Waiting for China's turnaround

Is China's economy about to turn a corner, and to what extent can it resume its role as a leading engine of growth for Asia and the world? These are high-stakes questions. With other major economies weakening and even threatened with recession, China's economic recovery and return to sustained growth can make a big difference to the global economy, and especially to Asia.

There are both short and medium term issues involved in determining China's growth trajectory.

In the short term - that is, for the rest of 2022 - the most important variable is the economic impact of China's so-called "dynamic zero- Covid-19" policy, which permits local governments to gradually lift lockdowns by area once they are cleared of Covid-19 infections, although mass testing, even of those fully vaccinated, will continue and people must show negative test results within at least 72 hours before they can move around. Although this is less draconian than the original version of the zero-Covid-19 policy, it can still lead to entire residential communities being locked down for days on end.

Writing in Foreign Affairs, Dr Yanzhong Huang, a senior fellow for global health at the US Council on Foreign Relations and a professor at Seton Hall University, reported that as at April 18, about 45 cities representing nearly 30 per cent of China's population and 40 per cent of its annual GDP were under full or partial lockdown.

Economists at Nomura Holdings have come up with similar estimates. Besides, vaccination rates of elderly citizens is still relatively low. A Shanghai municipal official said on Monday that 38 per cent of people aged 60 and above were not fully vaccinated.

In such circumstances, any comparisons with the experience of other countries must be interpreted with caution. In an upbeat report recently, DBS analysts pointed out that in Britain and the United States, the pandemic took about six weeks to peak and then another six weeks to fully subside, and if China follows the same pattern, daily new cases should return to low levels towards summer.

But the US and Britain had vaccinated a higher proportion of their elderly people, and with more effective vaccines than China has used, plus they did not pursue zero-Covid-19 policies, which have led to periodic lockdowns. So the same patterns may not repeat - and the economic consequences could also be different.

So far, the consequences for China have been dire. The latest economic data was the worst since the early months of the pandemic in 2020. Bloomberg Economics estimates that in April, China's economy contracted by around 0.7 per cent year on year. Retail sales were down 11 per cent, industrial production dropped 2.9 per cent, property sales by value crashed 46.6 per cent and export growth slumped to around 4 per cent, from 15 per cent in March. Forward-looking indicators such as the purchasing managers' index for manufacturing fell further from March to 47.4; any reading below 50 shows a contraction, suggesting that a quick turnaround is not on the cards.

On the positive side, the authorities plan to gradually lift Shanghai's eight-week lockdown next month after several days of zero-Covid-19 infections, so businesses operating there are turning cautiously optimistic. But the situation in other cities is not as encouraging; infections are continuing to spread in some large metros such as Beijing and Tianjin.

Although China's official growth forecasts for this year remains at 5.5 per cent, most economists have cut their projections to between 4 and 5 per cent. The International Monetary Fund's (IMF) latest is 4.4 per cent. But with the situation as uncertain as it is, these forecasts could be further revised.

China's authorities are adopting aggressive countermeasures. The central bank has reduced reserve requirements for banks - the amount of money they need to hold in reserve - to encourage them to increase lending, offered cheap loans to small businesses and cut mortgage interest rates to revive the beleaguered property sector. The government has also announced that it will boost infrastructure spending. Overall, Bloomberg estimates that the government has so far pledged 35.5 trillion yuan (S$7.3 trillion) of monetary and fiscal support this year, equivalent to around 31 per cent of GDP.

While these are positive steps, their effectiveness will be compromised by the continued pursuit of a zero-Covid-19 policy. When people and businesses are locked down or facing movement restrictions, their appetite to borrow, spend or invest will be obviously limited.

The fact that despite monetary easing, credit growth slowed sharply last month, with new loans falling to their lowest level since December 2017, should not be a surprise. Credit expansion will pick up as the pandemic ebbs, but the zero-Covid-19 policy will delay the process. Trying to stimulate the economy while such a policy is in place is like pressing the accelerator and the brake at the same time.

Spending on infrastructure and green projects could be more effective, but involves other hazards.

First it will require more borrowing by local governments, whose tax revenues - which were heavily dependent on land sales - have been depleted because of the property downturn. This will push up public debt, which is already approaching 300 per cent of GDP, more than double the level of 2006, and which the government has been trying to reduce.

Second, many of the projects that end up being financed during a politically directed spending binge may not turn out to be commercially viable.

Third, with China's capital output ratio having roughly tripled since 2007 - which means it takes three times as much capital to produce the same amount of output - the payoffs from investment in infrastructure will be far lower than in the past. In any event, infrastructure spending is unlikely to offset the impact of the sharp fall in the property sector, which accounted for almost one-third of China's GDP.

Even when China's economy does pick up - hopefully later this year - it will not have the benefit of the tailwinds it enjoyed in 2020 and 2021 when huge economic stimulus packages in the US and Europe had led to a surge in demand for electronics and other physical goods.

In 2021, China achieved export growth of 29.9 per cent and posted a record trade surplus. But this year will be a different story. With interest rates rising globally, the economies of China's biggest export customers are weakening. Its export growth has already started to slow down, which will hold back GDP growth.

Over the medium term - that is, over the next three to five years - the direction of China's policies will be crucial in determining its future growth. Over recent years, there are clear signs that China has shifted to an economic model that favours state-owned enterprises (SOEs) at the expense of the private sector.

In a study in February, the IMF has documented the symptoms of China's declining business dynamism.

Among its findings: Between 2003 and 2018, the revenue share of young firms - those under 10 years old - declined dramatically, from around 70 per cent to 30 per cent; older, larger and less productive firms have easier access to capital than younger, smaller and more dynamic firms - which has led to lower productivity growth overall; and the reform of SOEs has stalled since 2008. Such enterprises control around 40 per cent of all assets.

The bias in favour of SOEs has accelerated in the last two years. Since 2020, there has been a series of crackdowns on private firms in areas including e-commerce, fintech, cloud computing, ride-hailing, agri-tech, gaming and online education. Some of these companies such as Alibaba, Tencent, Didi and Pinduoduo are among the most dynamic and innovative in China and indeed are world leaders in their fields.

While the crackdowns may have been inspired by legitimate goals such as reducing inequalities and concentrations of wealth as well as the government's "common prosperity" agenda, such goals could have been addressed through more progressive tax policies on income and wealth as well as extending subsidies - for example on education - rather than by going after entrepreneurs and cutting their companies down to size.

The crackdown on fintech is especially puzzling. While there may have been some excesses in their credit assessment and lending practices, China's fintech firms were a financial lifeline for its small and medium-sized enterprises (SMEs), many of which are dynamic and innovative and lack access to the traditional banking system. And it was not the fintechs but the traditional banks which made the huge loans to the property companies such as Evergrande that have now gone sour. The fintechs, in fact, had far lower default rates.

In recent weeks, China's authorities have signalled that they will ease restrictions on technology companies - although the nature and extent of the relaxation have yet to be clarified. They also indicated that they will allow US regulators access to auditors' reports on the 200-plus Chinese companies listed in the US, which would enable those companies to continue being listed there and raise capital from global investors as well as raise their corporate governance standards.

These are positive signs of the emergence of friendlier policies towards China's private enterprises, which if sustained will add to the dynamism of China's business sector, as well as its growth prospects over the medium term.

But for 2022, China's economy will struggle to cope with the headwinds from its zero-Covid-19 policy, a persistent property crisis and a weakening global economy.