China’s ‘zero tolerance’ tests growth and the renminbi

China’s currency has weakened dramatically. Since mid-April, the renminbi has fallen to its lowest levels against the US dollar in a year and a half. Headwinds are intensifying against the country’s economy, casting doubt on whether the current mix of macroeconomic and public health policies can deliver the growth targeted by China’s government in a key political year. 

China’s economy is slowing significantly at the start of the second quarter due to its zero-Covid efforts to contain the omicron variant. China’s manufacturing and service sector surveys contracted in April for the second month in a row, with services at a reading of 42, their lowest level since February 2020. China’s urban unemployment rate jumped to 5.8% in March and will likely rise further. Even if China begins to ease restrictions in mid-May, its economy is on course to decelerate to below 2% growth in the second quarter, year-on-year. That would be the second-slowest growth recorded since the 1990s. 

Much of the world is operating at various levels of ‘co-existence’ with Covid. In contrast, China continues to work towards eradicating infections, but the high transmissibility of new variants has forced the authorities to resort to unpopular measures such as confining residents to their apartments. What started in late March as a two-phase, nine-day lockdown to contain Covid outbreaks in some of the largest cities including Shanghai, Beijing and Shenzhen, has become a two-month long battle requiring the isolation of an estimated 370 million people in 45 areas. 

Until recently, China’s pandemic strategy looked effective. For two years, the country never recorded more than a few hundred Covid infections per day, shielding industries from disruption. As a result, China’s economy recovered from the early pandemic shock quickly and total deaths as a share of its population have been lower than any other major economy. The approach appeared to be working well as recently as February, when new clusters of infections were quickly suppressed without a meaningful impact on economic activity.

Then between March and April, the number of reported new cases in China jumped to average around 30,000 per day and lockdowns followed. The more infectious omicron variant is unlikely to be suppressed completely even under China’s lockdowns. While Shanghai’s case numbers have declined, the city of Beijing is now on alert for a significant epidemic spike. Unless the country significantly shifts its public health strategy, major cities will continue to need to impose shutdowns, creating further negative shocks to near-term growth.

Our expectation is that the basic approach of “zero Covid” will be maintained over the next few months despite the economic costs. China’s elderly population needs additional protection against the virus due to inadequate booster jabs, and less effective domestic vaccines. The 20^th Communist Party Congress late this year, at which President Xi Jinping’s term will be extended and Communist Party (CCP) elites promoted, makes re-opening cities while Covid deaths continue to rise, politically unacceptable. Now that Shanghai’s situation seems to be stabilising, the authorities will prefer to see meaningful virus suppression followed by the relaxation of the toughest movement restrictions to allow consumption and industrial activities to rebound. 

In the longer-run, we still expect China to plan for re-opening after the CCP Congress. This will likely combine mass testing with more effective US and European vaccines, or the widespread use of oral antiviral pills. For now, China’s switch to an endemic Covid strategy will have to wait until the year’s end.

Growth dilemma

Given the Covid outbreaks’ impact on consumption and industrial output in the first half of 2022, we expect 2022 GDP growth closer to 4.3%, assuming the economy can begin to recover before June, and then rebound. This factors in recent hints by the Chinese leadership about additional easing. If the economy continues to suffer from successive lockdown shocks for key urban areas, full-year growth would certainly fall below 4%. 

With growth set to miss the official target, the Chinese leadership is guiding officials for more support measures. President Xi has reportedly told officials that China’s growth should be higher than the US’s and there must be efforts to strengthen infrastructure. The CCP Politburo also announced on 29 April that they “should waste no time in planning more policy tools” and “keep the economy running within a reasonable range.”   

While US and European monetary policy is focusing on tightening to fight inflation, China’s central bank has moved in the opposite direction for almost a year to stimulate growth. As the economy slowed, the People’s Bank of China (PBoC) in July 2021 resumed cutting the country’s Reserve Ratio Requirement (RRR) – the proportion of deposits that commercial banks have to set aside. A reduction in the RRR releases more liquidity into the banking system, and we expect the PBoC to cut this ratio by an additional 25 basis points in next weeks.

We also expect the government to boost fiscal spending more than announced in the National People’s Congress formal March budget. It will probably offer households and small and medium-size businesses direct support to counter the effects of lockdowns. The government will also consider increasing bond issuance at the local government level, as well as more aggressive capital expenditure on infrastructure projects. We previously expected a fiscal policy expansion worth 1% of GDP, and now see that figure rising to 2%, or more. The new stimulus plans will provide a degree of support for China’s infrastructure and strategic technology industries. 

Meanwhile, the PBoC plans to facilitate loans to targeted sectors and borrowers. To take fiscal policy further, China’s leadership would have to use local government financing platforms that created instability after the 2008 crisis. For now, this looks unlikely.

Is regulatory policy also shifting?

The government has also begun to hint at changes in regulatory policy. The property sector, which accounts for around one quarter of GDP, is already seeing a gradual shift. A series of restrictions imposed in August 2021 to cap speculation and rein-in leverage have slowed demand for housing and mortgages. To contain real estate risks, local authorities have been easing borrowing terms for homebuyers. Tight controls on financing for developers are also thawing, as developers tap onshore capital markets directly or use letters of credit issued by banks. However, the market remains volatile as default and restructuring worries on Chinese developers’ debt linger. 

China’s authorities also appear to be working to diffuse tensions over the listing requirements for Chinese firms on US stock exchanges. Starting in March 2022, the Securities and Exchange Commission has been naming Chinese stocks listed in the US that do not meet its audit and accounting regulations that date from 2020. Unless the named Chinese companies cannot provide required financial records to the US audit body, the US holding Foreign Companies Accountable Act may de-list them from public exchanges. 

While there is no clear resolution to the issue yet, China has signalled that it does not want to let it trigger another shock to capital markets, at least offering some hope that the question will not escalate. Still, even once added to the SEC’s list of non-compliant firms, Chinese companies have a two-year window in which to meet the requirements, or perhaps re-locate their listing to Hong Kong. The Chinese government is also signalling a potential easing of technology crackdowns that were a key source of volatility for China’s stock markets in 2021. It is holding a symposium with major tech companies to discuss their role in the economy, and reports suggest that the government may reassure businesses that regulators would refrain from further ‘rectifications’ or imposing new fines. This led to an exceptional rally in Chinese tech stocks last week.

Neutralised exposures

To capitalise on the growth in the world’s second-largest economy, we first included Chinese government bonds in our portfolios in July 2020. We then increased exposures because the sovereign debt offered an attractive yield compared with US 10-year Treasuries. In addition, the country enjoyed a more advanced pandemic recovery along with improving foreign investor access and a low correlation to other markets. 

This year, many of these factors have changed significantly and led us to adopt a neutral positioning. In particular, the yield spread between Chinese and US rates has now been eliminated as monetary policies diverge. Still, while renminbi-denominated Chinese government debt no longer offers a carry advantage over US Treasuries, we believe that globally invested portfolios can still benefit from the diversification effect, as they are de-correlated with most major asset classes. 

We remain neutral on Chinese equities. Valuations remain attractive versus both developed and emerging markets, but risks surrounding slowing growth, a property slump, stringent regulation of technology platforms and potential geopolitical ramifications keep us on the sidelines. To restore confidence and trigger a sustained rally, investors need more positive policy signals. Defensive sectors, such as healthcare and food staples, may be relatively more insulated from macro and currency weaknesses. Infrastructure spending should support some industrial, utility, and technology stocks. Once regulatory risks dissipate, Internet names that hold high levels of cash and can continue to support buybacks may benefit.

We have also adopted a more neutral view on the Chinese currency. The war in Ukraine, where China is trying to balance its conflicting geopolitical and economic interests, and slowing global growth have boosted demand for the US dollar since the start of the year. Until mid-April, the Chinese renminbi had remained stable against the dollar. That changed suddenly when the currency fell to a level not seen since November 2020. The move reflected investors’ disappointments with the damage from the lengthy and successive lockdowns as well as incremental monetary and fiscal policy support. 

This said we do not believe that China’s currency risks the kind of devaluation that it recorded in 2015-16 when annualised inflation was falling rapidly. We expect dollar-renminbi to trade in the 6.7-to-6.9 range over next three months with some scope for upside if the dollar strengthens against other major currencies. That implies additional renminbi depreciation from the current exchange rate of 6.60.