China’s Hot Growth Summer Will Probably Disappoint

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China is through the worst of its spring slump, as megacities like Shanghai and Beijing grope toward full reopening and fiscal stimulus starts to kick in. But that doesn’t add up to a strong rebound in the third quarter.

First, the good news: May economic data released Wednesday contained two key signs of strength which may help limit the damage from Shanghai’s recent lockdown. First, infrastructure investment moved convincingly upward, rising 7.3% year-over-year in May according to

HSBC,

more than twice April’s tepid 2.8% gain.

That jibes with data from Wind showing a huge increase in local government bond issuance over the past six weeks; infrastructure investment might accelerate further in June.

Second, industrial production surprised on the upside, helped by rebounding exports and auto production. The year-over-year decline in auto sales narrowed to 12.6% in May from 47.6% in April. Given that the government has just announced a big tax cut on auto sales, effective this month, June numbers will probably continue to improve.

But even assuming further hiccups in reopening are avoided, there are still several big problems which mean the growth rebound in the third quarter will likely remain subpar.

First, the People’s Bank of China is still acting cautiously, despite the clarion call to support growth from Premier

Li Keqiang

and other top officials. The central bank once again confounded analyst expectations for a cut to its key medium-term lending facility rate along with today’s data release.

Concern about further yuan weakness—with the potential to trigger big capital outflows in a Fed rate hiking cycle—still appears to be tying the central bank’s hands. After the PBOC announced a cut to banks’ reserve requirements in mid-April, short rates and corporate bond yields fell sharply—but so did the yuan, which dropped over 6% against the dollar from mid-April to mid-May.

Since then, the currency has stabilized, but bond yields have started creeping up again. If the rapid clip of local government debt issuance is going to continue—more than 700 billion yuan ($104 billion) of net issuance in both May and June to date according to Wind, the two highest monthly totals since mid-2020—more liquidity from the PBOC will be needed to avoid crowding out other borrowing.

At the same time, local governments are quickly using up their annual “special project” bond issuance quota. In combination with weak land sales, another critical source of municipal funding, that adds up to a looming “fiscal cliff” in the second half of the year, notes research consulting firm Capital Economics.

Beijing will either have to bring forward a big part of next year’s planned quota or take other strong measures to shore up local government finances. Another option—allowing more off-the-books borrowing by city governments—will be tricky as long as bond yields remain high, and would also undermine a concerted effort by Beijing to rein in such practices over the past five years.

Barring another big Covid outbreak this summer, China’s growth looks like it has bottomed out for now. But unless the PBOC is willing to risk much more yuan depreciation, and policy makers act to shore up local government finances fast, a weak rebound in the third quarter is still the most likely scenario.

Write to Nathaniel Taplin at [email protected]

Shanghai residents took selfies outside and toasted with champagne as the city emerged from a Covid-19 lockdown that lasted more than two months. But there are economic challenges ahead as China shows no signs of easing its zero-covid strategy. Photo: Qilai Shen/Bloomberg News

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Appeared in the June 16, 2022, print edition as ‘China’s Summer Will Probably Disappoint.’

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