China’s Economy Reels From Covid-19 Lockdowns

China’s economy had declined by a seasonally adjusted 2.6% quarter-on-quarter in the second quarter, according to official data. As a result, the annual economic growth rate slowed sharply to 0.4% y/y, from 4.8% y/y in the first quarter. The out-turn was much weaker than the consensus forecast of -1.5% q/q but in line with our expectation for a decline of 2.5% q/q.

The contraction in headline GDP in Q2 masks that activity began to rebound strongly during the quarter. Although the economy contracted sharply in April, most other indicators, such as the various PMIs, suggested that activity picked up as Covid-19 cases declined and lockdowns were eased.

Data for June, published alongside the total Q2 figures, appear to confirm that the economy returned to growth in June. Retail sales increased by 3.1% y/y in June, following a decline of 6.7% y/y in May, while industrial production expanded by 3.9% y/y and fixed asset investment continued to grow by about 6% y/y. The momentum built during the quarter points to a decent rebound in quarter-on-quarter growth in Q3.

China’s zero-Covid policy remains in place

Renewed lockdown measures remain a key threat to the rebound in China’s economy in the near term. Despite recent news that the quarantine period for travellers to China had been halved to one week plus three days of monitoring and some relaxation of testing in some cities, the government’s zero-Covid policy remains in place.

Covid-19 cases have begun to increase again after lockdowns were eased, and it has been confirmed that the highly infectious BA.5 variant of Omicron has arrived on the Chinese mainland. Some provinces have begun to impose restrictions again, and there is a risk that these are further tightened and new cases will appear in other places.

It is virtually impossible to predict when and where future cases will emerge. And it is also difficult to know how the authorities will react, given that the restrictions have varied by province. Embedded in our baseline forecast is an assumption that measures to contain the virus will remain a drag on the recovery in consumer-facing sectors along with a deterioration in the labour market. However, as we noted in our recent forecast update, a scenario of rolling lockdowns similar to those seen earlier this year would wipe out the current recovery and potentially devastate the economy.

Outlook for manufactured exports remains challenging

Meanwhile, the outlook for manufactured exports, which have been a key driver of growth over the past couple of years, is challenging. Admittedly, data released earlier this week reported double-digit export growth of 17.7% y/y in June, while the Caixin manufacturing PMI reported that new export orders climbed by seven points to an 18-month high of 52.3. However, this is likely to be noise in the data associated with easing past lockdowns – something that will make interpreting incoming data tricky – rather than evidence of a sustained recovery in exports. After all, the rest of the world threatens to tip into recession as consumers are squeezed by rampant inflation and rising interest rates.

However, we continue to expect evidence of a more sustained pick-up in activity to emerge. We have been arguing for some time that a trough in leading indicators, such as the credit impulse and real M1 (the supply of money, such as currency, demand deposits and other liquid deposits) late last year had set the scene for a cyclical recovery to emerge towards the end of the third quarter of this year.

Data released this week showed that those leading indicators continued to strengthen last month as new lending beat expectations. It is also expected that local governments will be allowed to bring forward borrowing scheduled for next year to add to stimulus measures that have already been announced.

We still have reservations about the strength of China’s recovery and find it difficult to believe that the government can get anywhere near its growth target of 5.5% this year without severely massaging the incoming data. Stimulus measures that have been put in place are just not big enough, while Covid-19 and ongoing problems in the housing market are obvious issues that are likely to hold back the recovery. Our forecast is for the economy to grow by 3.5% this year.

Notwithstanding this, though, we do at least expect China’s economy to show a positive dynamic in the months ahead when activity in the rest of the world appears to be stalling. Chinese equities have started to outperform in recent weeks, and our expectations for the global economy suggest that this should continue while there will be bumps in the road.