Past the worst but recovery to underwhelm

  • Overview – After the deepest downturn since the Cultural Revolution in Q1, China’s economy will return to growth this quarter. But with labour market strains holding back domestic demand and external headwinds intensifying, output is still set to contract this year and remain below the pre-virus path well into 2021.
  • Domestic Demand – Domestic activity rebounded when containment measures were lifted. But the recovery has since got stuck midway. Getting back to normal will be a drawn-out process as both consumer and investment demand are likely to remain subdued.
  • External Demand – China’s external position will deteriorate markedly this year as COVID-19 ravages global demand, with the country likely to run an annual trade deficit for the first time in decades.
  • Monetary Policy – The People’s Bank has cut rates by less than some other central banks, most notably the US Fed. But further declines are in the pipeline and policymakers are taking direct measures to make cheap credit more widely available.
  • Fiscal Policy – China’s fiscal response to the COVID-19 outbreak has been more low-key than during the Global Financial Crisis. But we still expect sizeable fiscal support in the coming quarters.
  • Inflation – The supply-side constraints that propped up prices for some goods in the initial stages of the COVID-19 outbreak have subsided. In the coming quarters, weak demand-side pressures and low commodity prices will pull down inflation for both consumers and producers.
  • Property Sector – The hit to property demand from COVID-19 looks set to accelerate the slowdown in construction that was getting underway even before the virus struck.
  • Hong Kong – Hong Kong has managed to keep the number of confirmed COVID-19 in check despite the city’s extensive ties with the mainland and the lack of strict domestic containment measures. But it won’t be able to avoid a huge economic shock as a result of the global spread of the virus.

Key Forecasts Table

Table 1: Key Forecasts

% y/y, average over period

2019

2020

2021

Annual

(unless otherwise stated)

Q4

Q1e

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

2019

2020f

2021f

2022f

China

Domestic Sector

Official GDP

6.0

-16.0

-6.0

-1.0

1.0

29.0

16.0

10.5

6.1

-5.0

15.0

4.5

CE China Activity Proxy

5.6

-16.0

-6.0

-1.0

1.0

29.0

16.0

10.5

5.5

-5.0

15.0

4.5

Industrial Production

5.9

-15.0

-7.0

-2.0

-1.0

25.0

15.0

10.0

5.7

-6.0

14.0

4.0

Fixed Asset Investment

5.4

-23.0

-9.0

-2.0

2.0

40.0

19.0

9.0

5.4

-8.0

18.0

4.0

Retail Sales

7.7

-25.0

-10.0

2.0

5.0

30.0

15.0

9.0

8.0

-7.0

16.0

7.0

Surveyed Urban Unemployment (%)

5.1

6.5

7.0

6.5

6.0

5.5

5.3

5.1

5.1

6.0

5.0

5.0

External Sector

Goods Exports (US$, % y/y)

1.9

-14.0

-48.5

-35.0

-19.0

7.0

53.0

32.5

0.5

-30.0

25.0

5.0

Goods Imports (US$, % y/y)

3.4

-2.5

-30.0

-12.0

-1.0

12.0

49.0

23.0

-2.8

-12.0

22.0

6.0

Goods Balance (US$bn)

127

13

-40

-50

5

-10

-45

-20

422

-70

-85

-110

Current Account (seas. adj., % of GDP)

0.7

0.3

-1.1

-1.7

-1.4

-1.0

-1.3

-1.3

1.0

-1.0

-1.5

-1.5

Prices

Consumer Prices

4.3

5.0

1.8

-0.2

-0.7

-0.3

1.7

2.4

2.9

1.5

1.5

2.0

Core Consumer Prices

1.4

1.2

0.9

1.0

1.2

1.5

2.2

2.0

1.6

1.0

2.0

1.5

Producer Prices

-1.2

-0.6

-5.0

-4.0

-2.0

0.0

8.0

6.0

-0.3

-3.0

4.5

1.0

Fiscal and Monetary

General Budget Balance (4q sum, % of GDP)

-4.9

-5.0

-6.0

-6.5

-7.0

-7.0

-6.5

-6.0

-4.9

-7.0

-6.0

-5.0

Money Supply (M2) (eop)

8.4

9.1

10.5

11.5

12.5

13.0

13.5

13.0

8.4

12.5

12.5

10.5

Aggregate Financing (AFRE) (eop)

10.7

11.5

13.0

14.0

15.0

15.5

16.0

15.5

10.7

15.0

15.0

13.0

Non-Financial Sector Debt (eop, % of GDP)

278

299

312

324

330

325

324

327

278

330

325

344

Policy Rates (end period, %)

7-Day Pledged Repo Rate (R007)

3.07

2.50

1.60

1.20

1.00

1.00

1.00

1.00

3.07

1.00

1.00

1.50

7-Day PBOC Reverse Repo Rate

2.50

2.20

1.60

1.20

1.00

1.00

1.00

1.00

2.5

1.00

1.00

1.50

1-Year Lending Prime Rate (LPR)

4.15

4.05

3.45

3.05

2.85

2.85

2.85

2.85

4.15

2.85

2.85

3.35

1-Year Medium-term lending facility (MLF)

3.25

3.15

2.55

2.15

1.95

1.95

1.95

1.95

3.25

1.95

1.95

2.45

RRR (major banks)

13.0

12.5

12.0

11.5

11.5

11.5

11.5

11.5

13.0

11.5

11.5

11.5

Markets (end period)

Shanghai Composite

3,050

2,750

3,000

3,100

3,200

3,225

3,250

3,275

3,050

3,200

3,300

-

3M SHIBOR (%)

3.02

1.93

1.50

1.20

1.10

1.10

1.10

1.10

3.02

1.10

1.10

1.60

2-yr Gov’t Bond (%)

2.46

1.95

1.20

1.00

0.80

0.80

0.80

0.80

2.46

0.80

0.80

1.30

10-yr Gov’t Bond (%)

3.16

2.61

2.20

1.90

1.60

1.50

1.40

1.40

3.16

1.60

1.40

1.80

RMB/USD (eop)

6.97

7.09

7.15

7.20

7.20

7.15

7.10

7.05

6.97

7.20

7.00

6.80

Hong Kong

GDP (% y/y)

-2.9

-9.5

-12.5

-3.5

+2.5

+11.0

+16.0

+8.5

-1.4

-5.5

+9.5

+1.5

Hang Seng Index (eop)

28,190

23,603

24,000

24,500

25,000

26,000

27,000

27,500

28,190

25,000

28,750

-

HKD/USD (eop)

7.8

7.8

7.8

7.8

7.8

7.8

7.8

7.8

7.8

7.8

7.8

7.8

prior to year-end adjustments from government funds;

Sources: CEIC, Refinitiv, Bloomberg, WIND, Capital Economics


Overview

Past the worst but recovery to underwhelm

  • After the deepest downturn since the Cultural Revolution in Q1, China’s economy will return to growth this quarter. But with labour market strains holding back domestic demand and external headwinds intensifying, output is still set to contract this year and remain below the pre-virus path well into 2021.
  • China’s economy was growing rapidly at the end of 2019 but was derailed by efforts to contain COVID-19. The data for the first two months of the year (which are combined) were very weak, with industry and services activity contracting around 13% y/y. (See Chart 1.) A slump in cement output suggests that activity on construction sites also halted. (See Chart 2.)
  • The March data are set to be even worse. Despite evidence of a recovery last month, output still looks to have been lower than the average across the first two months of the year (the COVID-19 containment efforts only began in earnest in late January). All told, we think GDP contracted 20% q/q in the first quarter (a fall of 16% y/y). (See Chart 3.)
  • With most social distancing restrictions now lifted, the economy is past the worst. The daily activity indicators that we track have improved in recent weeks. Output should return to growth this quarter. That said, a rapid recovery to the pre-virus path is unlikely.
  • For a start, even in the absence of restrictions, lingering concerns about the virus are keeping many consumers and workers home. Passenger traffic remains well below normal levels. (See Chart 4.) And around a fifth of the migrants that left the cities ahead of Lunar New Year have yet to return. Meanwhile, the shutdowns will leave a legacy of job losses and firm closures that will take time to reverse.
Chart 1: Industry and Services Activity (% y/y)

Chart 2: Construction Activity (% y/y)

Chart 3: GDP

Chart 4: Passenger Traffic (% of 2019 level, 7d ave.)

Sources: CEIC, Baidu, Capital Economics

Overview (continued)

Past the worst but recovery to underwhelm

  • Public records suggest that at least half a million firms were dissolved in Q1 and more are likely to close shop before long. Many SMEs only have enough cash to last a few months amidst the current weakness in sales.
  • The unemployment rate jumped in February (see Chart 5), with surveys pointing to further layoffs in March, and it will probably remain elevated in the coming months. The quarter of the urban workforce that are self-employed or part of family-run businesses will also remain cautious given the recent hit to their incomes.
  • Another near-term headwind is the COVID-19 disruption outside of China, which we think will lead to the sharpest global contraction since WWII this quarter. This looks set to pull down exports, which drive 15% of China’s GDP, by as much as 50%. (See Chart 6.)
  • The global weakness will slow China’s recovery. We now expect GDP to fall 5% this year (our prior forecast was -3%). This would be the first annual contraction since 1976.
  • But China will outperform most other major economies. Its shutdowns, while severe, were shorter than now seems likely elsewhere. And while a renewed outbreak is still a risk, China’s containment efforts look to have been effective.
  • Meanwhile, although policy support has been low-key relative to China’s post-GFC stimulus, state control of the much of the financial system has minimized defaults and kept credit growth stable even amidst the slump in demand. (See Chart 7.) This has averted layoffs on the scale now being seen elsewhere. While we think the economy won’t return to its pre-virus trend until well into 2021 (see Chart 8), that would be much earlier than is likely in other countries.

Chart 5: Surveyed Unemployment Rate (%)

Chart 6: Exports & Trade Partner GDP (% y/y)

Chart 7: Broad Credit Outstanding (% y/y)

Chart 8: GDP (Q4 2019 = 100)

Sources: CEIC, Capital Economics


Domestic Demand

Weak sentiment and labour conditions to hold back recovery

  • Domestic activity rebounded when containment measures were lifted. But the recovery has since got stuck midway. Getting back to normal will be a drawn-out process as both consumer and investment demand are likely to remain subdued.
  • Nearly all workplaces and shops have reopened. But the subdued level of subway usage (see Chart 9) suggests that many people are choosing still to remain at home. Lingering nervousness about infection is one reason. Another is that the lockdown dealt a major blow to employment and incomes.
  • The official unemployment rate jumped in February. And surveys imply that nearly half have had salary payments halted or delayed. (See Chart 10.) These factors will make it harder for consumer spending to recover from the collapse in Q1. (See Chart 11.)
  • Investment appears to have plummeted even more deeply than consumption in the first quarter. (See Chart 12.) Policy support should drive a rapid and sizeable rebound in infrastructure spending, even if not on the scale seen during the Global Financial Crisis. (See the policy sections below.)
  • But manufacturing investment, which is larger than infrastructure spending, will be slower to recover: the prospect of prolonged weakness in demand at home and abroad means that manufacturers will not be in a rush to expand operations any time soon.
  • While policymakers used the property sector to prop up activity during prior downturns, they have yet to loosen restriction on the sector. Overall property construction may contract this year for the first in over two decades. (See the property section below.)
Chart 9: Daily Activity (% of 2019 level)

Chart 10: Does your employer have problems with paying salaries?* (% of respondents)

Chart 11: Consumption & Retail Sales (% y/y)

Chart 12: Fixed Asset Investment (RMB, 3m % y/y)

Sources: CEIC, Zhaopin, Capital Economics


External Demand

Exports set for deepest contraction in decades

  • China’s external position will deteriorate markedly this year as COVID-19 ravages global demand, with the country likely to run an annual trade deficit for the first time in decades.
  • Trade values contracted in Q1, with factory and port shutdowns weighing especially hard on exports. (See Chart 13.) But worse is still to come for exporters. We think the global economy will contract by the most since WWII this quarter, with our GDP forecasts for China’s major trading partners pointing to a 50% y/y decline in exports. (See Chart 14.)
  • Further ahead, we think exports will remain below their pre-virus peak for at least a year as many countries struggle to quickly bounce back from the virus hit. The Phase One US-China trade deal is also at risk of falling apart, threatening further US tariffs. China will struggle to (and be reluctant to) ramp up purchases from the US as quickly as agreed and China’s initial cover-up of the virus has strengthened hawkish voices in Washington.
  • Imports won’t be immune to the weakness in foreign demand given that a quarter of inbound shipments feed into China’s export sector. But they should hold up better than exports given that domestic demand in China has bottomed out and should recover faster than elsewhere.
  • As a result, the current account could slip into deficit this year for the first time since 1993. (See Chart 15.) Inbound FDI is already contracting (see Chart 16) and could drop this year by the most since 2009.
  • This deterioration in China’s external position will put downward pressure on the renminbi. Policymakers won’t risk instability from a sharp currency move. But we think that they will allow a weakening to 7.20/$ by year-end.

Chart 13: Goods Trade ($, % y/y)

Chart 14: Exports & Trade Partner GDP (% y/y)

Chart 15: Current Account Balance (% of GDP)

Chart 16: Inbound Direct Investment ($, 3m % y/y)

Sources: CEIC, WIND, Capital Economics


Monetary Policy

State control amplifying boost from rate cuts

  • The People’s Bank has cut rates by less than some other central banks, most notably the US Fed. But further declines are in the pipeline and policymakers are taking direct measures to make cheap credit more widely available.
  • The PBOC has pushed down interbank rates using a variety of tools including open market operations, reductions to banks required reserve ratios (RRR) and cuts to the rates on its lending facilities (reverse repos, MLF, etc). As a result, the rate on 7-day repos (the most frequently traded interbank contract) has declined more than 100 basis points since the end of last year. (See Chart 17.)
  • We anticipate additional declines in the coming months. In a sign that the PBOC is preparing to do more, it recently cut the rate it pays on banks’ excess reserves from 0.72% to 0.32%, essentially lowering the floor on interbank rates. As a result, we now think the 7-day repo may decline by another 100bps to end the year at around 1.0% (our previous forecast was 2.0%).
  • On past form, this decline in interbank rates should be passed on to bank borrowers in full. (See Chart 18.) It will also pull down bond yields and the cost of shadow financing.
  • Just as important as the decline in rates is the direct intervention to keep cheap credit flowing. The PBOC has pushed the state banks to extend large amounts of preferential loans to struggling firms. Meanwhile, state support has limited bond defaults and kept credit spreads from widening much. (See Chart 19.)
  • As a result, credit growth remained stable in February, despite the collapse in demand, and started to accelerate in March. (See Chart 20.) We expect a further pick-up in the months ahead to offer a tailwind to the recovery.
Chart 17: 7-day Repo Rates (%)

Chart 18: Bank Lending Rates & Interbank Rates

Chart 19: Corporate Bond Credit Spread
AAA minus AA- (basis points, 5Y)

Chart 20: Broad Credit Outstanding (% y/y)

Sources: CEIC, WIND, Capital Economics


Fiscal Policy

No shock and awe but sizeable easing still likely

  • China’s fiscal response to the COVID-19 outbreak has been more low-key than during the Global Financial Crisis. But we still expect sizeable fiscal support in the coming quarters.
  • China’s budget deficit widened during the first two months of the year, as the COVID-19 outbreak began to weigh on fiscal revenue. (See Chart 21.) But the increase in the deficit was modest, in part because the economy-wide shutdowns hindered the government’s ability to step up traditional forms of spending.
  • The faster pace of government borrowing in Q1 suggests that a ramp up in spending is planned and that the deficit will widen further in the coming months. That said, the pick-up in borrowing remains small relative to past downturns. (See Chart 22.) And reports suggest that the National’s People’s Congress next month will reveal only modest increases in the annual budget deficit target and local government bond quotas.
  • But fiscal easing this year will likely end up being more significant than the conservative budget targets imply. Chinese policymakers are warier of the long-run costs of stimulus than in the past but they will still come under pressure to do more if, as we expect, the economy struggles to get back on track.
  • The government may tap its sizeable reserves (doing so is booked as revenue in the annual budget figures) in order to run a much larger deficit than targeted. (See Chart 23.) Restrictions on off-budget borrowing may also be relaxed. And waivers of social security payments will add close to 1% of GDP to fiscal stimulus. All told, we think the augmented deficit will widen by over 4% of GDP, a similar margin as during the Global Financial Crisis. (See Chart 24.)

Chart 21: Budget Balance (% of GDP, 12m sum)

Chart 22: Fiscal & Quasi-Fiscal Borrowing
(net increase, % of GDP, 4Q rolling)

Chart 23: Fiscal Deposits (% of GDP, seas. adj.)

Chart 24: Augmented Fiscal Balance (% of GDP)

Sources: CEIC, Bloomberg, WIND, Refinitiv, Capital Economics


Inflation

Labour market strains and commodity prices to pull down inflation

  • The supply-side constraints that propped up prices for some goods in the initial stages of the COVID-19 outbreak have subsided. In the coming quarters, weak demand-side pressures and low commodity prices will pull down inflation for both consumers and producers.
  • Part of the steep drop in headline consumer price inflation that we expect in the coming quarters (see Chart 25) will be driven by weak oil prices. We expect global crude prices to remain around current levels until at least the middle of the year.
  • As a result, fuel price inflation will remain negative for the rest of 2020. That will directly knock 0.2-0.4%-pts off headline consumer price inflation relative to the start of the year. Coupled with falls in other commodity prices, it will keep producer price inflation negative to the end of the year too. (See Chart 26.)
  • Disinflationary pressure on core inflation from weak domestic demand is likely to persist even longer. A substantial output gap is likely to exist well into next year. The labour market will similarly remain weak. (See Chart 27.)
  • In addition, African Swine Fever – which decimated China’s pig herd in late 2019 – has come under control. Pork price inflation is therefore likely to fall sharply over the months ahead. Food makes up about 20% of the consumer price index basket.
  • And although food prices rose a bit at the start of the COVID-19 outbreak – due to supply disruptions and, possibly, hoarding – they have now resumed their normal post-Lunar New Year downward trend. (See Chart 28.)

Chart 25: Consumer Price Inflation (% y/y)

Chart 26: Producer & Commodity Prices (% y/y)

Chart 27: Unemployment & Core Inflation

Chart 28: China Food Wholesale Price Index

Sources: CEIC, Capital Economics


Property

Weak sales & falling prices to weigh on construction

  • The hit to property demand from COVID-19 looks set to accelerate the slowdown in construction that was getting underway even before the virus struck.
  • Property sales volumes contracted around 40% in Q1 due to disruptions from COVID-19. Sales have picked up in recent weeks but remain well below last year’s level. (See Chart 29.)
  • Property demand is likely to stay weak for a while given that household incomes have been hit by job losses and pay cuts, and risk aversion will be high. And regulators appear reluctant to significantly relax property controls. Down-payment requirements remain elevated and mortgage rates have barely declined despite broader monetary easing. (See Chart 30.)
  • In the face of weak demand, property prices will come under pressure. Prices were flat across 70 key cities in February (see Chart 31) but are likely to have started falling in recent weeks. We expect the drop in prices to eventually eclipse the downturn in 2013/14.
  • Property construction began cooling last year as developers grappled with stagnant sales. But the COVID-19 outbreak has led to a much sharper slowdown. Admittedly, this was partly due to temporary labour shortages at construction sites. But land transactions have been very weak, even as supply-side disruptions have eased in recent weeks. This suggests that developers have turned more cautious on the outlook and that the pace of new property starts will remain slow. (See Chart 32.)
  • Given that the flurry of projects which broke ground a couple of years ago are also due to be completed soon, overall property construction may contract this year for the first in over two decades.

Chart 29: Property Sales (sqm, % y/y)

Chart 30: Mortgage Rates & Downpayment Requirements (latest=Feb.)

Chart 31: Residential Property Price: 70 Cities

(NBS Survey, % m/m)

Chart 32: Land Sales & Property Starts (3m % y/y)

Sources: CEIC, WIND, Capital Economics


Hong Kong

Contraction to deepen despite capable coronavirus response

  • Hong Kong has managed to keep the number of confirmed COVID-19 in check despite the city’s extensive ties with the mainland and the lack of strict domestic containment measures.
  • Two factors have contributed to this success. Firstly, the border with the mainland was practically closed by early February. (See Chart 33.) In addition, congestion data suggest that people in Hong Kong began to heed official guidance earlier than in, for example, Singapore, which has since had to resort to a city-wide lockdown.
  • While the city has fared relatively well in epidemiological terms, vanishing tourists and caution among domestic consumers have weighed heavily on spending. Retail sales appear to have had their weakest quarter ever in Q1, consistent with a deepening of the year-on-year contraction in consumption, which makes up two-thirds of GDP. (See Chart 34.)
  • The global spread of COVID-19 and lockdowns means that HK’s domestic success so far in containing the virus won’t shield its economy from a huge shock. Our forecast for global GDP implies that Hong Kong’s exports will contract by a quarter in Q2 (see Chart 35). This alone could reduce GDP by 5%.
  • The government plans to run a fiscal deficit equal to 10% of GDP this year. While this might keep companies afloat and people employed, the spending commitments will not materialize at scale until June, which might be too late to prevent unemployment from surging.
  • The political dissatisfaction that led to widespread social disruption – and pushed the economy into a recession – last year has barely improved. (See Chart 36). Political unrest could re-emerge on the other side of COVID-19.
Chart 33: HK Passenger Arrivals (‘000s)

Chart 34: Retail Sales & Consumption (% y/y)

Chart 35: Exports & Global GDP (% y/y)

Chart 36: “Are you satisfied with the performance of the HKSAR Government?”*

Sources: Refinitiv, HKU Public Opinion Programme, Capital Economics


Mark Williams, Chief Asia Economist, mark.williams@capitaleconomics.com
Julian Evans-Pritchard, Senior China Economist, julian.evans-pritchard@capitaleconomics.com
Martin Rasmussen, China Economist, martin.rasmussen@capitaleconomics.com
Sheana Yue, Research Assistant, Sheana.Yue@capitaleconomics.com

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