Chinese economy in search of new stimuli

Commentary by Ben Bennett, Head of Investment Strategy and Research at LGIM

The latest data regarding the performance of the Chinese economy has been very disappointing, with many sectors experiencing negative year-on-year growth. To give a few examples, the retail sector is still grappling with the negative repercussions of the lockdowns in the past year, and consumer spending has also fallen short of expectations. Furthermore, while the investment in fixed assets has not experienced a drastic collapse, the construction segment has seen a significant decline, with the real estate sector erasing all the gains made in the immediate post-pandemic reopening period. These data indicate a widespread weakness across the entire Dragon’s economy, leading us to revise our growth estimates downward for this market in 2023, from 5.8% to 5.5%.

Understanding the problem

The overall picture just described leads us to believe that economic support measures from the central government are highly likely, as demonstrated by the more accommodating stance reflected in the recent statements by Yi Gang, President of the People’s Bank of China, followed by a benchmark interest rate cut. However, before examining the remaining solutions available to policymakers in Beijing, it is important to delve into the underlying issues that have led to this slowdown, in order to understand why the measures implemented so far have not yielded the desired results.

1. Unlike developed markets, the savings of the Chinese population did not increase significantly during the pandemic, leading the post-Covid-19 rebound effect to quickly dissipate. Moreover, few are willing to purchase homes from unreliable companies, and the global recession in consumer goods production has weighed heavily on the Chinese economy.
2. In the real estate sector, private individuals continue to face difficulties despite the extension of debt maturities and announcements of financing for the completion of various projects. Banks are cautious about granting credit access.
3. Below-expectation land purchases by real estate companies have left local administrations with substantial financing gaps.
4. Finally, issues with the so-called “local government financing vehicles (LGFV)” are evident, especially in the poorer regions, causing even greater concerns for banks regarding the stability of their balance sheets, particularly in relation to loans granted.

These factors have given rise to economic conditions that have neutralized the support measures implemented by the central government. In fact, if citizens are not purchasing new homes from private sellers, reducing the burden of mortgages is futile. Similarly, seeking bank financing to complete a project is futile if banks only trust public entities. Lastly, even cutting interest rates by a few basis points does not work because it creates problems for the balance sheets of credit institutions.

What economic stimuli could work?

An effective measure could be a capital injection from the central government to support LGFVs. With this liquidity, the government could purchase the debt of private companies and, at the same time, reignite infrastructure investments.

Beijing could relatively easily take this path, given that China’s public debt is relatively low, and the central government has the power to direct the actions of financial institutions to support local administrations. However, this solution also presents a major drawback, as it would represent a return to the old model of China’s growth driven by public investments and the real estate market, a model that President Xi Jinping has repeatedly expressed a desire to move away from. Additionally, it would lead to greater dependence of local administrations on Beijing, which is a politically controversial issue.

Therefore, we believe that the most likely scenario can be summarized as “more of the same.” We expect that several hundred billion yuan will be invested in the reasonably near future to facilitate local authorities’ spending on infrastructure, provide support vouchers for consumption, and finance banks’ willingness to grant loans. Unfortunately, this does not foreshadow significant changes in the path of economic growth, as these measures do not address what China really needs: a transfer of risks and potential losses from the balance sheets of local administrations to those of the central government. Another event that would benefit China would be a global investment and production boom, but given the current macroeconomic conditions, it is more logical to expect the opposite.

Is it the right time to be contrarian?

The disappointing data and the limited options for supporting the economy have led to a general negative sentiment among investors towards China, as many see a reversal of the growth trend as unlikely. It is worth noting that active allocation levels in this market are currently at a 20-year low.

However, given that public opinion seems to have overwhelmingly taken a negative stance, we at LGIM have decided to rebalance our position by increasing our exposure to Chinese equities in some of our multi-asset portfolios. This is because we believe that expectations for a positive turnaround are so low that even a small package of economic stimuli could boost confidence and significantly reignite private spending and investment.