China Updates: Assessing the growth outlook and tail risk of Russia-related sanctions

Better than expected GDP Growth in Q1 but at risk to decelerate in Q2.  China’s economy grew at 4.8% YoY, better than the 4.2% consensus expectation as per Bloomberg survey in Q1.  The growth was driven by exports (+13.4% YoY in RMB terms) and fixed asset investment (+9.3% YoY).  Among fixed asset investment, the strength were mainly in infrastructure investment (+8.5% YoY) and manufacturing investment (+15.6% YoY) while property investment remained subdue (+0.7% YoY).   Industrial production came at +6.5% YoY but capacity utilization fell to 75.8% from 77.4% and 77.2% in Q4 and Q1 2021 respectively. Having been hit more harshly by COVID-related lockdowns, services was up only 2.5% YoY and retail sales rose 3.3% YoY in Q1 2022.

The risk is that the economy will decelerate further.  Looking into the details of the Q1 GDP and discerning the economic performance in March versus January and February, there was a significant slowdown in growth in March.  Industrial production slowed to +5% YoY in March from +7.5% YoY in January and February.   Fixed asset investment decelerated to 7.1% YoY in March (Jan & Feb: +12.2% YoY) and manufacturing investment was almost halved at 11.9% YoY (Jan & Feb: +20.9% YoY).  Retails sales fell 3.5% YoY (Jan & Feb: +6.7% YoY) and property investment declined 2.4% YoY in March (Jan & Feb: +3.7% YoY).  In March, unemployment rate rose to 5.8% nationwide (Jan & Feb: 5.4%). 

Intensified Covid-related lockdowns late March have caused severe disruption to production and logistics.  Economic growth in Q2 is set to slump.   Analysts at Nomura Securities estimate  that 45 cities that account for 40% of China’s GDP and 26% of population are under partial or full lockdowns.  Goldman Sachs analysts estimate that cities making up for more than 30% of China’s GDP are under partial or full lockdowns. 

To ease severe disruption to the operation of key industries, on April 16, Shanghai released a guideline and a list of 666 enterprises, mainly in auto manufacturing, pharmaceuticals, healthcare, semiconductors, energy and chemicals, eligible for resumption of production.  Nonetheless, challenges remain in getting the workers in locked down areas back to the factories and getting parts and supplies. 

According to China Merchant Securities, as of April 15, truck freight traffic indices fell 84.7% YoY in Shanghai, 42.9% YoY in Jiangsu province, 41.2% in Beijing, 23.8% in Guangdong, 10.8% in Zhejiang province, and 25% nationwide; national logistic park turnover index fell 37.2% YoY; major courier enterprises’ distribution centre turnover index declined 37.7%. 

Since April 7, various arms of the Chinese government have announced initiatives to mitigate the disruption including implementing nationwide Covid-test passport for truck drivers so as to avoid drivers being stopped for Covid-test everywhere or denied access to highways by local authorities.  The latest of such effort was a special State Council video conference on April 18, aiming at securing the smooth functioning of logistics and stabilizing the industry supply chain.  Vice Premier Liu He attended and spoke at the meeting. 

Lockdowns affecting spring planting of grains. While the lockdown of Shanghai and the resulting disruption to the operation of Tesla’s Shanghai factory and the production plants of Apple suppliers captured much attention, it is also important to note the potential negative impact of lockdowns on China’s grain production this year.  Restriction on people mobility during this time of the year caused problem to farms that need labor to do the spring planting.  Some of the rural population who have left their farms to work in the cities as migrant workers need to return to their farms during this time of the year to help spring planting.  This year, they are stuck by Covid-related lockdown. 

Jilin province accounts for about 10% of China’s acreage for farming corns.  The province has been locked down since March 15.  The disruption to people mobility and supply of fertilizers has posed threat to the spring planting season in April.  While the situation has been eased with gradual lifting of lockdown in the province and special transport arrangement from the local governments to help farmers to return to their villages, the priority of Covid-zero approach persists and similar risks may arise again in Jilin or other major grain farming provinces. Food security is particularly important in 2022 as the Russian invasion of Ukraine has removed a large amount of grain supply from the world market and sent prices sky high. 

March credit growth improved but loan demand was still weak. China’s new aggregate financing (AF) increased to RMB4,650bn in March from RMB1,193bn in February. It took the growth rate of outstanding AF to 10.6% YoY in March from 10.2% in February (Figure 1).  The growth rate of  outstanding RMB loan growth was unchanged at 11.4% YoY. M2 growth rebounded to a higher-than-expected 9.7% YoY in March from 9.2% in February.

The increase in new loans was mainly driven by new short-term corporate loans and bill financing, not medium to longer term loans.  New loans to the household sector picked up to positive RMB754bn in March from negative RMB337bn in February, but were still well below their level a year earlier of RMB1,148bn. The medium- to long-term component (mostly mortgage loans) improved to positive RMB374bn from negative RMB46bn a month agao, but still far below March 2021’s level of RMB624bn.  The People’s Bank of China (PBoC) has been encouraging banks to lend but demand for medium to longer term loans is still weak.  The still-weak mortgage loan growth also suggests a continued contraction in the property sector despite the rolling out of numerous supportive policies from many local governments. 

The PBoC cut Reserve Requirement Ratio. On April 13, in a State Council executive meeting chaired by Premier Li Keqiang, the Chinese Government pledged to “cut reserve requirement ratio (RRR) at the appropriate time”.  On April 15, the PBoC announced a reduction of RRR by 0.25% which was estimated to increase the loanable fund in the Chinese banking system by RMB 530 billion.  While the timing was well within expectation, the magnitude was smaller than the 50bps widely anticipated.  In fact, it was the first time that the PBoC cut RRR by only 25bps instead of the typical 50bps or even 100bps in times. 

The PBoC has also defied expectations and has not cut its policy 1-year Medium-term Lending Facility (MLF) rate.  The PBoC seems concerned about the relative tight net interest margins for banks and calls for small and medium-sized banks to lower deposit rates by 10bps. 

The PBoC may also want to keep some powder dry and not to fire all bullets in one go.  As we have discussed before, the room for the PBoC to cut rates is quite limited, given the yield spread between Chinese government bonds and U.S. Treasuries have turned negative across the bulk of the yield curve from 2-year to 20-year (Figure 2).  In recent years, foreign investors have been investing in Chinese government bonds to benefit for the positive carry. With the spread between Chinese government bonds and U.S. Treasuries having narrowed and eventually turned to negative, foreign holders of onshore Chinese bonds, mainly Chinese government bonds, have turned to be net seller in February and March 2022.  The China Central Depository and Clearing data shows that foreign holding of Chinese bonds having decreased by RMB 165 billion to RMB 3.57 trillion in March from its January high of RMB 3.73 trillion (Figure 3). 

It is important to note that the terms of trade for China has been deteriorating as the prices of energy and commodities surging.  China imports over 70% of its crude oil consumption, 40% of natural gas and 20% of grains (including soybean) which are all priced in the dollar.  A steadily appreciating renminbi versus the dollar has helped kept China’s inflation low.  It is understandable that the PBoC does not want to incur depreciating pressure on the renminbi with aggressive rate cuts. The PBoC may be inclined to adopt other easing measures than relying primarily on cutting policy interest rates to support the economy.  Recently, the PBoC has transferred RMB 600 billion of retained earnings to the Ministry of Finance and will transfer another RMB 500 billion to the latter later this year.

On April 18, the PBoC and the State Administration of Foreign Exchange (SAFE) jointly issued a notice to pledge targeted supports to the segments of the real economy that are hit hard by the pandemic.  Among the 23 new measures, the PBoC is to increase lending quotas for rural and SME sectors, and increase the share of private enterprises in getting new bank loans.  The PBoC also calls for local authorities to flexibly determine minimum down payment ratio and loan interest rates to meet reasonable housing demand. 

The tail risk of Russia-related secondary sanctions.  Adhering to the rhetoric of strategic partnership with Russia, maintaining commercial relationship with Russia, and avoiding to condemn Russia for the latter’s invasion of Ukraine but pointing fingers instead to the United States and NATO, have put China at odds with the United States and Europe. 

China and Russia however are not strategic allies.  In spite of the Joint Statement between Russia and China made during the Winter Olympics on February 4, 2022, the “strategic partnership”  between China and Russia has a multilateral international relationship setting in mind as it remarks that the “sides will strengthen cooperation within multilateral mechanisms, including the United Nations, and encourage the international community to prioritize development issues in the global macro-policy coordination.” Both China and Russia want to have a sympathetic voice and supports in areas that they consider “core interests” respectively.    For example, Russia reaffirms “its support for the One-China principle, confirms that Taiwan is an inalienable part of China, and opposes any forms  of independence of Taiwan” and China is “sympathetic to and supports the proposals put forward by the Russian Federation to create long-term legally binding security guarantees in Europe.”

For China, the partnership with Russia is more utilitarian than a whole-hearted strategic alliance with shared principles and strategic goals.  Having decided that China and the United States are in strategic competition or even rivalry, China considers Russia instrumentally useful in creating strategic and military ambiguity and some leverage against the United States.  It is worth to note that China has never recognized Russia’s 2014 annexation of Crimea as doing so will have violated the principles of respecting sovereignty and territorial integrity proclaimed by China.

The Russian invasion of Ukraine has put China in an awkward position.   The avoidance of joining other countries in condemning Russia’s invasion has made China’s long-held foreign policy principles of respecting sovereignty and territorial integrity hypocritical.  Even more importantly, it has made China at odds with Europe which China has been working hard to try to cultivate a closer relationship and put a wedge against the United States. 

China certainly does not want to be collateral damage and become subject to sanctions.  Chinese financial institutions have been extremely careful to ensure compliance with the sanction against Russia, even though China officially denies the legitimacy of sanctions imposed on Russia. The access to the global market and financial system is too important for China to be put at risk.   Reportedly, Chinese banks have stopped issuing letter of credits to Russian entities and the Asian Infrastructure and Investment, an institution of China’s Belt and Road Initiative, has ceased lending to Russia (Garcia-Herrero 2022).  Russia does hold a sizable chunk of its reserve in renminbi (USD 75 billion equivalent or 17% of Russia’s foreign reserve as of end of 2020; Arslanalp et al. 2022, p.25) but it is operationally quite impossible to use the fund to settle trades in currencies other than renminbi as suggested in Steil and Rocca (2022) without being caught by the Office of Foreign Assets Control of the US Department of the Treasury.

However, a much weakened Russia or a regime change in Russia is also not what President Xi of China wants to see.  Either of them will have significant implications on China domestically as well as externally.   China will probably continue to trade with Russia as much as possible within the limit of the sanction imposed against Russia by the West.  The challenge will come if the United States and Europe decide to enlarge the scope of the sanction to cover trading in most or even all civilian goods and services.  Economically, it is obviously much better to retain access to the global market and financial system at the expense of trading with Russia.  It will present a very difficult choice for President Xi to make in a time approaching the all-important 20th Party Congress as it may be perceived as appeasement to the United States.  Nonetheless, the principal contradiction (in Marxist lexicology, it means the dominant issue), in Xi’s view, is “the contradiction between unbalanced and inadequate development and the people’s ever-growing needs for a better life” (McCahill Jr, 2017 ; Xinhua 2021) The other contradictions are secondary.  

Maintaining social and economic stability is also the utmost focus of the Chinese Communist Party this year which is critical for Xi to secure his unprecedent third 5-year term.  Risking China’s economic and social stability to defy sanctions in support of Russia is probably unlikely. The tail risk of being a victim of secondary sanctions is real but China’s tendency is to be in compliance of the sanctions as far as possible no matter how reluctantly.