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4 May 2023

Policymakers caution about China’s economic outlook despite upbeat data

Key takeaways

• Chinese stakeholders across business, finance and politics remain unconvinced about the strength of the country’s economic recovery. The Politburo highlighted that improvement is mainly “restorative”, and that weak internal dynamics persist.
  
  
• Real estate sector activity slowed again in April after a strong Q1 – prompting speculation about pent-up demand having already been exhausted.
  
  
• China’s long-term economic growth outlook is increasingly being put into question, with geopolitics often being highlighted as a major obstacle. The fundamental mismatch between the CPC and China’s private sector is also a significant challenge.

Investors are not fully buying into the rebound story

Retail sales for March exceeded expectations by a significant margin. Importantly, Chinese households are spending on services and discretionary goods such as clothing, cosmetics, and jewellery again – even exceeding 2021 and 2019 levels that were not distorted by pandemic restrictions. This year’s Labour Day holiday also strengthened the narrative of a strong recovery, with spending and number of trips made above pre-pandemic levels in many parts of the country.

At the same time, market participants and policymakers are becoming less optimistic. The services section of the non-manufacturing PMI fell to 55.1 in April from 56.9 in March – with construction activity still being the indicator’s driving force at 63.9. Investors in Hong Kong argue that a rebound was going to take place almost by default, but now question its sustainability and if we are seeing the start of a new robust expansionary economic cycle. This is also reflected in the prices of commodities and Chinese equities, which have given up large portions of their post-pandemic gains. Even travel stocks fell 5%-15% on the first day of trading after the Labour Day holiday. Starbucks also pointed out in its earnings call on May 2nd that sales have moderated after the initial boom. In Beijing, the Politburo seems to agree. Indeed, China’s leadership noted when it met on April 28th that “the current improvement in economic performance is mainly restorative”, and that China’s post-pandemic recovery continues to be challenged by weak “internal dynamics”. Moreover, as evidenced in retail sales data, the recovery is highly uneven with luxury sales booming and urban demand much stronger than in rural areas.

Leaders noted that “restoring and expanding demand is the key to a sustained economic rebound”, but offered few details about what will be done to achieve this. Shopping festivals are taking place across the country, but they will not increase demand in absolute terms unless incomes also increase. If wages remain stagnant, they will merely divert spending from one item to another. This is not to say that policymakers are ignoring the importance of income growth. On the contrary, it has been a key theme for the last few months. The issue, however, is that policymakers seemingly are not too interested in trying to make up for years of weak income growth – which in part could be addressed through cash handouts as suggested by numerous policy advisors. One reason for this – besides fiscal constraints – is likely that even if the central leadership wants income levels to rise to support domestic demand, they also face pushback from local officials whose main priority is to keep their manufacturing firms “competitive” versus national and international rivals.

Short-term bounce to a new normal in the real estate sector

Cautious optimism is also the prevailing view of China’s real estate sector. Similar to the broader economy, recovery is taking place from extremely depressed levels in 2022 – albeit mainly in wealthier urban areas. But weakening sales data – even in tier 1 and 2 cities – and fewer people coming to view properties in April, has prompted some speculation about most pent-up demand having already been exhausted. With the introduction of a property tax also looming, investors, would-be homeowners and developers remain in “wait and see” mode.

While demand may improve again if the broader economic recovery strengthens in the months ahead, the long-term trajectory for the sector is less bright. Beijing has made it clear the industry will not return to its “glory days”, and most market participants believe annual sales only will return to levels seen between 2016 and 2019 – well below the 2021 peak. This view is supported by construction data, which showed that floor space started in Q1 fell by 18% from already low 2022 levels. This is partly because project completion and destocking are being prioritised, and partly because buyers remain sceptical about pre-paying for unfinished homes. Indeed, demand for second-hand homes continues to outperform newbuilds. Builders are likely also taking into count the eventual introduction of a property tax, which will further erode the appeal of investing in real estate.

The outlook for private developers is looking particularly challenging, especially for those with significant exposure to cities ranked as tier 3 or lower. While private developers focused on tier 1 cities who also happen to be publicly favoured by Beijing, such as Longfor, have performed well in 2023 – seeing sales more than double from both 2019 and 2022 levels – this is not the case for the majority of private developers. Guangzhou-based KWG for instance saw sales decline for 13 straight months before it eventually defaulted on May 2nd. Conversely, in part, because buyers know there is substantially less risk of delays on projects run by state-backed entities, many SOEs have seen triple-digit sales increases on both a YOY basis and relative to 2019 levels. Hangzhou-based Greentown for instance, which is 28% controlled by the State-Owned Assets Supervision and Administration Commission, saw March 2023 sales increase by 456% from 2019 levels.

Questions about China’s medium-to-long-term growth prospects

Looking beyond the still uncertain post-pandemic recovery, a somewhat downbeat consensus is emerging about China’s medium-to-long-term growth outlook. Geopolitics is often highlighted as a key factor because it is eroding China’s appeal as an investment destination. The Politburo noted during its April 28th meeting that “economic transition and upgrading face new headwinds” – likely referring to geopolitical obstacles complicating its “high-tech ambitions”. Domestic investors are also not fully convinced that the tide has turned despite Beijing’s best efforts to persuade entrepreneurs they are welcome and needed. Not only are funding costs often 200-300 bps higher for private firms than for SOEs, but there is also concern that another “regulatory cycle” will be launched once the private sector again grows too powerful for the CPC’s liking in 5-10 years’ time.

Beijing’s challenge is that it needs a strong and vibrant private sector to deliver what President Xi Jinping describes as “high-quality growth”, or private investment and consumption. But as most people agree, including Wen Jiabao, the former premier, reforming the economy towards “high-quality growth” will also require political reform that possibly could risk undermining the CPC’s grip on power. Meng Wanzhou, the daughter of Huawei founder Ren Zhengfei, may not have been talking about the difficult relationship between the CPC and China’s private sector when she said “Innovation is only possible with an open mind” during a launch event at Huawei’s Dongguan offices in April. But she nevertheless crystallised one of the key challenges facing China’s economy in the long term.

Key considerations

• The start of an expansionary Chinese economic cycle is no longer a guarantee for commodity price booms. The real estate sector is not being used as a “growth booster”, and there is a limit to how much new transportation infrastructure that can be built.
  
  
• Investors believe there still are profits to be made from betting on troubled private real estate developers and will need to carefully assess regional exposure. China’s recovery is highly uneven, especially in the property market.
  
  
• Foreign firms competing with Chinese peers in China and on the global stage need to take note of extraordinary efforts by policymakers to increase Chinese market share in global trade. The automobile and solar stories are likely just the beginning.

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