Chinese Economy Continues to Sputter Post-Lockdown

While the Covid-19 situation is looking up in Shanghai, the Chinese economy’s outlook is just the opposite. At this point, we are revising down China’s second-quarter growth to roughly 0%, with full-year growth of around 4%.

This downward revision is predicated on factors that were not present during the 2020 lockdown, making that period less apt of an analogy than we previously assumed. Because this time is different, the normalization of economic activity in Shanghai will not lead to the same V-shaped recovery in 2020.

The main differences are 1) stimulus has been much weaker in this round than in 2020; 2) this lockdown hit during what was already an economic down cycle as illustrated by consumer sentiment.

Constraints on stimulus

Despite the worst Covid outbreak since 2020, Beijing has refrained from significant monetary and fiscal stimulus. Aside from modest reserve requirement ratio and lending rate cuts (25 bps and 15 bps, respectively), fiscal spending will be essentially flat after adjusting for tax and land sales revenue shortfalls. This is in stark contrast to the 10% increase in fiscal spending in 2020. Relief measures, such as reducing corporate social security contributions, have also been smaller in scale compared to 2020.

The reluctance on monetary easing isn’t particularly surprising, as we had noted that People’s Bank of China (PBOC) cannot dramatically lower rates during an aggressive US Federal Reserve tightening cycle. The fear of the 2015 capital outflows scenario weighs heavily on the PBOC’s calculus.

What is more surprising is the reticence on using Beijing’s “go-to” playbook of countercyclical stimulus. That requires understanding the behavior of local governments in a political “election” year.

With President Xi Jinping strongly and publicly endorsing the zero Covid strategy, that has become the lodestar for local officials who are hitching their political prospects to executing such a strategy. Consequently, what was once a fixation on the “GDP target” has turned into a preoccupation on meeting the “zero Covid” goal for local cadres.

Indeed, the mandates change, but the system’s behavior dies hard. Just like gung-ho local officials who used to want to overshoot on GDP growth, they’re now incentivized to be more “Catholic than the Pope” on zero Covid, potentially taking more extreme measures than what is being mandated.

Beijing’s recent efforts to make local officials even more obedient, such as the so-called “Two Upholds,” have likely exacerbated this tendency. For instance, in the name of zero Covid, many cities have implemented complete lockdowns when cases were only in the single digits. Some local governments have gone so far as to prohibit farming or even shutting down highways.

This puts Beijing between a rock and a hard place. Politically it cannot back down from zero Covid, but it also fears that fiscal stimulus will be used to cover the cost of zero Covid measures, incentivizing local governments to take the execution to more extremes.

One thing the central government can do, however, is to curtail local excesses on zero Covid by controlling the purse strings. That is why despite the significant slowdown, Premier Li Keqiang recently told officials to not expect more fiscal transfers.

Lockdown coincided with down cycle

Unlike during the 2020 and 2021 periods, the private sector and Chinese households now appear to have dampened their outlook on the future. For instance, the private sector is scaling back. Many small and medium enterprises (SMEs) did not fully recover from the previous lockdown and are now in even worse shape than in 2020. A national survey finds that close to 40% of SMEs only have enough cash for one month of operations.

When it comes to households, their income growth has slowed to below GDP growth. That combined with a weak job market means that consumption growth was already negative even before the Shanghai lockdown (see Figure 1).

Figure 1. Consumption Growth Was Already Negative Before Shanghai LockdownSource: Wind.

Now, this Omicron wave has made it clear to Chinese households that lockdowns may be far from over. As a result, households are spending more conservatively and are also deleveraging (see Figure 2). In retrospect, that relative optimism in 2020/2021, when Beijing contained Covid and industrial production subsequently roared back to life, was predicated on a false sense of China having “solved” Covid while other countries were still mired in lockdowns.

Figure 2. Chinese Households Are Now Deleveraging (in billion yuan)Note: This shows monthly consumer loan changes compared to same month last year.
Source: Wind.

It hasn’t helped that the Chinese government has yet to unveil a “plan B” alternative to zero Covid. That’s because in this political year, Beijing’s overwhelming focus is to ensure stability to get through the 20th Party Congress. It already has its hands full in responding to millions of unemployed college students and migrant workers, which could metastasize into social stability issues if left unattended.

As such, government capacity and efforts will be geared toward stability maintenance before the political conclave in the fall. The preoccupation with firefighting means that Beijing will have to kick the can down the road on handling the economic fallout and addressing long-term public health challenges.