China started the year on an even keel: while growth was slowing, it was doing so in predictable and undramatic fashion, with macro policy steady and in easing mode. That backdrop remains, but a range of risks has snapped into focus in recent weeks, and markets have reacted with extreme volatility.
Investors have been rattled by two kinds of uncertainties: ‘black swans’, or unanticipated major events like the war in Ukraine and China’s relationship to the conflict; and ‘grey rhinos’, or risks that were big and identifiable but overlooked - like the potential for a resurgence of Covid-19 outbreaks in China, or the latest de-listings of American Depositary Receipts (ADRs), on top of the ongoing impact of regulatory changes in education, technology and healthcare. Here, we briefly assess what’s changed, and update our forecasts for China’s outlook.
Fundamental shifts
Contrary to the situation in most developed markets, which opened the year with above-target inflation boosting the case for policy tightening, China entered 2022 with an easing policy setting. At the same time, evidence has been building that the worst of China’s property sector slowdown has passed. Indeed, activity data through February confirmed this assessment, with numbers beating market expectations handsomely. Specifically, a range of activity data such as industrial production, electricity production, and online sales showed solid sequential momentum and came in better than expectations. Property market sales also showed a sequential rebound - though data in this category is still decidedly weak compared to a year ago as the new policy reality focussed on this sector beds in. The jury is out on whether the recent measures taken to encourage property demand, such as targeted relaxation of mortgage rates, will be enough.
Covid resurgence
Enter the first grey rhino. China’s recent sharp rise of Covid-19 cases coupled with the country’s ‘zero-Covid policy’ renewed investors’ fears of another pandemic-related economic slowdown, as lockdowns hit major cities such as Shenzhen and parts of Shanghai. According to the latest estimates, around 31 per cent of China GDP come from areas where there is a mid-to-high risk of Covid outbreaks and associated lockdowns. Of course, the duration and intensity of lockdowns matter, but the application of zero-Covid has certainly increased downside risks to the official 2022 GDP growth target of around 5.5 per cent. We estimate a 1 percentage point reduction in growth is possible given the extent of lockdowns we have seen to date, meaning that for China to meet its growth target, it would need to stimulate other areas.
It remains to be seen if China’s zero-Covid policy will change going forward, especially as the rest of the world starts to live with the virus with the help of mass vaccinations and herd immunity. Data show 86 per cent of the Chinese population have been fully vaccinated, and nearly 40 per cent are boosted. And the proportion keeps rising fast. Local reports indicate the government cares about the vaccination ratio in elderly age cohorts too and is giving it another push. The National Health Commission of China has issued the ninth version of Covid-19 diagnosis and treatment guidelines, with changes to ensure more efficient allocation of medical resources. There are also indications that lockdowns are increasingly adapted to local situations, and this variability shows that China is trying to find the right balance between ensuring economic growth and combating the virus. China is trying to get this round under control, and adjusting policies to adapt to the new features of the Omicron variants, such as adding new testing and treatment methods.
Delistings revisited
The second grey rhino for investors came in the form of a new development in a multiyear accounting dispute between the US and China. On March 8, the US Securities and Exchange Commission identified five Chinese stocks for potential delisting from US exchanges. The news triggered a sharp selloff and correction of around 30 per cent in the value of many Chinese ADRs - albeit followed by a massive rally after senior Chinese officials gave deliberate and coordinated reassurances of support for the economy and financial markets.
If instituted, the delistings would be the first implementation of the Holding Foreign Companies Accountable Act (HFCAA), which became law in the US on December 18, 2020. The act was a US attempt to pry open the books of Chinese companies to the US auditing regulator, and empowers the SEC to target and ultimately delist companies whose accounts haven’t been signed off by US-recognised auditors.
Unless an agreement on audit sharing can be reached, it could mean that these five ADRs will be delisted, but we think this is unlikely to happen before 2024. In the meantime, there are concerns that more Chinese ADRs will be added to the list, further dampening investor sentiment on the sector. It could prompt more Chinese companies to privatise and seek a new listing onshore in Shanghai or Shenzhen, or in Hong Kong or another offshore market.
For companies that already have a secondary listing in Hong Kong, the effect of an ADR delisting is less dramatic, as in most cases investors could simply convert their US positions on a fully fungible basis to shares of equivalent value that are traded on the Hong Kong stock exchange. The concern is that some global institutional investors won’t be able to own Hong Kong-listed names due to their fund mandates or compliance requirements, while many retail investors might not like owning Hong Kong-listed shares due to different trading time zones and complications in account management. But we think this would involve a small minority of ADR investors. Furthermore, according to Goldman Sachs estimates, while US investors own around US$750 billion of Chinese equities across A shares, H shares and ADRs, less than 8 per cent of this are likely to be held by investors that cannot trade in Hong Kong. And any negative impact on broader liquidity in Chinese names is likely to be more than offset in time - because companies migrating from ADRs to Hong Kong listings may become eligible for Southbound Stock Connect, meaning their shares become available to mainland retail investors for the first time.
Ukraine unknowns
The black swan event weighing on China markets is Russia’s invasion of Ukraine, which began in late February. Investors are concerned that China could get dragged into the conflict militarily or could be persuaded to offer financial or other assistance to Russia, which could in turn see China subjected to sanctions or other measures imposed by the group of countries including the US, EU and UK that are aligned in opposition to Russia’s invasion of Ukraine. The uncertainty points to a deeper fissure in the global geopolitical and geo-economic order that has been in place since the end of the second world war.
Still, interdependence remains high between China and other nations. It’s important to point out that China is significantly more integrated into the world economy than Russia, and that China’s interdependence with developed markets runs much deeper. In terms of current economic share as a percentage of world GDP on a purchasing power parity basis, China stands at 18.7 per cent versus 3.1 per cent for Russia. When it comes to trade, the difference is even greater. China’s share of world exports stands at 14.2 per cent in value terms versus 2.2 per cent for Russia. For imports, the shares are 10.5 per cent and 1.2 per cent respectively.
Any assessment of extreme risks needs to stay grounded in facts. While a high degree of uncertainty remains, recent pronouncements by Chinese officials that China intends to remain a neutral party to the conflict have provided some measure of assurance. Chinese officials have recently emphasised their respect for Ukraine’s sovereignty and support for a peaceful settlement of the current crisis. And while a virtual summit between Joe Biden and Xi Jinping on March 18 appeared not to contain any breakthroughs, the fact the two leaders were holding talks was seen as a positive development.
Policy and macro implications
On the policy front, as a mixture of both actual and perceived shocks have hit the Chinese economy, we have also seen a major change in policy intentions as marked by the takeaways from a March 16 meeting of the Financial Stability and Development Committee led by Vice Premier Liu He, one of the most influential voices on financial and economic issues in China. The pro-market and pro-growth messages delivered at this meeting triggered a dramatic two-day rally in Chinese stocks on March 16-17 that reversed many of the losses from the ADR selloff at the start of the week.
We expect China’s policymakers to be proactive in supporting growth from here. On the macro front, in the coming weeks we now expect both an interest rate cut and a reduction to the reserve requirement ratio (RRR) for banks, as well as a strong increase in fiscal spending support for the economy. Investors lack details, however, on the plans to reach the GDP target, and we suspect growth this year could be end-loaded. Credit deployment indicators started to turn a corner last year but have been relatively weak and volatile due to the challenges facing the economy. We think this ambiguous trend will now change, with an accelerated focus on long-term credit deployment and a pickup in the pace of broad credit growth as measured by total social financing (TSF), which was weak in February. While black swans and grey rhinos may have rattled markets, China’s policymakers appear attuned to the risks and ready to act accordingly.
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