Refitting China’s broken growth engine

The Chinese growth locomotive is battered

As discussed in our Q3 and Q4 outlooks last year, China has been in the transformation to a new economic development paradigm, walking away from its labour-intensive, energy-intensive and export-oriented model that had been the backbone of the development of the Chinese economy in the prior decades to focus on high value-added industries, self-reliance and comprehensive national power.

The terrain on which the transformation travels is rough. Transforming an economy with a declining working-age population, and with a workforce that is largely unskilled and from rural areas, is a daunting task. The surge in volatility in global energy prices and an increasingly hostile external environment driven by concerns about supply chains and geopolitical tension are additional hurdles. The crackdown on the real estate sector, the mega-cap internet platform companies, and the tycoons and vested interests behind both sectors to steer economic development to a new path, pursue the course of common prosperity, and claw back economic power have added further challenges on keeping the growth engine even moving forward.

In Q4, China hit the gigantic pothole of the surge of the highly infective Omicron variant of Covid-19, which completely upended the pandemic containment model that had once been touted to symbolise the superiority of socialist China’s way of governance. The skyrocketing fiscal burdens of implementing quarantines and costs of tens of billions of PCR tests and the general disruption of economic activities and land sale revenues brought local governments to a fiscal cliff. Discontent first bubbled up on social media and eventually saw citizens taking to the street briefly in November of last year.

Fixing the economic engine becoming the priority

With economic growth grinding to a halt, refitting and reviving the economic engine brought a quick about-face in policies. On 11 November 2022, the Chinese health authorities relaxed guidelines for the country’s pandemic containment measures, with a series of further relaxations and the subsequent abandonment of the dynamic zero-Covid policy in December 2022. On 13 November last year, the People’s Bank of China and the Banking and Insurance Regulatory Commission jointly issued 16 measures to improve private property developers’ access to funding and opened the gate for a number of other additional policies to help shore up the balance sheets of property developers. 

At the Chinese Communist Party’s Central Economic Conference held on 15 and 16 December 2022, the Chinese leadership sent out a clear signal of shifting to a conciliatory stance towards the private sector and pledged to support internet platform companies without mentioning preventing the disorderly expansion of capital which haunted internet platform companies since 2020.

On 26 December 2022, the Chinese authorities announced a downshift of the handling of Covid-19 infections to category-B, the same as avian flu, hepatitis, tuberculosis and so on, and a lifting of border restrictions starting from 8 January 2023. On 9 January, Guo Shuqing, China’s top financial regulator, said that the campaign to rectify the 14 mega-cap internet platform companies’ financial business arms was basically completed. 

In short, over the past two months, China has taken a U-turn in policies regarding Covid-19, the property sector and internet platform economy as it tries to fix the economy. The magnitude and pace of the shifts have far exceeded the expectations of many investors who were expecting a more gradualist approach and ‘opening up’ timing closer to March 2023 or later. 

Facing down geopolitical hazards

Besides the domestically oriented policy measures, China has shown tentative signs of becoming more conciliatory toward the United States and its allies after a sense of escalating confrontation. When they were in Bali, Indonesia for the G20 Summit in late November, China’s President Xi and US President Biden held a three-hour long meeting, with both leaders showing some goodwill gestures. 

Further gestures towards the US were later deliberately expressed by the newly appointed minister of foreign affairs, Qin Gang, in an article in the Washington Post. Qin Gang turned up the charm and affectionately recollected his days as ambassador to the US, praising Americans as “broad-minded, friendly and hard-working” and saying that the “future of the entire planet depends on a healthy and stable China-U.S. relationship”. 

Another move to thaw tensions was China’s invitation of Australia’s foreign minister to visit in December last year. China subsequently placed an order to import Australian coal for the first time in more than two years after it imposed an unofficial ban on Australian coal in 2020. 

The confluence of the policy cycle and credit cycle amplifies the reacceleration potential

These substantial policy shifts were rolled out rapidly in a matter of two months and clearly demonstrated the Chinese determination to adjust the direction of the new development paradigm from 2020 and dig the economy out of the Covid-19 containment pothole. We believe that China’s drive to structurally transform its economy into a new economic paradigm remains intact. The recent policy shifts are to fix the economy as if in a cyclical downturn. In spite of the short-termism potentially embedded in the policy shifts, they are in the confluence of an upturn in China’s credit cycle and can produce powerful impacts on the Chinese economy and its equity market.

China’s credit impulse is an index that measures the flow of new credit as a percentage of GDP and its 12-month rate of change tends to lead the turn in the real economy by 10 to 12 months. In Figure 1, we plot the year-over-year percentage change of the Bloomberg China Credit Impulse Index 11 months forward against China’s Manufacturing Purchasing Manager Index. The Credit Impulse has bottomed and turned to trend upward since Q4 last year and points to expansion through most of 2023.