China’s dual-track economic recovery in 2021: should markets be worried about tightening financial conditions?

With a dual-track economic recovery taking shape in China, markets have grown increasingly wary of tightening financial conditions. Is there cause for concern?

Early success with pandemic management has meant China’s economy was able to return to growth much earlier than its global peers (Q3 2020), with the recovery driven by government-backed infrastructure investment, a resilient property sector, and its ability to fill global supply chain gaps left by countries struggling to keep coronavirus under control. China’s trade surplus hit a record $78 billion in December – due largely to stronger export growth.

A dual-track recovery leads to fears of tighter financial conditions

Yet the recovery is an uneven one (see chart below). Although industrial production – driven by manufacturing & exports – has recovered above levels seen before the crisis, consumption has been slower to recoup lost ground as social distancing policies weighed on service sectors and retail sales, both of which have lagged.

Monthly real activities from December 2019 onward: a dual-track recovery

Sources: CEIC Data, NatWest Markets

While strong capital inflows and a buoyant current account surplus have been positive for China (and support further appreciation of the yuan), the dual-track nature of the recovery has led to growing concerns that policymakers may take their foot off the gas and tighten financial conditions. Our own China Stress Index, which capture investors’ general level of concern towards China – from perception of the growth & policy outlook to reactions to discrete events, headlines & data releases – suggests those concerns may start to weigh on market sentiment.

China Stress Index: markets worry about tightening

Sources: Bloomberg, PBoC, NBS, USTR, Chinese Commerce Ministry, NatWest Markets

Three reasons why tightening fears are overblown

We think there are three main reasons why we don’t see imminent tightening of financial conditions on the horizon in China.

Monetary & fiscal policy: gradual normalisation, targeted easing

The People’s Bank of China (PBoC) supported the initial recovery from the pandemic with relatively strong credit supply and money growth, as well as a broad-based benchmark policy rate cut. But the stimulus measures implemented in 2020 were quite targeted and when compared with other large countries & regions didn’t flood the market with new money (see below), so we expect the withdrawal of those pandemic-related measures to be equally mild and gradual.

More money, more problems: China’s money supply grew less aggressively in 2020 vs. other large countries & regions

Sources: CEIC Data, NatWest Markets

Our base case is for most benchmark rates – the loan prime rate and the reserve requirement ratio – to remain unchanged, with ongoing capital markets reforms likely to accelerate and facilitate more bond & equity financing. And we expect special lending facility set up during the pandemic to help small and medium sized businesses (SMEs) will be tapered gradually.

On the fiscal policy front, we see infrastructure investment stabilising along with continued infrastructure-focused bond issuance. With the fiscal deficit target lowered to 3% of gross domestic product (GDP) in 2021 (from 3.6% in 2020), we think tax cuts introduced during the pandemic could become more targeted as we move through the recovery – but will be extended nevertheless.

Borrowing demand has peaked

We see the authorities focusing on stabilising the debt ratio by gradually reducing credit growth, and we can already see that the credit impulse – a broad measure of borrowing demand from the private sector – peaked in Q4 last year.

Credit impulse & new aggregate financing demand peaked in Q4 2020

Sources: CEIC Data, NatWest Markets

That said, we think the scale of credit easing will be on par with previous cycles seen in 2012 and 2015 – but far more moderate than in 2008-09 following the global financial crisis.

Direct FX interventions are off the table

In previous years, big changes to the US dollar or yuan outlook would have been a cause for concern to those scanning for potential sharp changes in monetary policy. But the PBoC stopped actively & directly intervening in FX markets in 2018 and doesn’t currently manage any specific USD-CNY rate.

PBoC FX purchases have been close to zero

Sources: CEIC Data, NatWest Markets, PBoC

Monthly FX purchases by the PBoC have been close to zero, and we think the central bank will only aim to slow the pace of one-sided appreciation or depreciation when absolutely necessary. That said, the PBoC has been relaxing administrative hurdles gradually to allow more capital outflows to offset strong inflow pressure and slow the yuan’s rapid pace of appreciation seen in recent months.

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