China’s path to recovery
As China was the first to suffer from COVID-19, it has also been the first to begin restarting its economy. What can we learn from its path to recovery?
Our Top Market Takeaways for April 7, 2020.
Are we out of the woods yet?
Stocks soared on Monday on news that COVID-19 fatalities looked to be slowing in some hotspots like New York and hard-hit countries like Spain, Italy and Germany. The S&P 500 (+7.0%) had its best day in a fortnight, now +19% higher from its low reached on March 23. The index has only seen 16 daily moves of that magnitude or more since 1950, and six of them have occurred this year.
Denmark and Austria became the first countries in Europe to announce steps to gradually relax lockdown guidelines, and Germany is said to be drawing up similar plans to be decided over the next two weeks. The Chinese city of Wuhan—the first to suffer an outbreak—will follow the rest of Hubei Province and relax restrictive measures. After 76 days of a historic lockdown, transportation will resume and travel restrictions on residents who hold “green” health QR codes (a technology to track infections, “green” means symptom-free) will be lifted tomorrow.
While the news of slowing infections in some areas is certainly welcome, the virus remains a very real threat. UK Prime Minister Boris Johnson was moved to intensive care last night following his hospitalization on Sunday. Japan declared a state of emergency after cases made a comeback in areas like Tokyo and Osaka. Cases in the United States are nearing 370,000 and the death toll is now over 11,000. As long as the virus exists somewhere, the rest of the world will be focused on its path.
Nonetheless, there are tentative signs that social distancing is working, and there is more focus on what the world will look like “after.” As Wuhan gets back into motion this week, some are looking to China as a test case for how the economy might rebound.
China: How quickly can the economy rebound?
As China was the first to deal with the shock of COVID-19, it has also been the first to begin restarting its economy after containment. There are, of course, limitations to using China as a template for how the rest of the world may get back on track, but the ebbs and flows of China’s economic cycle have been very important to investors over the last decade. As the world’s second-largest economy and a key player in global supply chains, it is worth closely following China’s transition from “lockdown” to “normalcy.”
China is now recovering, but how quickly?
The full scale of China’s economic shock during the first quarter is just now coming into view. Based on reported business resumption rates and an analysis of daily activity data, we estimate that at the end of February, China’s economy was operating at just 57% of its typical output. Within the context of these numbers, it is very likely China’s economy underwent a severe economic contraction in Q1, potentially by as much as 20% on a year-over-year basis.
Despite this weakness, and as COVID-19 gradually came under control, economic activity rebounded as more businesses resumed operations and consumers increased spending. Initially, progress was slow; key indicators such as coal consumption for electricity, property sales and traffic congestion appeared to hover around 70% of 2019 levels, implying very weak year-on-year growth. Over the past week, however, data has improved rapidly, climbing to as high as 90% of typical output.
Description: The bar chart shows 2020 as a % of 2019 business activity over the same period in the year before based on the number of days it has been since the last day of the official Chinese New Year holiday. It shows that progress has been slow for weeks, but there was a big jump in business activity in the last week.
As mentioned above, this recent resumption toward normal activity is crucial. China will face headwinds from collapsing global trade in the coming quarter. The extent to which it can resume activity will be a key factor as to whether the economy grows in 2020 or contracts. The amount of uncertainty makes it difficult to forecast growth, but we think the most likely outcome is that businesses get stuck at around 90% of typical output in Q2, leading to real GDP growth in China of approximately 1% in 2020.
As we learn more as to the outbreak’s economic impact on the rest of the world, it could very well be the case that this outlook is too optimistic—extreme contractions are expected in the U.S. and European economies in the weeks ahead. However, China’s economy is more domestically oriented than in the past, so whether the economy can maintain this positive momentum toward full economic resumption or it falls back below trend will depend on the policies implemented by Beijing.
What policy support can we expect?
How the Chinese economy rebounds will be determined in large part by the policy support committed to by Beijing. While policymakers in the developed world are offering “all they have,” China is still determining its full-scale approach. Most support in China so far has come from the monetary side. The People’s Bank of China has cut the reserve requirement ratio (RRR) twice this year, cut key policy rates such as the 7-day reverse repo rate, carried out liquidity injections in the interbank market, and expanded relending and refinancing facilities to bolster lending. However, while these moves are supportive in nature, they, similar to their developed market counterparts, can do little to stimulate in an environment of high uncertainty.
Fiscal policy will be needed, but so far the government has only carried out smaller-scale relief programs. Moving forward, there have been clear signals from top leadership of “more proactive and forceful” fiscal policies that will expand the fiscal deficit. Overall, we are expecting a bump in the issuance of special treasury bonds and local government special purpose bonds to help fund infrastructure investment, increased subsidies and welfare programs, a loan payment deferral program, and other measures meant to boost consumption.
While the actual scale of the fiscal stimulus package is still unclear (we will see more details when the budget gets passed later this month), it’s worth noting that we are not expecting a “four trillion yuan” fiscal bazooka as we saw during 2008–09, when the general government fiscal budget moved from a surplus to a near 3% deficit. Total stimulus was as high as 12% of GDP, including the off-balance sheet debt financing by local government financing vehicles (LGFVs).
For China, current policy space is much more limited than the post–Global Financial Crisis era. According to Xinhua News, China’s consolidated fiscal deficit, which is simply measured as the difference between government expenditure and government revenues, reached 5.59% of GDP at the end of 2019 (including general government funds) after the tax/fee cuts over the past two years. The official deficit reached 2.79%, which is subject to a 3% cap. Although it’s very likely the 3% cap will be lifted, space for further stimulus would be limited to around 2%–3% of GDP (well below that seen in 2008–09).
In addition to limited budget space, fiscal stimulus decisions also have to be made in conjunction with still elevated debt levels, surging housing prices and potential crowding-out of the private sector.
Description: The bar chart shows China’s general government fiscal deficit as a percentage of GDP from 1999 through February 29, 2020. It highlights an expansion in 2008–2009, 2015–2016 and 2018–2019. It shows that now is the starting point of a new cycle with a constrained budget space.
We believe effective stimulus would direct credit and subsidies to the most affected sectors instead of the broader economy, focus on measures that support domestic demand from households, and avoid a crowding-out effect on the private sector. We have already observed caution from local governments toward lifting housing market restrictions (which should be viewed as a positive because of the growing imbalances in the housing market). And in addition to traditional infrastructure investment, potential policy could focus on “new infrastructure” projects such as upgrades to digital technology and renewable energy development. In the near term, measures to carefully manage local government and banking sector balance sheets would be key to keeping structural risks under control.
The limits of a “China Template”
In discussing China’s path back to “normal,” it’s worth pointing out that there are limitations to making comparisons for how the outbreak’s timeline and aftermath might play out in the rest of the world. The situation in China is different from conditions in the West in a number of important ways:
- On testing. COVID-19 testing was easily accessible and free across most East Asian countries—most people who felt they needed a test were able to get one. This differs in how testing has been rolled out in the United States and European countries, which have seen massive delays, and in some cases, requisite criteria to be in place to get tested. Obviously, testing is critical to ensure you have controlled an outbreak.
- On travel. Travel is merely discouraged in the United States, not outright banned. Travel volumes are down substantially, but the ability to travel increases the likelihood that more regions experience their own outbreaks.
- On tracking, contact tracing and information. China and other Asian countries such as South Korea have utilized technology to track COVID-19 cases, hone in on outbreaks, and follow up with those who may have been exposed. A number of applications even update residents within a building if distancing guidance is disobeyed. A number of big data efforts, such as those produced by Palantir, are being used by the CDC in the United States and NHS in the United Kingdom, but so far, efforts on an individual scale are minimal at best. This will be critical in making sure small outbreaks do not become big outbreaks when the economy re-opens.
- On the importance of trade. The United States is primarily a services-driven economy, and in this sense, does not have as much of a reliance on external demand. The bounce-back may be just as reliant on consumers’ willingness to get out of the house and spend as it is on government policy. On the other hand, while China has taken steps to transition its economy toward the consumer, trade is still very important, and thus stands to be impacted more by reduced demand around the world.
Just as the initial containment strategy differed between China and the West, so will the eventual recovery. The West can look to China or Korea for examples to follow and those to avoid, but the inherent differences make a like-for-like comparison impossible. Perhaps the one true similarity is that the nature of the virus makes it so that when it is a problem somewhere, the ripple effects will be felt everywhere.
All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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