- Retail sales increased more than expected while urban Fixed Asset Investments pared Q1 losses. Moreover, Caixin’s Services PMI rebounded sharply to 56.8, the sixth month above the watershed level (50).
- Growth is on track to reach our forecast of 2.1% for 2020, which assumes a stronger recovery of 6.9% y/y in Q4. Moreover, economic recovery is becoming broader based, which together with a strong favorable base effect in Q1, points to upside risks in 2021. We have therefore revised our 2021 GDP growth forecast up to 8.0% from prior 7.5%.
- China’s 14-FYP and vision for 2035 will place more emphasis on domestic demand. This will be key to unlock China’s future growth potential, as final consumption expenditure remains low in relative terms (Chart 2). No growth target was announced. However, it is likely that a flexible GDP range (4.5-5.0%) combined with a per capita income target will be announced ahead of the National People’s Congress.
- Going forward, PBOC will likely implement targeted measures to curb tighter domestic liquidity. However, substantially positive nominal interest rates and a wider real rate differential with the United States should continue to support inflows into bonds and fuel further currency appreciation.
Economic recovery is becoming broader based
The economy expanded 4.9% y/y in Q3, up from 3.2% in Q2 and -6.8% in Q1. The supply-side continued to lead the recovery. Exports increased 9.0% y/y on average in Q3, compared to 0.2% in Q2, on the back of higher demand for electronics and personal protective equipment (PPE). This helped to propel a recovery in the manufacturing sector, with industrial production rebounding to pre-COVID levels (Chart 1). Growth is on track to reach our forecast of 2.1% for 2020, but there are some downside pressures, as this assumes a stronger recovery of 6.9% y/y in Q4. Fresh lockdown measures in key export markets such as the US (19% of total exports) and Europe (17%) will likely drag on activity in Q4. Continued demand for PPE and 5G phones may help to offset some of the downside, but this may not be enough.
On the bright side, September activity indicators show that the recovery is spilling from the supply side onto the demand side. Retail sales increased to 3.3% y/y and urban Fixed Asset Investments (FAI) also pared Q1 losses, expanding by 0.8% y/y YTD. The uptick in FAI was supported by both public and private sector investment. Notably, real estate investment increased by 5.6% y/y, up from 4.6% the previous month. This narrative is further reinforced by better performance in services. The National Bureau of Statistics’ (NBS) non-manufacturing PMI reached 56.2 in October, while Caixin’s Services PMI reached 56.8, the sixth month above the watershed level (50).
China’s economic recovery is becoming broader based, which together with a strong favorable base effect in Q1, points to upside risks in 2021. We have therefore revised our 2021 GDP forecast up to 8.0% from prior 7.5%. There are, however, some downside risks to this scenario. China’s structural fragilities have increased during the postpandemic period, tied to a buildup in corporate leverage (260% of GDP). Moreover, it is unlikely that geopolitical tensions will dissipate overnight in spite of the latest election outcome. Democrats may prioritize sanctions over tariffs and show renewed interest in multilateral trade deals, but existing tariffs will remain in place for some time, as support for a tougher stance on China is bipartisan.
China to focus on quality over quantity of growth in the next five years. What does this mean ?
198 members of the Central Committee met during the Fifth Plenum in late October to discuss China’s 14th Five-Year Plan (14-FYP, 2021-2025). The meeting also provided insights into China’s long-range objectives through the year 2035. official draft will only be approved during the National People’s Congress (NPC) on March 2021. Based on the preliminary proposals released after the Fifth Plenum, we have summarized the top 5 themes below:
- Growth targets: No specific GDP target was announced, with the communiqué emphasizing quality over quantity of growth. However, this target will not be abandoned entirely, as China needs to continue expanding its economy to avoid falling into the middleincome trap, doubling per capita Gross National Income (GNI) levels before the end of the five year period in order to exceed the World Bank’s threshold of USD 12,536 for high-income nations. This 14-FYP period will likely feature flexible annual GDP range (4.5- 5.0%) targets combined with a per capita GNI target to achieve this goal. More details to be released during December’s Economic Work Conference.
- Internal circulation: This is the main component of China’s “Dual Circulation” strategy and places more emphasis on domestic demand. China’s final consumption expenditure as a share of GDP is low relative to other markets according to figures by the World Bank (Chart 2). China will need to boost domestic consumption significantly between now and 2035, making this a source of global growth. The second part of internal circulation affects selfsufficiency. In line with “Made in China 2025”, China aims to become a global leader in key 21st Century technologies, which will require domestic innovation. The plan also aims to reduce dependency on imports of foreign high value-added components to hedge external risks, as some vulnerability has built up over the years. For instance, integrated circuits have overtaken crude oil to become China’s largest import since 2015, reaching 305 billion USD in 2019.
- External circulation: Opening and reform will continue to be pursued, albeit in a targeted manner. Foreign Direct Investment (FDI) into high value-added sectors will continue to be encouraged. High quality Outbound Direct Investment (ODI) will also be promoted, with a focus on the Belt and Road. Lastly, the authorities will forge ahead with plans to gradually internationalise the currency through heightened use in trade denomination and along the Belt and Road.
- Carbon neutral 2060: The President announced this goal in the UN Assembly in Sept 2020. A key feature of China’s plan to become a high-income nation is to ensure that environmental standards are not compromised in the name of development. Promoting a carbon neutral target by 2060 also links up to internal circulation by allowing China to dominate in key hightech sectors.
- Structural reforms: The Fifth Plenum did not fail to mention China’s structural fragilities. The market will be given a more prominent role in resource allocation. This suggests that structural reforms and deleveraging efforts will continue to be pursued in order to boost total factor productivity. The hukou household registration system may be relaxed further to facilitate urbanisation in second and third tier cities.
Policy stance to remain targeted ahead of March 2021
The People’s Bank of China (PBOC) underwent an easing cycle between January and May this year (Chart 3). However, the bank has since adopted a more pragmatic approach to managing the crisis. It left rates on hold and opted instead for forbearance and targeted measures to support lending amongst small and medium enterprises (SMEs), which account for 80% of employment. These include postponing the reporting of non-performing loans and a moratorium on interest and principal repayments for SMEs until March 2021. That allowed the banks to report no significant increase in the non-performing loan (NPL) ratio in Q2 (1.94%). PBOC also required big commercial banks to boost loans to SMEs by 40%, compared to 30% in 2019.
However, domestic liquidity has tightened significantly as a result of PBOC’s targeted approach and the ongoing recovery. The Shanghai Interbank Rate (SHIBOR) has edged up gradually since May, reaching pre-COVID highs, and banks’ NCD spreads widened the most since May. This may become an issue as we near the end of the moratorium period on March 2021, as a potential increase in insolvencies could erode household income via the employment channel, derailing the recovery in domestic demand. However, this should not be systemic in nature, as
we expect that PBOC will intervene to ensure that liquidity remains ample ahead of the transition. Insolvencies remain subdued, while bond defaults slowed in the first 9 months of 2020 relative to the same period last year. Rather than rate cuts, we expect more qualitative fixes, including liquidity injections via open market operations and even extensions to the current financial forbearance guidelines.
Implications for investors
- Internal circulation: Domestic-oriented sectors stand to benefit the most from the 14-FYP and 2035 vision.China’s drive towards self-sufficiency will also benefit new infrastructure. We have seen sector rotation into cyclicals and defensive sectors in the past months, but the investor’s preference continues towards a growth tilt, leading MSCI China (MXCN) to increase by 8% in October, recovering by 50% since March lows. Heading into H1 2021, the gradual rotation into quality growth will likely continue, with a heavier focus on consumption.
- Cyclical laggards: Cyclical laggards will continue to experience headwinds heading into H1 2021, as the onus will shift to the domestic front. These include old infrastructure (cement, construction, machinery), financials, airlines, utilities and energy.
- Government bonds and FX: PBOC’s targeted policy stance has resulted in substantially positive nominal interest rates. Together with stabilising inflation, this should continue to support inflows. Moreover, the domestic tilt should result in a shift in foreign exchange policy, leading to further strengthening on the nominal and real effective exchange fronts.
Senior Economist, Asia