China’s economy grew robustly in the first quarter of 2021, at least on the face of it. However, underlying growth momentum has slowed. This should reduce any risk of monetary tightening that investors are worried about. The real risk is tighter regulation: Fintech lending, shadow banking and non-systemic zombie companies face a crackdown.
China’s GDP expanded by a solid 18.3% in the first quarter, but this mainly reflects a (distorting) base effect. As a result, it is not a useful guide to the direction of policy and financial markets.
Compared to the first quarter of 2019, overall growth was a more modest 10.3%. The main indicators – retail sales, fixed-asset investment, freight traffic and real estate investment – were hardly robust (see Exhibit 1).
The latest data shows two things:
1) China has yet to correct its lopsided recovery: The consumption/demand side of the economy is still lagging the production side in terms of growth.
2) In view of the robust headline growth in the first quarter, growth target for this year of 6.0%+ implies that Beijing has more leeway to pursue its financial de-risking policy.
The first quarter is likely the peak of China’s economic recovery from the pandemic-induced slowdown ahead of a slower growth as exports contribute less to GDP in the coming months and growth of fixed-asset investment falls. Consumption will likely recover sluggishly as uncertainty over the outlook for deleveraging policy and reform clouds confidence, limiting the provision of credit and causing job and income insecurity. By the fourth quarter, growth could slide towards 6.0%.
The People’s Bank of China (PBoC) is handling a complicated dual mandate: De-risking the financial system and preventing any financial accidents while sustaining GDP growth. This backdrop is likely to lead to higher Chinese bond yields and higher volatility for Chinese stocks in the short term.
Slowing growth and rising financial stress may eventually prompt the PBoC to ease policy, albeit still selectively, but that will likely be a story in the second half of this year.
The true tightening risk this year is regulatory. Shadow banking, including fintech lending, will bear the brunt of the pressure as well as weak borrowers that are not systemic. Meanwhile, the PBoC’s cautious policy stance, which is meant to facilitate Beijing’s deleveraging efforts, could create a negative credit impulse in the coming months. This will aggravate stress from rising defaults.
The rise in the share of state-owned-enterprises (SOE) defaults (see Exhibit 2) shows Beijing’s retreat from its implicit policy guarantee. While this is structurally positive for Chinese assets and credit pricing, the move will hurt market confidence before investors come to terms with the new normal.
The central bank uses two broad indicators for conducting policy:
1) Keeping M2 money supply growth at the same rate as nominal GDP growth
2) Keeping the amount of new bank lending at last year’s level.
Data shows that there is no reason for it to ease policy since these indicators are already above their targets. M2 growth was at 10.1% compared to 6.8% of nominal GDP growth at the end of 2020. New bank loans have been growing at annual 16%. If they do not slow down, new bank loans will overshoot last year’s level, violating the PBoC’s guideline.
Hence, PBoC policy has a tight monetary bias in the context of Beijing’s financial de-risking efforts. Policy is broadly neutral to ensure there is enough liquidity to preserve economic growth and keep the credit system functioning. It is a fine policy balance that the PBoC is trying to strike.
A combination of slowing GDP growth momentum (but not to below 6.0%), rising financial stress (as reflected by rising defaults) and a falling credit impulse implies more upside for yields and more volatile stocks in the short term.
However, these factors could prompt the PBoC to do more selective easing eventually. That should be positive for the markets, but not before the second half of this year.
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 This is reflected in the ratio of new credit flows to nominal GDP.