Can China’s economy get its mojo back?

• With China’s strict zero-COVID policy having hit economic activity, growth has fallen behind that of rival Asian economies who’ve abandoned lockdowns, boosted fiscal support and benefited from higher commodity prices
• Encouraging growth in industrial production has been of little comfort against the country’s raft of faltering domestic economic data
• Chinese inflation is on the rise, but is still benign when compared to the US and Europe – 2.8% in September - a figure many western governments can only dream of. Inflation is also expected to moderate through 2023
• The country’s recovery in 2023 is forecast to be sluggish, and the path to the top of the global economic rankings may be far from smooth, or even attainable

China’s focus on containing COVID-19 through containment measures, together with a property crisis and slowing demand for its exports, are at the heart of the subdued growth prospects facing the world’s second-largest economy.

Rigorous enforcement of COVID-19 restrictions, a collapsing property market, and weaker external demand have conspired to drag down growth. The world’s second largest economy grew by just 0.4% between April and June (Q2), the worst expansion in output (excluding the pandemic hit in Q1 of 2020) in data available since 1992. The economy recovered in Q3, with gross domestic product (GDP) growth of 3.9%, which was still short of its official 5.5% target. 

China’s growth rate has now fallen behind that of rival Asian economies which have abandoned lockdowns, boosted fiscal support, and benefited from higher commodity prices. For 2023, while we expect some reacceleration from the current depressed levels, but the mixture of structural and cyclical headwinds suggest that growth will once again fall short of its potential. 

Fascination with a zero-COVID approach

China is an outlier in the battle against coronavirus, with its focus on suppressing the disease through a mixture of aggressive testing, enforced periods of quarantine, and city-wide lockdowns. 

The proffered rationale behind the policy is the country’s large elderly population, its uneven regional development, and insufficient medical resources. The combination of a lower efficacy rate from its domestically-produced vaccine and relatively low vaccination rates among vulnerable populations has generated fears that its national health service would be overrun, and deaths would surge. 

China’s recorded deaths from coronavirus have been far fewer than other major regions. In fact, World Health Organisation data shows that China has reported less than 30,000 COVID-19 fatalities, compared to the US which, despite having a much lower population, has surpassed the one million mark¹.

Spluttering recovery

While the strategy has subdued the spread of the disease, its impact on the domestic economy and global supply chains has been severe. China’s labour market, retail sales, and service sector growth have come under renewed pressure as restrictions have intensified. Unemployment rose to 5.5% in September compared to 4.9% a year earlier. 

Activity data shows that domestic aeroplane flights have been running at around 40% of pre-COVID levels, tourist spending and visits have seen large declines in recent months, and the recovery in auto-sales has stalled. 

Retail sales growth in September slowed to 2.5%, compared to August’s 5.4% increase. We expect consumer activity will remain lacklustre in 2023 due to ongoing COVID-19 restrictions, rising unemployment and limited policy support. 

Industrial production a bright spot

Industrial production has been one bright spot, with growth of 6.3% registered in September². This coincides with the introduction of the “closed loop management” approach, a system by which factories arrange for staff to live and work within its facilities. This arrangement allows for production to continue while adhering to the strict COVID-19 rules, but does come at a social cost. 

Industrial production has also benefited from the improvement in supply chains at China’s ports, the recovery in car manufacturing and a pickup in electrical machinery and equipment investment. 

As domestic demand falters and the slowing global economy leads to a weaker demand for exports, the prospect of a further significant rebound in industrial production in 2023 looks unlikely. 

Exports, as measured through container throughput, registered a double-digit contraction in early September. Order backlogs in key manufacturing and exporting hubs have declined and figures show that falling demand in areas such as computers and semiconductors. We expect exports to decline by 2-5% in 2023. 

The latest Caixin manufacturing PMI figures revealed a noticeable fall in its new orders component, adding to concerns about future growth prospects. 

Collapsing property market

The Chinese property sector accounts for around 25% of GDP when construction, land sales, and other related activity are taken into consideration. Previous measures to cool the housing market, the fallout from the property developer debt scandal, and a growing movement to boycott mortgage payments in protest over stalled construction have smashed activity levels. Home prices fell for a thirteenth consecutive month in September. Meanwhile, new starts fell 46% and land purchases slumped 57% in July (see chart).

Authorities have been trying to alleviate the distress in the housing market by easing mortgage rates, reducing down-payment ratios for first-time buyers in the major cities from 30% to 20% and relaxing buying restrictions outside of the four tier-one cities. 

Given the broad range of pressures, we remain cautious about the potential for a recovery in the property sector. Homebuyer sentiment remains poor, household leverage is elevated, and the outlook for the labour market has been more uncertain. 

For 2023, we expect a longer and deeper contraction in housing investment, with an estimated contraction of  8-10% year-on-year. The current dislocation in the housing market is also expected to create long-term scarring which could weigh on growth prospects for many years. 

Infrastructure rebuild

Infrastructure investment has helped to mitigate some of the sharp slowdown experienced elsewhere in the economy. China believes that injecting vast sums into large-scale projects will help to modernise its economy and deliver an industrial transformation. 

Traditional infrastructure projects are being fast-tracked in areas including transportation, energy, and water resources. China is implementing a massive renewable energy strategy, creating the world’s longest water tunnel and developing a high-speed rail network. 

Authorities are also determined to deliver an enormous digital transformation, which revolves around building massive data centres and deploying ultra-fast digital networks. 

The significant increase in credit growth and a faster approvals process have encouraged us to increase our growth forecast for infrastructure investment to 8-10% for 2022. During times of economic weakness, China has traditionally turned to infrastructure investment (such as in 2008-09 and 2012-13) although current levels are still significantly lower than during previous cycles.  

We expect the projected level of infrastructure investment will boost growth annually by around 0.5% in 2023, which although supportive, is not enough to materially turnaround China’s growth profile. 

Inflation

China’s price pressures are subdued when measured against the multi-decade highs in inflation seen in many western economies. 

The country’s consumer price index (CPI) rose to 2.8% year-on-year in September. Headline CPI was pushed higher by an increase in food prices, but lower levels of consumption have helped to reduce core inflation.  

Housing inflation (rentals) has eased for ten consecutive months, while recreation inflation fell to an 18-month low of 1.2% in September. We expect Chinese CPI to moderate through 2023 averaging just 2% compared to 2.2% registered in 2022 (see table).

Policy outlook clouded by COVID-19 response

Given the scale of the economic woes and the mild inflation profile, economists’ have been calling for a more pronounced policy response. Assistance for the housing market has come in the form of bailout funds and special loans. Meanwhile, the People’s Bank of China has reduced the banks’ reserve requirement ratio, relaxed its credit policy, and cut rates.  

Although these measures are helpful at the margins, they are unlikely to provide a meaningful boost to activity. While we can expect some further support over the next year, we anticipate that policymakers will maintain the “no big stimulus view”, given their concerns about leverage levels, fears over stoking inflation, and a further weakening of the currency. 

Despite the persistent rhetoric around the need to adhere to zero-COVID principles, we expect the authorities to ease some of China’s travel restrictions in the coming months. Officials are reportedly debating measures that would cut quarantine periods for international travellers and allow the resumption of some overseas fights. 

However, given the surge in Omicron cases following the partial reopening back in March, any easing of rules is likely to be gradual and subject to revision depending upon the path of the pandemic. 

On the political side, President Xi has said that China will continue to strive for a peaceful reunification with Taiwan, but fell short of renouncing the use of force. We anticipate that ongoing concerns over China’s intentions towards Taiwan and a ratcheting up of tensions with the US will  further add to geopolitical risk in 2023.  

Sluggish short-term growth outlook

Without a material pivot from the zero-COVID containment policy, China’s recovery is expected to remain inhibited through next year. We would expect some improvement from the sluggish 3.3% 2022 growth rate to around 3.8% in 2023, still a long way behind the 8.1% achieved in 2021. 

In the medium term, China’s growth profile should be underpinned by becoming a high-tech, sustainable, and domestically-focused economy. At the 20th Communist Party Congress, officials reiterated the commitment to transition from high-speed growth to high-quality development. 

Within that self-reliance framework, there is determination to develop the foundations which will deliver domestically-driven scientific and technological breakthroughs.  

Improvements in domestic demand are expected to be achieved through its “Dual Circulation” strategy and the continued focus on the concept of Common Prosperity. The Common Prosperity doctrine aims to narrow the income gap and expand the middle class. The authorities believe that this can be achieved by rewarding productivity and standardising income distribution and wealth accumulation mechanisms.

China has all the attributes needed to become the world’s largest economy eventually, but as recent turbulence attests, the path to the top of the rankings will not be unencumbered.

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