Most of the news coming out of China is gloomy, making it easy to feel pessimistic. I remain optimistic, however, because the main problems are poor, short-term policy choices by the government, rather than deeper, structural issues which are harder to correct, says Andy Rothman (pictured), Investment Strategist, Matthews Asia.

Over the last three decades, Beijing has often made poor choices, but has usually changed to a more pragmatic path, and I expect that to happen again.

COVID is a mess in China, but a political mess, rather than a public health crisis, so easier to fix. Lockdowns and logistics nightmares meant that there was no macroeconomic joy in the first quarter, and April will be even worse.

The lockdowns are likely to ease by next month, and a significant stimulus should follow, designed to jumpstart an economic recovery by the fall. A more pragmatic approach towards Putin's invasion of Ukraine, and the broader relationship with the U.S., is also possible.

Fortunately, the COVID problem is largely political and bureaucratic, so solutions are readily available. The economic impact is, in the short term, dramatic, with factories and shops closed, and logistics have slowed to a crawl in much of the country.

There is, however, room for optimism for three reasons.

Firstly, experience suggests the number of new COVID cases in Shanghai - accounting for over 90% of cases in China - may peak soon, allowing for restrictions to be eased. 

Second, although the number of COVID cases in China has risen since late March, the number of cases is not very high, especially relative to the size of China's population.

Third, over 90% of cases in China are asymptomatic meaning that the hospital system is not overwhelmed. 
Given this data, why has the Chinese government opted to respond with draconian lockdowns, while most of the rest of the world is lifting its public health restrictions? In my view, the answer is vaccinations.

The Chinese government appears to be frightened that the very low rate of vaccinations among older people presents too large a risk to living with COVID. Additionally, the inactivated whole virus vaccines produced domestically (by Sinovac-CoronaVac and Sinopharm) and used in China are less effective than the mRNA vaccines produced by foreign companies, but Beijing has not approved the mRNA jabs for use in China.

Until recently, the Chinese government's zero-tolerance for COVID policy worked well and allowed a healthy level of economic activity. The incremental expansion in the size of China's nominal GDP last year (an increase of RMB 13 trillion, or about US$ 2 trillion, roughly equal to the size of Italy's economy) was the largest in the country's history.

Regrettably, in recent weeks the government has enforced lockdowns rather than raising the vaccination rate of the older population. When the lockdowns ease, hopefully Beijing will take the pragmatic path of approving mRNA vaccines and boosting its older population.

The key for the short-term economic environment is the ending of widespread lockdowns. 

Soon after people are released from home confinement, and allowed to return to factories, offices and shops, I expect the government to initiate a major stimulus program, designed to support a visible economic recovery by the time of the fall Party Congress, when Xi Jinping will formally be awarded a third, five-year term as Party chief. As Premier Li Keqiang said earlier this month, "Policy support needs to intensify at an appropriate time."

Given the disastrous economic (and social) impact of the lockdowns, I expect the government to double down on the planned easing cycle with stronger credit flows to corporates and households. More rate cuts, including for mortgages and more government spending, including for public works projects. (In the first quarter, infrastructure investment rose 8.5% year-over-year (YoY), the fastest pace since 2018.) Support for small firms, including loan and rent relief. Possibly direct aid to consumers to jumpstart post-lockdown spending.

It will take time for all of this to get underway, so I don't expect to see a visible recovery until the second half of this year.
Residential recovery in second half

I'm also optimistic that China's residential property market will begin to bounce back in the second half of the year.

My optimism is grounded in evidence of strong fundamentals and of policy easing.

The fundamentals include that most new home sales are to owner-occupiers, and buyers are required to put down a lot of cash.

Chinese homebuyers who use a mortgage must put down at least 20% cash for a primary residence (and much more for an investment property), in sharp contrast to the 2% median cash down payment in the U.S. in 2006, prior to our housing crisis.

Prices have remained healthy, rising roughly in line with income growth through last year. Over the last five years, home prices rose at an average annual pace of 7.7%, while per capita urban household income rose at an average annual rate of 7.1%. Over the last 10 years, home prices increased at an average annual rate of 7.6%, compared to average annual income growth of 8.1%.

The market weakness that began last year was caused by government policy, not soft demand. In a misguided effort to stress the market and promote the takeover of weaker, riskier developers, last May, the government instructed banks to limit issuance of mortgage loans to homebuyers.

As a result, after rising 39% YoY during the first five months of 2021, new home sales (on a square meter basis) declined 13% YoY during the following seven months. This led 16 developers, together accounting for 12% of new home sales by volume last year, to default on debt obligations.

Government officials have acknowledged they put too much pressure on the property market and have signalled that they will take a less restrictive approach this year. Mortgage availability has improved and rates have been reduced. In many cities, the cash down payment ratio has been cut, although no lower than 20%. The central government has permitted local officials to take other steps to promote sales, including relaxing home purchase restrictions and increasing access to home provident loan funds.

There is plenty of pent-up demand that wasn't met during the last three quarters, so—assuming the widespread COVID lockdowns end soon—the growth rate of sales and prices is likely to recover by mid-year.
Inflation not an easing obstacle in China

The consumer price index (CPI) is rising in China, but not nearly enough to make the central bank nervous about easing. 

Rising global oil prices have had much less impact on CPI in China, because energy is a smaller share of the consumer basket, and because when global oil prices rise, the Chinese government has a mechanism in place which forces state-run oil companies to absorb some of the increase above a certain level, rather than pass it on to consumers.

This month's lockdowns are likely to lead to temporarily higher food prices, but I do not expect CPI to rise to a level high enough to interfere with the Chinese central bank's plans to cut interest rates and boost credit availability, at a time when the Fed plans to keep raising rates in the U.S.

Pragmatic reasons for optimism

Beijing has made many poor choices, usually driven by misguided political factors. But, the government has usually changed course to a more pragmatic path, and I expect that to happen again.

When I first visited China as a student, 80% of China's population was living below the World Bank's poverty line. Today, Chinese consumers are estimated to account for 20% of global luxury sales.

In the 10 years through 2019, China, on average, accounted for about one-third of global economic growth, larger than the combined share of global growth from the U.S., Europe and Japan. In 2020, China was the only major economy to register growth.

This was all the result of pragmatic policies that emphasized market-based reforms and de-emphasized the economic role of the state. When I returned to China in 1984 as a junior American diplomat, there were no private companies—everyone worked for the state.

Today, almost 90% of urban employment is in small, privately owned, entrepreneurial firms. With the state-sector continuing to shrink. All of the net, new job creation comes from private companies.

Some foreign observers have argued that under Xi Jinping, the Party has rolled back those reforms and has favoured state-owned enterprises (SOEs), but the data does not support that theory. The share of employment and of exports accounted for by privately owned companies has continued to rise, and last year was the 10th consecutive year in which the services and consumption (tertiary) part of GDP was larger than the manufacturing and construction (secondary) part.

Some investors have been concerned that last year's regulatory crackdown was an effort to roll back China's private sector, but that is unlikely. In my view, Xi is attempting to address the same socio-economic concerns that most democracies are wrestling with, although initial implementation has been chaotic.

If the regulatory process is improved, and Xi succeeds in reducing inequality and strengthening corporate competition, he could lay a foundation for the next phase of China's market-based development. If he fails, it would be because of poor implementation of policies designed to create "common prosperity," not because he is anti-entrepreneur. We've already seen some negative consequences of poor implementation, but I expect these to be improved in the coming quarters.

Risk Considerations

Investments involve risk. Past performance is no guarantee of future results. Investing in China may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation.

By Andy Rothman, Investment Strategist, Matthews Asia