China’s economic momentum slowed into the third quarter as a resurgent coronavirus weighed on consumption, and it will slow even further in the fourth quarter, dragging down our full-year 2021 economic growth estimates from 8.5% of gross domestic product (GDP) to 8.2%.

Growth is cooling slightly (100 = GDP in Q4 2019)

But against that backdrop, exports and industrial production outperformed, the latter rising 13.1% year-to-date, as the world’s purse strings loosened on the back of a recovery. Domestically, consumption has also stabilised – retail sales also rose 18.1% in the first 8 months of this year compared with the same period in 2020. Going forward, we expect consumption growth will accelerate and think China will continue to benefit from rising external demand, which is positive for exports. But the recent supply shortages (especially electricity) will likely have a negative impact on global supply chains and put upward pressure on prices in the near term.

China’s trade balance is improving (annual totals in USD billions)

Producer price inflation (PPI) surged to decade-highs of 9.5% in August, driven by shortages of raw materials that have been more acute and longer lasting than previously thought due to the Delta variant outbreak. Domestic consumers, on the other hand, have been fortunate to see little of this passed onto them in the form of price hikes. Consumer price inflation (CPI) did rebound slightly, reaching 0.8% in Q3, but remains well below the government’s 3% target.

We think CPI will remain soft going forward, as food prices cool and domestic demand continues to recover gradually, and we expect PPI to ease as supply shortages start to taper off in the early months of next year.

Consumer prices should soften but raw material prices will take more time to ease (year-on-year percentage change in inflation)

A slowing property sector, soft consumer spending and credit market stress were met with a dovish – albeit targeted – response from the People’s Bank of China (PBoC) this year. It has, for instance, swooped in to support small and micro enterprises with a CNY 300 billion re-lending facility, and has tried to ensure the interbank market has ample liquidity through cuts to the reserve requirement ratio (the minimum amount that a commercial bank must hold in liquid assets).

We expect another 50 basis points of cuts in the reserve requirement ratio in Q4 to partially meet the liquidity demand for CNY 2.45 trillion maturing medium-term lending facility. We also think the fiscal impulse (a broad indicator that reflects the impact of China’s fiscal policy on economic demand) will rebound slightly in order to help stabilise infrastructure investment. Finally, we believe the PBoC will keep benchmark rates such as the Loan Prime Rate (LPR) unchanged until at least end-2022.

In recent months, policy makers elevated achieving “Common Prosperity” – a broad ambition to generate more balanced growth across the economy – to the number one long-term policy goal in China.

This is as much symbolic as it is substantial. More clarity is needed from policymakers on the finer points of “Common Prosperity”, which should arrive during the upcoming Plenum and Politburo meetings in November. But we already have seen hints of the policy at work – it includes a series of targeted regulatory changes introduced in the technology, telecoms, education, and pharmaceuticals sectors and aimed at mitigating risks like excessive debt accumulation, data security, and inequality of access to services. In the meantime, capital inflows have slowed since Q2 as foreign investors stayed on the side-lines due to intensified regulatory change.

Monthly bond and equity flows have slowed (USD billions)

Going forward, we expect regulatory changes to continue across sectors and aim at bringing more certainty and fairness for doing business in China, both for foreign and domestic businesses. It will also see governments shift away from turning to the property and construction sectors to generate a quick bump in GDP, and instead focus on improving the social safety net and labour productivity. We’re also sceptical that “Common Prosperity” will necessarily disadvantage entrepreneurs and asset owners.

Uncertainties created by a resurgent pandemic and disruptions to global supply chains remain the biggest challenges confronting businesses in the short term. Indeed, rising shipping and raw material costs will continue to weigh on the profitability of Chinese manufacturers and those who depend on their wares. Ultimately, this risks inflation rising (and broadening) and growth falling.

Shipping costs also remain high, and are rippling through global supply chains (index of shipping prices, January 2020 = 100)

At the same time, concerns over credit market stress in China will weigh on investor sentiment. We think the risk of default in various pockets of the economy – including, most visibly, the property sector – add to the headwinds facing China’s financial markets and economic stability.

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