Xi still see the state as the fix, not the impediment
President Xi Jinping gave a speech this week in which he called for a “new development model” that emphasises a greater role for China’s domestic market in response to the global COVID-19 downturn and growing tensions with the West.
Xi is right that China’s economy will need to rely increasingly on domestic demand. Although exports have been remarkably resilient recently, that reflects a temporary prop from a surge in demand for PPE and work from home equipment. The big picture is that growth among China’s major trading partners is likely to remain weak for an extended period of time. Meanwhile, decoupling will make it more challenging for Chinese firms to expand in overseas markets.
To help offset this, Xi is flagging the need for further government support for domestic demand. Much of this is already in the pipeline. For example, his call for more proactive fiscal policy sits well with the ramp-up in government bond issuance planned for the rest of the year.
In the near term, these efforts to shore up domestic demand are likely to be effective. Indeed, stimulus has already led to a rapid rebound in GDP to above its pre-virus levels. And we expect output to return to trend by the end of the year, long before other major economies. But sustaining rapid growth in domestic demand further ahead will be more of a challenge.
Infrastructure spending, the key engine of the current recovery, clearly boosts demand in the short-run. But China already has a very well-developed public capital stock for a country at its income level and so faces diminishing returns from building more.
Instead, the long-term success of Xi’s “new development model” will largely rest on making use of the existing capital stock more efficiently to generate faster total factor productivity gains.
One driver of such gains that is getting renewed attention is urbanisation, which was top of the agenda at this week’s State Council meeting. But this latest push appears to mostly be a continuation of the “new urbanisation” plan launched in 2014, which has so far underwhelmed. Migration into the cities has been much more modest than in the past recently, with most of the increase in the urban population simply due to the reclassification of areas from rural to urban. (See Chart 1.)
Chart 1: New Urban Residents (mn)
Sources: CEIC, Capital Economics
Another focus of Xi’s “new model” is spurring domestic innovation. Given tensions with the West, he is understandably keen to reduce China’s reliance on foreign technology. But innovation is hard to dictate from above and increased state involvement in the economy risks having the opposite effect. One lesson from the past decade is that the Chinese state struggles to allocate resources and credit as efficiently as the private sector, which is why the surge in debt ratios has been concentrated among state firms and local governments. Rather than embracing a change of direction, China appears to be doubling down its existing state-led model, which is partly to blame for the downward trend its potential growth rate.
The week ahead
GDP data will probably show that Hong Kong’s recession extended into Q2. But we expect the mainland PMIs to remain more upbeat and point to a further recover at the start of Q3.
Hong Kong GDP (Q2, Adv.) Wed. 29th Jul.
GDP q/q (y/y)
Mainland rebound and fiscal stimulus to offset weak consumption
Hong Kong’s economy contracted the most on record in Q1 in q/q terms as lockdowns cut short a nascent recovery from last fall’s disruptive protests. Though the y/y contraction in Q2 could well be the sharpest ever, the decline should have eased in q/q terms.
Retail sales during April and May suggest that the y/y contraction in consumption steepened. (See Chart 2.) A decline of 15% y/y in consumption during Q2 – which makes up two-thirds of GDP – would shave off 3.5%-pts from headline GDP growth.
We think investment will have fared better and offset some of the weakness in consumer spending. After all, economic activity on the mainland – which many businesses in Hong Kong are highly reliant on – gained momentum last quarter. Meanwhile, the government’s ambitious stimulus fiscal package should have begun to materialize and led to a surge in government expenditure.
Chart 2: Retail Sales & Consumption (% y/y)
Sources: Refinitiv, Capital Economics
Manufacturing PMIs (Jul.) Fri. 31st Jul. / Mon. 3rd Aug.
“Official” PMI (31st Jul.)
Caixin/Markit PMI (3rd Aug.)
Activity continues to rebound
In June, industrial output growth stabilized at a level broadly in line with its level prior to the COVID-19 outbreak. (See Chart 3.) This suggests that conditions in industry have normalized, and that manufacturing activity is unlikely to get much more of a boost from reopening factories and fulfilling the backlogs of orders that accumulated during lockdowns. Any further recover will therefore need to rely entirely on stronger demand.
There are signs that the pace of increase in activity could have edged up this month. The new orders and output components of the Standard Chartered SME Confidence Index survey, for example, improved marginally in July. This suggests that SMEs, who fared worse than larger firms earlier in the year, continued to see activity recover at the start of Q3. This suggests that growth in the broader manufacturing sector may have picked up too.
Chart 3: Industrial Value Added & Output (% y/y)
Sources: CEIC, Capital Economics
Non-manufacturing PMIs (Jul.) Fri. 31st Jul. / Wed. 5th Aug.
“Official” Non-man. PMI (31st Jul.)
Caixin/Markit Services PMI (5th Aug.)
Consumer confidence returning
The service PMIs have picked up in recent months, though surveys conducted by the People’s Bank (PBOC) showed that consumer confidence remained weak across in Q2.
But there are signs that consumers have begun to feel comfortable venturing out into cities once again in the past few weeks, and this should have boosted services activity. Restaurant orders and subway usage – two of the high-frequency indicators that have improved at the slowest pace in recent months – began to climb at the start of July. (See Chart 4.) This suggests that consumers might have begun to spend some of the money they saved earlier in the year.
The construction index of the official PMI will probably have remained strong and might even have increased. Government bond issuance has jumped during the past couple of months, with much of the proceeds earmarked for infrastructure investment.
Chart 4: Economic Activity (% of 2019, 7d ave.)
Sources: Wind, Baidu, Capital Economics
Economic Diary & Forecasts
Profits of Large Industrial Firms (Jun.)
Trade Balance (Jun., HKD)
GDP (Q2, q/q(y/y))
Retail Sales (Jun.)
“Official” Manufacturing PMI (Jul.)
“Official” Non-Manufacturing PMI (Jul.)
Selected future data releases and events:
Caixin Manufacturing PMI (Jul.)
Caixin Services PMI (Jul.)
Main Economic & Market Forecasts
%q/q annualised (%y/y), unless stated
GDP (CE CAP-derived estimates)
Broad Credit (AFRE)
7-day PBOC reverse repo† %
1-year Loan Prime Rate† (LPR) %
1-year MLF Rate† %
10-year Government Bond Yield† %
RRR (major banks)† %
Shanghai Composite Index†
Hong Kong GDP
Hang Seng Index†
Sources: Bloomberg, CEIC, Capital Economics *Q2; ** Jun.; ***Q1; † End of period