The unprecedented economic shock caused by the Covid-19 outbreak in China has set the country on a path that indicates the political will and economic impetus to shift gears.
At the 13th annual National People’s Congress (NPC) – which is meeting 22-28 May 2020 – China’s top legislative body did not set an explicit GDP growth target for the first time, citing post-Covid-19 uncertainties domestically, as well as challenging global economic and trade conditions.
Instead, China’s “government work report” articulated a focus on employment, protecting basic livelihood and reducing poverty as main economic objectives (Exhibit 1). As one of the first economies to emerge from lockdowns postpandemic, China is clearly conscious of the arduous recovery path that will take its toll on the livelihoods of Chinese citizens.
China’s 1Q20 GDP declined 6.8% year-on-year, hence we anticipate that even with a reasonable bounce in 2Q20 (and the avoidance of a renewed outbreak), it is mathematically very difficult for China to achieve a positive figure for 2020 as a whole.
In recent weeks, US-China tensions have escalated beyond the original bugbear of trade. The fault lines have now emerged across healthcare (in Covid-19 related allegations), capital markets (with regard to US investments in China), technology (in restrictions placed on Huawei) and geopolitics (catalysed by China’s announcement of a national security law for Hong Kong.)
In response to the external environment, as well as endogenous factors, we see China shifting gears in these four key areas.
1. Livelihoods over headline economic growth
China’s focus on urban job creation as its highest priority in 2020 over an explicit growth target indicates a shift towards relief for the economic shock after its first quarterly GDP contraction since 1992.
China’s target for 9 million new urban jobs in 2020 as its highest priority compares with last year’s employment target of 11 million jobs and actual job creation of 13.5 million in 2019. Also, the government expects to keep the full year unemployment rate at 5.5%.
Being first to be hit by the Covid-19 pandemic, which has caused 4,000 deaths and 80,000 infections in China, the country was both first-in and first-out in terms of social distancing and lockdown measures. Post-relaxation of these measures, China has experienced an encouraging recovery in industrial production (+3.9% YoY in April) and a gradual return to normalcy in terms of business activity.
The NPC’s focus of expenditure growth will be on employment, support for basic living standards, small and medium enterprises, rental and interest payment subsidies, consumption support and essential public services. Local government construction priorities are earmarked for "new" infrastructure such as broadband, 5G, new energy vehicles infrastructure, industrial upgrading, urbanization efforts and improvements in rural livelihoods.
Source: China 2020 Government Work Report
Consequently, the fiscal deficit will rise by RMB1 trillion year-on-year to reach RMB3.76 trillion (approximately 3.6% of GDP) compared with 2.8% last year. Special central government bond issuance of RMB1 trillion and special local government bond issuance of RMB3.75 trillion (vs RMB2.15 trillion in 2019) are also planned. The sum of policy announcements in the work report bring China’s year-to-date total of stimulus announcements to approximately 8.4% of GDP.
In terms of inflation, China’s target level for the consumer price index is 3.5%, compared with 3% for the past two years, indicating an effort to avert deflationary pressures. Monetary policy announcements in 2020 have been accommodative and are outlined in last week’s People’s Bank of China Monetary Policy Report, foreshadowing faster aggregate financing growth in 2020 compared to last year.
2. A new hegemony in technology
On 15 May 2020, the US Bureau of Industry and Security (BIS) announced rule changes that restrict Huawei’s ability to use US software and technology to design and manufacture its semiconductors. This development poses a near-term risk to China’s 5G rollout given Huawei’s substantial share of China’s 5G base stations.
The combined impact of the vacillating trade situation and economic impact of Covid-19 has led companies to streamline supply chains into more localized and automated workflows. This latest development gives further impetus for China to speed up its localization efforts within Greater China. How China responds to the recent developments in the semiconductor space would indicate a shift in its hitherto commercial engagements with the dominant players in the tech supply chain.
3. Recalibrating capital markets
US-China tensions have begun to colour decision-making in the international capital markets.
On 12 May 2020, the White House and the US Labor Department ordered a federal pension fund board to halt investments in Chinese stocks. The Federal Retirement Thrift Investment Board was warned against investing billions of dollars in retirement savings in “risky companies that pose a threat to US national security.” This was in response to a planned move to an international MSCI Index benchmark which had weightage on China stocks.
The market is also concerned about the Chinese American Depositary Receipts (ADRs) listed in the US. On 20 May 2020, the US Senate passed the Holding Foreign Companies Accountable Act via unanimous consent. The draft bill requires 1) foreign companies listed in the US to disclose if they are owned or controlled by a foreign government and 2) prohibits the securities of a company from being listed on any US exchanges if the company fails to comply with the Public Company Accounting Oversight Board’s (PCAOB) audit 3 years in a row.
Chinese ADRs aggregate about ~USD1 trillion of market capitalisation, representing ~3% of the US equity market. Goldman Sachs estimates that US investors currently hold around one-third of Chinese ADRs which are worth ~USD350 billon and account for ~50% of their Chinese equities holdings. This move could accelerate the move towards secondary listing.
4. Geopolitical perspectives
Apart from US President Trump’s anti-China rhetoric in relation to the Covid-19 outbreak, fault lines across trade, technology, intellectual property and geopolitics remain risks for markets. In trade, we anticipate a re-focus by the US on the Phase 1 trade deal – latest developments suggest that it is almost impossible for China to fulfill its earlier commitment to increase purchases of US goods and services by USD200 billion over a two-year period.
In addition, Beijing’s latest decision on 21 May 2020 to introduce a national security law banning sedition, secession and treason, via Annex III of Hong Kong’s Basic Law has renewed flashpoints over the past weekend. This could also trigger the international community’s response which would compromise China’s growing presence within the international arena.
How does this impact investors?
These significant gear shifts in China’s political and economic machinery will impact the way that investors ought to be positioned in terms of exposure to China.
1. Implications for FX
The NPC report kept the same line on the RMB exchange rate – “staying broadly stable” at the “appropriate and equilibrium” level with greater two-way volatilities. Tight capital controls, wider China-US rate differentials along with an expected improvement in the current account balance due to collapsed tourism outflows have made the job of keeping the RMB stable around the 7 level versus the USD easier so far this year.
With China staying committed to implementing the "Phase 1" trade deal, the authorities are likely to prevent sharp RMB depreciation, in our view, to avoid aggravating US-China tensions.
The recent re-escalation of US-China tensions is not good news for our baseline of RMB stability, which assumes that a return of a fullblown trade war will be avoided. That said, the lesson of 2019 is that economic logic is not necessarily the best guide to divining the path of US-China relations. USDHKD forwards climbed after China’s latest national security law proposal geared towards Hong Kong. We remain confident in the HKD peg status quo but renewed depreciation pressure on the HKD on higher political uncertainty will likely strain HKD liquidity further.
2. Structural opportunities in China
While there has yet to be any sector specific policy stimulus announced, the NPC sheds light on structural opportunities. Policy beneficiaries would include both traditional infrastructure and “new” infrastructure in areas explicitly highlighted for growth by the government such as broadband, 5G applications and new energy vehicles, and construction-related sectors amid rising targets for upgrading urban communities.
Meanwhile, the government’s focus on job growth and alleviation of the impact of Covid-19 on household finances and livelihoods provides a positive read-through for the consumer sector. Given the challenging external demand outlook and re-escalation of US-China tensions, domestic demand would continue to be a key focus in supporting growth.
3. China property sector – equities and fixed income
Real estate data that we track closely have recently shown encouraging signs of China’s recovery from Covid-19 damage, although the overall picture remains largely subdued. According to the National Bureau of Statistics, real estate investment (REI) grew 7.0% YoY in April, versus 1.1% YoY in March. The transaction value and volume of residential properties sold fell 2.6% YoY and 1.5% YoY to RMB1.04 trillion and 106.8 million sqm in April, respectively, versus double-digit declines of 12.1% and 13.9% YoY during the month of March.
From an equity valuation perspective, Chinese developers are trading at a forward price-to-earnings multiple of 5.6x, which is 1.1 standard deviation (s.d.) below the 8-year average of 6.8x. The forward price-to-book ratio of 1.02x is half a s.d. below the 8-year mean (1.15x), while the forward dividend yield is attractive at 6.7% (1.4 s.d. above the 8-year average of 5.1%).
From a fixed income perspective, the China property sector is relatively insulated from the Covid-19 weakness and we remain constructive on the sector. Contracted sales of Chinese property companies under our coverage continue to recover. For the four months to April 2020, BBB-rated Chinese developers under our coverage recorded positive contracted sales growth YoY, and high yield developers recorded single-digit negative growth. We expect Chinese developers to record contracted sales growth of 0-10% YoY in 2020. Refinancing risk in the sector is contained, with both the onshore and offshore market continuing to have appetite for property bonds.
4. Watch the risks
As China’s economic outlook remains unpredictable due to Covid-19 and geopolitical tensions remain volatile in the months ahead, we urge investors to remain cautious.
With US elections coming up, a tough stance on China likely to be key part of President Trump’s campaign.
Of concern is President Trump’s recent insistence that China will be held to its trade purchase commitments under the Phase 1 trade deal signed in January 2020.
China would likely counter that it is only reasonable to renegotiate the targets given the unanticipated shocks from the Covid-19 crisis, and that with the US further restricting exports of technological goods to China, it is being unfairly obstructed from meeting its purchase commitments.
Considering that the trajectory of the recovery from Covid-19 is uncertain and potentially long drawn-out, China is unlikely to agree to a simplistic delay of the target dates. There is no easy resolution and we should expect a tense set of renegotiations ahead.
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Version: March 2020