Equities face protracted slump, but the yuan’s immediate prospects remain decent 

• We turned negative on Chinese stocks after the RRR cut in mid-July and the intensified regulatory crackdown that followed
• The economic recovery has lost momentum and financial risks are mounting, dimming short-term stock market prospects, while the focus on bringing the private sector to heel and on “common prosperity” make long-term investment in Chinese equities nigh impossible

• We expect the yuan to stay stable or on a mild strengthening trend against the dollar for the rest of the year as domestic demand growth falters while export demand is sustained
• But the yuan’s fate could change drastically in 2022 as deleveraging, decoupling and redistribution enfeeble China’s economy  

Enodo nowcast points to weaker growth in H2

• Our August nowcast suggests growth will weaken in Q3 to 0.9% from 1.3% in Q2, dragged down by manufacturing and export headwinds and China’s struggling small and medium-size businesses
• It then projects a rebound to 1.5% in Q4, but September’s PMI data, which are not in this iteration, and our overall analysis suggest this is likely to prove optimistic 

• We expect annual growth to slow in H2 due to a strong base effect and continued loss of economic momentum
• On August 20th our nowcast of official GDP put annual real growth at 5.7% in Q3 and 4.2% in Q4
•  Is Beijing really prepared for official annual growth rates in coming years to stay in the 2-4% range at best?

• After its spectacular post-Covid recovery, especially given the structural trend of weakening growth post-GFC, China’s economic engine is spluttering 
• As we have said in the context of the global pandemic, Beijing’s policy of zero tolerance of Covid rather than learning to live with the virus is set to keep uncertainty high and frustrate efforts to place the economy on a solid recovery path 

• Exports turned into a growth driver in 2020, despite the yuan’s rise, as China was in a position to gain global export market share
• As the world is vaccinated and lockdowns are eased, global demand is shifting to services from goods made in China, weighing on exports while domestic demand is hamstrung by deleveraging and zero Covid tolerance

• Global supply chain bottlenecks and the Covid resurgence, which now seems under control, have hobbled China’s export machine
• With the Great Decoupling unlikely to abate, we expect the continual rerouting and breaking of global supply chains to be a salient feature of the world economy in the next few years

• Meanwhile, the main source of domestic demand weakness is the consumer
• The latest data shows consumer confidence plunged in July,  and it is likely to weaken further as Beijing’s efforts at delivering “common prosperity” are set to depress consumer spending

“Common prosperity” a noble task…

• Xi Jinping has embarked on an ambitious but uncharted path as he aims to make good on the Party’s promise of a socialist system that does not put the “needs of the few over the needs of the many”
• As we have highlighted in a number of reports over the past two years, Xi is genuinely determined to address gaping income and wealth inequality in China

• To its credit, by hook or crook China has managed to eradicate extreme poverty, but the gulf between the incomes of urban and rural Chinese remains
• Xi’s rural revitalisation programme has helped unleash the untapped spending potential of rural residents and raise their income levels, but boosting productivity growth in agriculture remains a daunting task

…but likely to erode the incentives that have underpinned China’s growth  

• As we pointed out a while back, Deng Xiaoping never said that to get rich was glorious. What he meant was that it was acceptable for some people to get rich first as China caught up and developed its industry but that ultimately the Party is building an equal, socialist society 
• That China has become one of the most unequal economies in the world does not sit well with the Party  

• Xi and the CCP view the principal contradiction as that between unbalanced and inadequate development and the ever-growing needs of the people for a better life
• The leadership, partly under pressure from America’s pushback against China’s ambitions, has accelerated its efforts to resolve this contradiction by a regulatory overhaul that’s spanning all aspects of the economy

Beijing struggles to make consumers a growth engine

• China’s consumer was a bit more perky in Q2, but this trend does not seem to have been sustained in Q3
• We have been arguing that China’s rebalancing towards consumption has been in reverse gear for some time, and the more explicit focus now on “common prosperity” is only going to accelerate the reversal

• Beijing has struggled to get consumers to loosen their purse strings post-Covid; real urban household spending per capita plunged in 2020
• Even real rural spending per capita declined, despite continued government support as part of its rural revitalisation plan

• Consumption in towns and cities accounts for 80% of overall household spending, so rural spending has to skyrocket to take up the baton from urban areas
• But in Xi’s China it is clear that ostentatious spending and waste, whether by well-off urbanites or rural residents, are not tolerated

• Real household per capita income growth weakened last year but remained robust. Beijing is providing targeted income support to struggling households and boosting employment income for certain occupations, such as delivery drivers
• But it has been finding it hard to channel needed liquidity to small and medium-term businesses, which account for over 80% of total employment

• Floor space sold surged in Q2, which might explain some of the better consumer spending performance
• But property regulations were tightened again in Q3 as Beijing is determined to keep a firm lid on housing. The main threat to consumer confidence and spending comes from the housing market. The penny is finally dropping for the Chinese, whose main asset is housing, that the authorities are serious about capping house price growth

• The most recent survey data suggests households are a bit less willing to hold savings deposits, which seems the only glimmer of hope for consumer spending 
• But on balance, after some green shoots in 2016-2018, the much hoped-for rebalancing of growth towards consumer spending is now a thing of the past and is unlikely to make a decisive comeback 

China to focus on deleveraging amid rising financial distress

• Beijing had just managed to arrest the steep rise in its non-government non-financial debt-to-GDP ratio when Covid-19 hit and Beijing threw caution to the winds
• Debt soared again, reaching 224% by Q3 2020, exceeding Japan’s bubble-time peak, but dipped to 222% in Q4 (latest BIS data available)

• Wholesale borrowing and lending has exploded again since mid-2018. This suggests financial distress is on the rise, as indicated too by Huarong’s and Evergrande’s financial troubles
• Firms are not earning the income needed to service their loans while the non-bank financial institutions that extended them credit are being forced to borrow more on the interbank market

• The amount of defaulted debt increased in 2020 with a spate of large SoE defaults towards the end of the year denting investor confidence
• 2021 is set to see more SoE debt defaults and probably the first LGFV bond defaults, too, as Beijing presses ahead with the de-risking of its financial sector it delayed because of Covid

• Defaults on commercial acceptances are rising fast and bondholders could take fright if they keep rising
• By replacing short-term debt, acceptances help meet the limits that Beijing imposed last August on how much China’s 12 largest property developers could borrow
• Evergrande is by far the biggest issuer of these corporate IOUs

Monetary conditions unlikely to ease…

• Broad money growth has weakened further in the past few months but remains supportive of output growth around 5% at present. Enodo uses its comprehensive M3 measure as a key indicator of overall monetary conditions in China
• Recent easing is unlikely to result in looser overall monetary conditions as China needs to continue to deleverage and is struggling to channel credit to SMEs 

• China’s unexpected blanket reserve requirement ratio cut in mid-July was a significant policy U-turn and signals that Beijing is far more concerned with the economy than previously understood
• We expect at least one more RRR cut this year to help banks tackle rising bad assets by cutting funding costs

…Beijing’s efforts to implement “cross-cyclical” policy

• The central government has slowed the pace at which it approves the issuance of special purpose bonds by local governments, such that less than half had been used up as of July
• Worries about local governments accumulating bad debt have been the main reason, but the pace of issuance has picked up in the past month

• The RRR cut is supposed to reduce firms' borrowing costs by lowering banks' funding costs. In June, the formula for calculating the upper limit on deposit rates was changed, lowering the ceiling on all but the shortest of term deposits
• So Beijing persists in repressing households financially, and access to credit, not high funding costs, remains a key problem