By Tuuli McCully
The “Common Prosperity” ideology is set to drive Chinese authorities’ policy agenda, likely leading to continued government intervention into private sector affairs. A debt crisis in China’s real estate sector clouds the economic outlook; a targeted approach to debt restructuring is anticipated. Real GDP gains are expected to stabilize at slightly above 5% y/y in 2022, assisted by growth-supportive monetary and fiscal policies. Soft domestic demand will keep demand-driven inflationary pressures at bay.
PUBLIC POLICY CONSIDERATIONS
An ideological shift is taking place in China. The Chinese government is emphasizing “common prosperity” as one of its key policy objectives, pointing out that private sector capital should work for the people instead of being driven by profits. President Xi Jinping is working to mold China into a “modern socialist power”, where the private sector is asked to support the Communist Party’s goals. Given that China is a highly unequal society with large income disparities, we assess that the policy shift reflects the government’s priority of maintaining social stability. The “common prosperity” ideology seems to be behind the government’s increased intervention into private sector affairs, in such areas as technology, education, gaming, entertainment, e-commerce, property and many others. We believe that the government’s interventionist approach will remain in place in the foreseeable future.
China’s real estate sector’s debt burden has raised significant investor concerns in recent months, as Evergrande—one of the country’s largest developers—has failed to pay interest due on certain bonds, defaulted on bond payments in December, and will face further sizable debt repayments over the coming quarters. Real estate is one of the key pillars of the Chinese economy; therefore, potential broader financial stress needs to be monitored closely. While information regarding the current and future state of Evergrande remains scant, we foresee the government being involved in orchestrating a managed restructuring of the company, which would prevent its disorderly downfall and provide a guideline for any potential future challenges faced by the country’s other developers. Given the “common prosperity” goal and social stability considerations, we believe that the Chinese government will give priority to supporting ordinary people over institutional investors. Local governments, for example, are stepping in to ensure certain development projects are continued in order to protect those who have made down-payments on homes. This simultaneously underpins the construction sector and its suppliers, as well as overall employment in related industries. Nevertheless, such intervention builds additional financial pressure on local governments that are already facing lower revenues due to lacklustre land sales. Internationally, we assess that any global spillovers from the real estate debt crisis are set to remain limited and felt mostly through changes in international investors’ risk sentiment. This reflects the fact that the Chinese bond market is not deeply integrated into the global financial market due to China’s capital controls; foreign investors account for less than 5% of the onshore bond market’s investor base.
ECONOMIC GROWTH OUTLOOK
Downward pressures on the Chinese economy have intensified in recent months. The economy is facing several simultaneous headwinds: 1) the real estate sector’s downturn, 2) the Chinese government’s zero-tolerance toward Covid-19, 3) supply-chain bottlenecks, as well as 4) regulatory tightening and the government’s intervention into the private sector’s affairs. China’s real GDP expanded by 4.0% y/y in Q4 2021 following a 4.9% gain over the prior three months. Nonetheless, the country’s output increased by 8.1% in 2021 as a whole, thanks to rapid gains in the first half of 2021 that largely reflected a low base in the prior year when the economy came to a pandemic-induced halt. We expect the Chinese government to set a growth target of “above 5%” for 2022 following the annual National People’s Congress in early March. We assess that China’s monetary and fiscal policies will become more accommodative over the next few months, which will help the economy to meet the growth target. Accordingly, we forecast China’s real GDP to expand by 5.1% in 2022, followed by a 5.3% gain in 2023, in line with China’s estimated potential growth of around 5–6% y/y.
Chinese policymaking in 2022 will be focused on maintaining stability. Indeed, the policy environment is set to become more growth-supportive to prevent the economy from stumbling. On the fiscal side, local governments are accelerating their issuance of special-purpose bonds that are used for various infrastructure projects in such areas as technology, new-energy, urban transportation, utilities facilities, and rural development. Reportedly, the government is also considering additional tax and fee cuts to support manufacturing and small businesses.
Fixed investment remains a key growth driver in China, but tighter lending standards have resulted in a weaker growth in capital investment. The troubled real estate sector and related activities account for about a quarter of Chinese GDP; accordingly, weaker housing demand and less funding available for real estate development are adversely impacting fixed asset investment activity. While private sector sentiment remains fragile, some of the softness will be offset by higher public infrastructure investment.
Recent weakness in Chinese household spending reflects uncertainty related to the Chinese government’s zero-tolerance toward Covid-19 and softer employment prospects, highlighting the fact that China’s economic recovery remains uneven and fragile. The real estate sector’s debt crisis casts a shadow on the consumer as around 70% of household wealth is linked to real estate; fire sales and declining house prices would erode consumer confidence and household balance sheets, limiting spending prospects.
China’s external sector has benefitted from rebounding global demand with the nation’s exports in 2021 being 21% higher (in CNY terms) than in 2020. While we expect continued solid export gains, some moderation is likely in the near term as global demand dynamics will normalize from goods to services along with the reopening of economies. Moreover, high freight costs and material prices are hurting exporters. As the US remains China’s most important export market—shipments to the US accounted for 18% of total Chinese exports last year—the US-China trade relationship will play a key role in China’s external sector outlook. Following an intense trade conflict between the two countries over recent years, the US has recently resumed diplomatic dialogue with China. While we do not expect the Biden administration to announce any tariff reductions on Chinese imports in the near future, we consider the return to the negotiation table a positive development. Nonetheless, the bilateral relationship will remain challenging over the foreseeable future on the back of fundamental differences in ideology as well as in political and economic structures.
MONETARY POLICY AND INFLATION OUTLOOK
Conducting monetary policy in China is a balancing act between supporting the economy and addressing rising financial imbalances, such as weaker quality of debt. Nevertheless, it seems that the economy’s recent softness is pushing policy focus more towards supporting growth. Indeed, Chinese policymakers have recently encouraged banks to increase lending to help stabilize the economy.
Meanwhile, the People’s Bank of China (PBoC) will likely continue to lower financing costs in the real economy. The PBoC’s 1-year and 5-year Loan Prime Rate fixings have been lowered by 15 and 5 bps, respectively, since mid-December, and we expect further cuts of 10-20 bps in the first half of the year. In December, the PBoC cut the Reserve Requirement Ratio by 50 bps, and we foresee another reduction of the same magnitude in the first quarter of the year, potentially followed by another cut in Q2. The central bank will also continue to use targeted tools to loosen monetary conditions without increasing the economy’s financial imbalances. For example, providing support to small and medium-sized enterprises through the central bank’s relending program will underpin employment in the economy.
The PBoC will likely continue to monitor the banking system’s liquidity situation closely, stepping in to alleviate any stress resulting from the real estate sector’s debt crisis. Should weaker lenders encounter any financial difficulties in the face of potentially rising non-performing real estate loans, we would expect China’s monetary authorities to intervene effectively to limit any banking sector instability. We also note that the Chinese banking system is dominated by state-owned banks, which will underpin confidence in the financial system during times of stress.
We forecast China’s headline inflation to accelerate somewhat from the December 2021 level of 1.5% y/y. While inflation is set to remain well below the government’s 3% target, we expect growth in consumer prices to reach 2.3% y/y by the end of the year on the back of base effects, higher food prices, as well as elevated input costs being partially passed over to consumer prices. Price pressures further up the distribution chain remain high for now (at 10.3% y/y in December) but will likely ease over the course of the year. We believe that firms’ limited pricing power—due to weak domestic demand—is likely to prevent a significant spillover from the producer side to consumer prices.
About the Author
Tuuli McCully is Scotiabank’s chief economist for the Asia-Pacific region. Tuuli is a regular contributor to international media outlets, including Bloomberg, BBC World News, CNBC, and Reuters. She is also actively involved in market strategy and client development and is a regular contributor to the Economics Department’s publications. Tuuli joined Scotiabank in 2006 in Toronto; she has been based in Singapore since 2016. She holds a Master of Science degree in Economics from the Helsinki School of Economics in Finland. She is currently pursuing a Ph.D. in Economics on a part-time basis.
