Abstract: Since October, market views have diverged on the outlook of China’s economic recovery: the first type of view believes that economic recovery will continue, the second holds that the economy has already showed signs of overheating, and the third states that the economy is peaking. This essay reviews four basic facts of China’s economic recovery since the outbreak of COVID-19 and discusses the possible reasons behind the three different views.
In the past two quarters of this year, there was a strong consensus in the market regarding the outlook of China’s economic recovery. Some of the macroeconomic indicators of October performed better than expected, e.g. the rebound of investment, but more were basically consistent with market expectation, e.g. export remained robust, consumption recovered slowly and inflation remained low.
However, market views started to diverge significantly as to the outlook of China’s economic recovery. There are at least three interpretations on the October macro data, each corresponding to one stage of economy cycle. The first believes that the recovery is continuing, the second that the economy is already showing signs of overheating, and the third that the economy is peaking.
Why are the same economic data interpreted in such different ways, particularly considering the strong consensus in the last two quarters? Such a change is very interesting because what appears to be the difference in opinions actually reflects the difference in the basis and logic of judgment.
This essay seeks to sort out the basic facts of macroeconomic recovery since the outbreak of COVID-19, and unveil the policy conditions behind different views. It does not intend to contribute new ideas to the current macroeconomic discussions, but hopes to direct the discussions to more specific issues and deepen the understanding of China’s macroeconomic operation at present.
Fact 1: Policy forces have played an important role in this round of credit expansion
Policy forces which have contributed to the current round of credit expansion are reflected in three aspects:
First, loose monetary policy. In the wake of the outbreak, major central banks around the world have adopted fairly loose monetary policies, and China has been no exception. In China's case, it is easing both in the price of capital (interest rates) and in quantity (the scale of social financing), which have provided the necessary conditions for the economy to recover and supported rapid credit expansion. Second, a sharp increase in government bond financing. In 2020, the scale of the three types of government bonds increased by 3.6 trillion yuan compared with the previous year. Third, supportive credit policies for micro, small and medium-sized enterprises and the manufacturing sector. The scale of personal business loans increased by 830 billion yuan over the previous year, which were mainly business loans secured by individual businesses and small and micro businesses with their own real estate properties. Medium- to long-term loans to industrial enterprises increased by nearly 1 trillion yuan over historical average. Such kind of supportive credit contributed more than 60 percent to the growth of social financing, at a cost generally lower than LPR.
Policy does matter to credit expansion, but whether the momentum of this round of expansion will sustain after policies exit depends on how large a role policies have played so far. This is the first divergence in the market.
If policies did play a critical role, based on the recovery of the economy over the past two quarters, the momentum of spontaneous credit expansion in the market should clearly be insufficient. Clues can be drawn from the performance of consumption, consumer loans and manufacturing investment. If so, in the future, as policies gradually normalize, China's economy will face downward pressure.
On the other hand, if the role of policy has been auxiliary, the economic recovery so far would have largely been driven by the rebound of the market, which indicates that the subsequent recovery would sustain. Based on historical performance, such momentum could continue for at least two quarters, and the Chinese economy would not see a significant downward trend by the middle of 2021, let alone downward pressure.
Fact 2: Property sector has shown great resilience
To understand the macroeconomic performance this year, we should focus on two sectors: one is real estate, the other is export. A review of market expectation in the early days of the COVID-19 outbreak can show that the performance of the real estate industry and export has been significantly beyond market expectation.
Since the outbreak of the pandemic, China's real estate industry has shown extraordinary resilience, providing critical support to aggregate demand. Based on the current trend of growth, the growth rate of real estate investment this year should be 7.5%-8% as long as no extreme situations occur in the last two months of this year, with floor space started and sold remaining more or less unchanged from 2019. These figures are largely in line with market expectation at the end of 2019, when it was unlikely to anticipate an extreme event such as a pandemic. In other words, COVID-19 has not had any real impact on China's real estate sector. The resilience of the real estate sector has not only stabilized aggregate demand, but also provided sufficient revenues from land sales for local governments, enabling them to better cope with the fiscal pressure brought by the pandemic.
Whether the property sector can remain resilient in the context of tightening monetary policy and controls on the scale of debt owned by real estate companies is the second divergence regarding China’s macro outlook. While the policy might not be friendly to the property sector, the market has several reasons to be optimistic. First, developers may rush to complete ongoing projects rather than investing in new ones in the future, which could become the driving force of real estate investment. Second, they may stabilize sales through promotion and hedge the effect of policy tightening by accelerating payment collection.
Both of these reasons have their points, but each of them is flawed to some extent. For example, the historical time series of floor area completed does not precisely align with real estate investment. It is highly possible to see accelerated completion, but we cannot directly relate it to real estate investment. For another example, since 2018, residents' new consumption loans have seen a trend of marginal contraction. This year, the new consumption loans have decreased by 430 billion yuan compared with last year. This is not a signal that residents will actively increase leverage to buy houses. Previous data also shows that there has never been a situation where residents start to increase leverage when the monetary policy sees marginal tightening.
Fact 3: Strong export performance significantly exceeds market expectation
At the early stage of the pandemic, market forecasts on exports generally used the 2009 scenario as a reference. At that time, China's annual exports shrank by nearly a quarter, and the whole sector was shrouded in gloom. Even the most optimistic of predictions, taking into consideration the exchange rate, the implementation of the Sino-US trade agreement and other factors, held that exports in 2020 may not be as bad as 2009, but not much better either.
From January to October 2020, China's export value has reached the same level as that of the same period last year. The year-on-year growth rate of exports turned positive in June, and reached 11.4% in October, hitting record high since March 2019. According to our firm survey, the orders of most export industries have fully restored to the previous level, and some enterprises even have orders booked up to next June. The price of containers has skyrocketed. The freight rate on the US West Coast route has doubled several times. There are some supply-level factors, but the strong demand is the decisive one.
Now we can see there is clear logic behind this year's better-than-expected export performance.
At the supply level, the pandemic has directly affected the production and supply systems globally, and the production capacity of many countries has been significantly suppressed, especially in emerging economies. In the early stages of the outbreak, only China had the production capacity to supply the world with anti-epidemic products such as masks and protective clothing. A large number of orders flocked to China, and the export industry has been booming since the third quarter. The result is that China's share of global exports has increased rapidly and has reached a record high. In June, China's export share in the world's 24 major economies reached 16.2%.
At the demand level, developed economies immediately adopted extremely loose monetary policies and launched far more fiscal stimulus than that in 2008. The most important fiscal stimulus was adopted by the United States: by distributing fiscal funds to the residential sector directly, it successfully stabilized its own domestic consumption and thereby a critical part of China's exports. The rebound in exports can help restore manufacturing investment. According to historical experience, this stimulus effect will probably lead by about a year. Therefore, whether the rebound in exports can sustain is another key factor in macro performance in the next half to one year.
Currently, even if the vaccines can be put into production as soon as possible, there are still multiple steps ahead such as production expansion, distribution, and effect observation, all of which will take time. Even with the most optimistic expectation, it will take more than half a year from the advent of the vaccine to the restoration of normal economic order abroad. In other words, it is unlikely that the blow brought by the pandemic on supply will disappear in the next one to two quarters. In the face of a fall and winter surge of COVID-19, without vaccines widely available, developed countries have to, again, resort to economic lockdowns. They have also announced their intention to launch a new round of fiscal stimulus, which have already buoyed capital markets in major developed economies. If the new round of fiscal stimulus is carried out as scheduled, and the scale and form of the stimulus are in line with market expectation, the capital markets will continue to revel. For China, if total foreign demand can be stabilized, exports will maintain the current strong trend. Therefore, the second round of fiscal stimulus in developed countries will be one of the most important factors for the market.
Fact 4: Infrastructure construction did not meet expectation while consumption recovery was sluggish
In the past two decades, infrastructure investment has played an important role in the Chinese economy. In 2009 and 2015, China's economy faced tremendous downward pressure. At that time, it was first and foremost investment in infrastructure, followed by real estate investment, which ultimately drove the recovery of the entire economic. In the second quarter of 2018, China began to regulate local government financing to prevent and control local debt risks, leading to a cliff-like decline in infrastructure growth, and a sudden increase of downward pressure on the Chinese economy.
At the beginning of the outbreak, the market placed high hopes on infrastructure investment this year. It was generally predicted that the annual growth rate of infrastructure investment would be around 10%, or even 15%. From January to October 2020, cumulative investment in infrastructure grew by only 3.2% year on year, and the whole year figure could probably reach about 5%, which was significantly lower than previous expectations.
In fact, China’s fiscal arrangements this year have already accounted for this gap. Although the Chinese government pushed its budget deficit to a record high, the major consideration behind the move was to close the gap in fiscal revenue. We need to look at the growth in fiscal expenditures to judge whether fiscal policies are proactive. In 2020, China’s budget fiscal spending grew at 3.4%, the lowest rate since 1994. Even if we take expenditures from government funds into account, the growth rate would be around 9.3%, also the lowest in recent years. Most of the fiscal expenditures have been directed to top-priority tasks—stabilizing employment, finance, trade, investments and market expectations, supporting people’s livelihood and market entities, protecting food and energy securities as well as supply chains, and maintaining the normal functioning of primary-level governments. As a result, only limited funds have been invested in infrastructure, which to a certain extent restricted the effects of the fiscal multiplier.
The lower-than-expected growth of infrastructure investment can also be partly attributed to changes in the financing model. In recent years, special bonds have become an important financing tool for infrastructure projects. However, to ensure debt sustainability, it’s required that only projects with up-to-standard level of cash flows can enjoy the support of special bonds. This requirement has, as a matter of fact, overlooked the changes in the structure of infrastructure projects, because most of them are exactly public or quasi-public good projects that lack cash flows. Consequently, special bonds can only be issued to a small proportion of infrastructure projects that already have cash flows, while many others without cash flows end up excluded from the program. This structural contradiction prevails in many places across the country. Meanwhile, once the scale of special bond issuance is determined, the pace and progress of issuance will be subject to the appraisal of related government departments, who require the whole process to be finished within a set timeframe. This has given rise to reversals in project arrangements, where infrastructure projects are belatedly approved after special bonds for them are already issued, which made the use of fiscal funds even more inefficient.
In general, infrastructure investments, although played a part in stabilizing growth, have not been a major driver for China’s economic development this year. And the third divergence in judging China’s macroeconomic outlook arises as to whether infrastructure investments will turn out to hamper economic growth in 2021. Debts of the government sector have ballooned to cushion the pandemic’s blow, which is definitely unsustainable. That’s why going forward, it’s very likely that fiscal expenditures will be maintained at a relatively high level, with its growth marginally slowed, but of course we don’t expect any fiscal cliff to emerge. Considering these factors, it’s actually difficult for infrastructure investments to even keep the current mild growth.
Despite the multitude of negative factors impeding the growth in infrastructure investments, there remain bright spots. The year of 2021 will be the start of China’s 14th Five-Year Plan Period, and new infrastructures such as 5G and urban renewal will create new demands for investments. The key is their magnitude. If the additional demands for new infrastructure investments are large enough, they would be able to offset the marginal decrease in demands for traditional infrastructure investments, meaning that the impact of total infrastructure investments on the macroeconomy would be more or less neutral.
Compared with infrastructure investments, market expectation on the recovery of consumer spending has never been optimistic. The monthly figure for total social retail sales did not return to the last year’s level until August this year, and the yearly growth will very probably be negative. Even slower is the recovery in service consumption, which was pulled back to last year’s level in as late as September. In comparison, the recovery of spending on durables was not slow, especially automobiles and electronic communication devices. These two sectors are typically cyclical, with a cycle of about 2-3 years. Starting from Q4, 2019, they have already entered a new cycle of recovery, which has sustained to today despite the disruption of the COVID-19 outbreak, and this is an important factor propping up the recovery of consumer spending up to now.
The overall slow recovery in consumer spending shows that there have been no remarkable improvements in household disposable income, and the cash inflows of households remain insufficient to support fast growth in spending. But meanwhile, some also hold the view that consumption is gradually replacing investments as the new force driving sustained macroeconomic recovery. This claim is based on the assumption of fast improvements in household disposable income, which, however, is actually closely associated with nominal economic growth. Therefore, viewing spending as the new driving force for economic recovery could be based on an ill-grounded circular logic.
Policy support is especially important against the lack of endogenous power for consumption growth. In 2009, to cope with the global financial crisis, China, for the first time, provided subsidies for rural residents to purchase cars, which played a crucial role in revitalizing the car market. On November 18 this year, the Chinese State Council reiterated the importance to stimulate domestic demands and consumer spending, and proposed concrete measures such as renewing the subsidies for rural residents’ car purchases and promote spending on home appliances, furniture and related goods. The ultimate policy effects will be determined by the scale of fiscal supports and corresponding incentive mechanisms. If the average level of fiscal subsidies can reach that in 2009, namely around 10%, without placing too much fiscal stress on local governments, we could expect a new wave of speedy recovery in durable spending.
In summary, the divergent understanding and predictions of the macroeconomic situation and policy responses going forward as discussed in this article have shaped opinions with regard to the Chinese economy’s performance in the coming year. This will allow us to make more focused and in-depth discussions. Of course, all these views will adjust to new facts on the ground. Divergences could turn into consensus, whereupon new divergence could emerge. That’s exactly where the charm of macroeconomic research lies.
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