Zero-Covid weighs on China’s growth in Q2

At 0.4% year-on-year (YoY), GDP growth in the second quarter of 2022 was down sharply from the already below-target 4.8% in the first quarter. Beijing has already stepped up its easing policy to boost growth and introduced more flexibility in its zero Covid policy.

Nonetheless, lockdown measures aimed at containing the spread of the virus continued to hamper business. Other headwinds include the recent boycott of mortgage payments by buyers of unfinished homes as developers struggle to stay afloat. At this stage, its impact remains uncertain.

We therefore do not expect a V-shaped growth rebound in the second half of 2022, although we believe that the medium-term outlook is improving.

Missing the growth target

Even if GDP were to grow by 5-6% in the second half of the year – which we consider an optimistic assumption – full-year growth is likely to be well below the official target (see chart 1). The market consensus for growth in 2022 is between 3% and 4%.

In June, there were signs of recovery amid looser Covid restrictions and macroeconomic policy support.

Notably, industrial production rose 4.0% year-on-year (vs. 0.7% in May) thanks to improved production of cars and electrical equipment. Retail sales increased by 3.1% (after -6.7% in May) driven by the strength of automobile and restaurant sales. Fixed asset investment rose 6.0% (vs. 4.7% in May), supported by a 13% increase in infrastructure investment.

Political stimulus and risk

The easing of policy after April’s Politburo meeting and a steady easing of lockdown measures have seen China’s stock market post a notable rebound since late April. This recently came to an end after a sub-variant of Omicron caused Covid curbs to surge in a number of cities (Exhibit 2).

Generally speaking, Beijing has stepped up its policy support since the second quarter by accelerating the issuance of special local government (LG) bonds, increasing tax refunds, injecting more liquidity into the economy and easing real estate policies.

Further easing is likely to come in the form of further infrastructure spending1 and funding. Infrastructure investment is already showing a strong recovery. The financing will include the carry-over of RMB 1.5 trillion in special LG bonds from the 2023 quota, the easing of financing conditions for Local Government Financial Vehicles (LGFV) and the increase in political bank loans (estimated at RMB 800 billion). RMB) to environmental projects.

Unlike most countries in the world, high inflation is less of a problem for China. Headline consumer price inflation has averaged around 2.0% yoy and core inflation around 1.5% yoy since 2013.

This allows China to conduct an accommodative monetary policy in the face of global policy tightening. As a result, overall funding picked up (Figure 3) and the DR-007 money market rate remained well below the People’s Bank of China’s target of 2.1%.

In our view, the biggest risk to growth is the zero-Covid policy. The resulting uncertainty has hurt production and supply chains, mobility and especially the capital goods and consumer sectors.

Loss of consumer and business confidence and economic disruption are problems that monetary easing cannot effectively address. Therefore, we expect Beijing to step up its fiscal stimulus to directly increase aggregate demand.

What changed?

After more than a year of regulatory tightening on technology and related sectors, this headwind to growth may ease as investigations into major fintech and e-commerce companies are completed. Future regulatory reform is likely to focus on policy implementation rather than the introduction of new regulation. This should dissipate much of the political uncertainty in these sectors.

Further relief could come from the increased flexibility of the zero-Covid approach since June. Lockdowns are now quick and targeted, while quarantine periods have been shortened. Only non-essential services are suspended, PCR testing in high-risk areas is more frequent, and low-risk areas are reopened more quickly.

This new approach should reduce widespread disruption from lockdowns, help protect supply chains and reduce political uncertainty.

However, with an increasing number of homebuyers defaulting on their mortgages, there is a new risk to growth. This concerns homes purchased on pre-sold terms that are not completed and delivered to buyers by cash-strapped developers.

Since pre-sales have dramatically increased developer leverage, the increased mortgage payment boycott could create a credit crunch for developers and lead to defaults in offshore US dollar bond markets (where they borrowed heavily) and more non-performing loans in local banks.

There is a potential risk of contagion: rising mortgage defaults could hurt homebuyer confidence, further dampen property sales and force more developers to put projects on hold. This could lead to more mortgage defaults, creating a downward spiral of housing problems.

What can Beijing do?

To contain systemic risk, Beijing may ease property market policy further, although a general bailout is not expected.

In addition to ample cash, it can leverage the resources of local government, SoE and LGFV to kick-start suspended projects and maintain public confidence by signaling that housing completions are a top priority. Public developers can also take over from weak developers to weed out bad players and help shore up the real estate market.

Recently, regulators asked the China Construction Bank to set up a fund to buy real estate projects under construction and convert them into long-term rental apartments. If this practice is implemented more widely, it could amount to a Troubled Asset Relief Program (TARP) of the type the US government put in place after the 2007-2008 global financial crisis to purchase toxic assets and stabilize the financial system.

Reallocation to Chinese Assets

Macro headwinds could trap government bond yields in the 2.8% to 3.0% range in the coming months, with the upside limited by worries about growth and monetary easing and the lowered by concerns about credit risk and the resumption of credit impulse.

Political risk will likely create volatility for Chinese equities in the near term, but the market also welcomed the domestic good news, particularly on a more flexible zero-Covid policy, paving the way for an eventual recovery.

In our view, the medium-term outlook is brighter for China than for the West, where clouds have begun to gather in the United States (which is facing recession) and Europe (which is suffering from its dependence on Russian energy).

So, in relative terms, the divergence in China’s monetary policy and GDP trends relative to the West could prompt investors to eventually reallocate assets to China-related assets.


1 As we argued recently, China needs a Keynesian solution to save growth in addition to monetary easing. See “Chi Flash: Saving China’s Economic Growth», April 25, 2022.


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Robert D. Coleman