. The index was developed with a base level of 100 as of July 31, 1964.