China Update: recovery green shoots being at risk as the Covid-19 storm clouds gather
Market Strategist, Greater China
Summary: After lifting much of the lockdown in June, the Chinese economy has been showing some meaningful, though still moderate signs of recovery. The resurgence of Covid-19 cases including a more contagious sub-strain has caused worries of investors. Local governments are facing fiscal pressures but continue to execute heavy lifting in infrastructure construction projects.
China’s PMIs were back to the expansionary territory in JuneBoth the official NBS PMIs and the Caixin PMIs beat expectations and bounced above the 50-point threshold to signal that the business activities expanded in June. The official NBS Manufacturing and the Caixin Manufacturing PMI came at 50.2 (vs 49.6 in May) and 51.7 (vs 48.1) respectively. The largest positive surprise were found in the service sector. The NBS non-manufacturing PMI climbed to 54.7 in June from 47.8 in May, with most notable strength found in the services sector sub-index, which surged to 54.3 in June from 47.1 in May. Likewise, Caixin Services PMI rose sharply to 54.5 in June from 41.4 in May, confirming that the improvement in the service sector being broad-based and found also in private enterprise SMEs. These improvements, by and large were resulted from the lifting of lockdowns over much of the country in June.
Credit expansion picked up in June
The growth rate of outstanding aggregate financing came at 10.8% YoY in June, being the fastest over the past 12 months and 0.3 percentage points higher from May (10.5%). Outstanding RMB loans grew 11.2% YoY in June (vs 11.0% YoY in May). M2 grew 11.4% YoY in June (vs 11.1% YoY in May).
New RMB loans climbed to RMB2,810 billion in June from RMB1,890 billion in May, attributable to a surge in new corporate loans to RMB2,212 billion. Within new corporate loans, it is noteworthy that medium to long-term loans, having risen to RMB1,450 billion in June from RMB555 billion in May, accounted for much of the increase. The jump in medium to long-term loans to corporate represented both the Chinese authorities’ efforts in urging banks to lend to targeted industries and pick-up in loan demand from corporate.
The increase in new loans to households was relatively weaker than the performance in the corporate side. While the amount of new loans to households climbed to RMB848 billion in June from RMB289 in May, it was below June last year. New medium to long-term household loans (mainly mortgage loans) soared to RMB417 billion, nearly quadrupled the amount in May, but it was still nearly 20% below the level in June last year.
New issuance of government bonds rose to RMB1,618 billion in June versus RMB1,058 billion in May and RMB751 billion in June 2021. The government bond net issuance amount this June was indeed the highest on record. It was the result of the Ministry of Finance’s order to local governments to front loan and fully utilize their RMB3,650 billion annual special bond issuance quota by the end of June and spend the proceeds on infrastructure construction by the end of August. In June, local governments rushed to issue RMB1,371 billion special bonds.
Net corporate bond issuance recovered to RMB250 billion in June from a decline of RMB11 billion in May. Most of these corporate bond financing went to local government financing vehicles (LGFVs). Property developers’ onshore RMB bond financing was merely RMB11 billion in June.
Resurgence of Covid-19 cases, including a more contagious strain, posts the biggest risk to the green shoots of recovery
Broad-based improvement in PMIs, substantial increases in net issuance of local government special bonds (to support infrastructure construction) and bounce in medium to long-term loans to corporate are encouraging signals that the Chinese economy seems being set to accelerate its recovery from the slump in April well into Q3.
The green shoots of recovery emerging in June however are at risk as China’s daily number of new locally transmitted Covid-19 cases has gone up and stayed at above 300 since July 4. Adding fuel to the fire, over 50 new cases everyday were reported in Shanghai over the past four days and the first case of more contagious BA.5 sub-strain of the omicron variant was reported in Shanghai last Friday. 31 cities (accounting for about 17% of China’s population and 25% of GDP) are reportedly now imposing some sorts of lockdowns or district-based restrictive pandemic control measures, nearly tripling the 11 cities (8% of population and 15% of GDP) just a week ago. The 7-day moving average of metro passenger trips in China’s 15 major cities was down 11% from last year and that of road freight transportation was 17% lower than same period last year. As China is “unwaveringly” holding onto its zero-Covid policy, risk premiums have started to rise again for Chinese equities in response to the resurgence of Covid-19 cases in the country.
Local governments are under pressures from every front
The economic burden of mass PCR tests, together with the administrative costs of other pandemic control are largely borne by local governments. The cost of administering PCR tests will not be paid by the national health insurance fund but by local governments. Given the prominent position of zero-Covid policy in government policies as well as party politics, officials in local governments are incentivized to prioritize resources towards pandemic control over other policy objectives, including stimulating the economy. Mass testing millions of people regularly is expensive and is dragging hugely on local governments’ already stringent fiscal budgets and is likely to draw resources away from other government expenditures.
As a relief measure to boost the economy, China’s central government has launched a RMB1.64 trillion value-added tax (VAT) rebate programme. VAT revenues in China are split equally between the central government and local governments. In other words, local governments are bearing half of the fiscal burden of the VAT rebate. VAT tax revenues, accounting for 38% (as of 2020), is the largest item of the local government tax revenues and were down 43% in the first five months of the year. The second largest item, five taxes related to land and real estate (including land use right and land value-added tax), accounts for about 26% of local tax revenues. The five taxes have also been under pressure (down 7.9% in the first 5 months of 2022) due to the weak property market. On top of on-budget tax revenues, off-budget revenues from sales of land use rights is an important source of income for local governments. From January to May 2022, revenues from sales of land use rights plunged to RMB1.86 trillion, 29% lower form last year.
Analysts are expecting that the local government budget revenue shortfalls will be covered by some of the recent measures rolled out by the central government since May, including additional quotas for policy bank lending and bond issuance, railway construction bond issuance, and frontloading of fiscal transfers.
Local government special bonds are a key driver for infrastructure spending
The central government has also given local government an annual quota of RMB3.65 trillion to issue special bonds which are primary earmarked for infrastructure projects and instructed the latter to issue all of special bonds by the end of June and spend the proceeds by the end of August. It is widely expected that some special bond quota (the latest market talk is for RMB1.5 trillion) from 2023 will be brought forward to the 4th quarter of this year.
According to the estimates from Goldman Sachs, 70% of the RMB 2 trillion proceeds from local government bonds issued from January to May 2022 was spent on infrastructure projects. The industrial breakdowns of these infrastructure projects are: municipal construction and industrial park (34%), transportation infrastructure (18%), education, health and social work (18%), social housing (15%), rural revitalization, agriculture, forestry and water conservancy (8%), ecological construction and environmental protection (4%), logistics, energy and others (3%).
The sharp falls in commodity prices since June may be a relief for some mid- to downstream manufacturing industries
When we first brought up in April this year the idea of investing in companies that might benefit from the rise in infrastructure construction in China, we were remindful to note that we had a strong preference on the upstream industries, such as oil and gas exploration and development and mining industries. In the first half of the year, upstream industries did in fact had much better profitability than mid- to downstream manufacturing industries whose operating margins were compressed by higher input costs.
After commodity prices plunged over 20% across the board since early June, especially in industrial metals, we believe that the lower commodity prices may help some of the manufacturing industries to recover from such margin compression. This is important as many infrastructure-related industries have a high percentage of their costs in energy and industrial metals. For examples, according to estimates derived from the input-output tables of the National Bureau of Statistics of China, the electric transmission and control equipment industry has about 60% of its costs in energy (16%), ferrous metals (12%) and non-ferrous metals (32%).
Given years of under-investment in the energy and mining industries in the Western world, we are expecting a prolonged secular bull market in energy and commodities. Therefore, we are only tactically extending our investing interests from the downstream infrastructure related companies to some mid- to down-stream infrastructure related manufacturing companies in the third quarter when commodity prices are facing some near-term headwinds.