As Viral Outbreak Improves, Demand Holds the Key to Economic Recovery

Much commentary in the last week has focused on anemic economic activity since China officially went back to work on February 10. The main concern has been over jumpstarting production, which indeed remains weak when looking at high frequency indicators (see Figure 1). For instance, daily coal consumption at major power plants is still less than half that of normal levels, and lower freight prices further suggest that current demand for industrial commodities is soft.

Yet the main obstacle to returning to business as usual has less to do with the current constraint on production. Instead, the challenge has more to do with consumer sentiment and the mass psychology of uncertainty. In short, it is the lack of demand rather than supply constraints that is holding up a swift recovery. And if demand recovery leads the way, then supply will easily follow.

Figure 1. Few Signs of Industrial Recovery So Far
Note: This index has been adjusted for the dates of the Chinese New Year in both 2020 and 2019. For both years, that date is set as 0. The X axis is a range between five days before new year’s day to 24 days after new year’s day. A value greater than one on the Y axis means full recovery.
Source: Wind.

Mass psychology is of course impossible to predict with any confidence, and it can easily turn on a dime. Although we previously highlighted that the viral outbreak, while serious, was not particularly deadly, the fear of spread and draconian quarantine measures have continued to grip the general public. Now that trends appear to be improving, with the official number of daily new cases dropping below 100 outside of Hubei province, the peak could still fall around our previous estimate of 120,000 cases.

If that scenario comes to pass, then we continue to hold the view that the overall economic impact of the viral outbreak will be transitory. Indeed, markets seem to be converging toward this scenario, as future prices of major industrial commodities are now higher than at the time of our last commentary. Even so, the near-term economic shock is unavoidable, and it is important to properly diagnose the nature of that impact.

Fixation on supply-side constraints somewhat misplaced

The current production bottlenecks could evaporate fairly quickly. For one, in the current environment, Chinese firms still have to go through extensive administrative review to resume production, and many are still awaiting their approvals. As of February 14, only about half of the large firms reportedly obtained approvals to restart production.

While this will certainly have an impact on production, a closer examination of sectoral capacity utilization suggests that these supply constraints are not the main culprit of suboptimal production. Rather, it appears that below potential demand is playing a bigger role in determining the pace of the return to normalcy. When demand becomes robust again, firms should be able to ramp up production even with the restrictions in place.

This can be clearly illustrated in the case of tire production. While truck and passenger car tire production were at similar levels during the Lunar New Year, their production diverged significantly over the last week (see Figure 2). In fact, truck tire production is now already higher than in the week before Lunar New Year.

Figure 2. Truck Tire Production Rebounds Faster than Passenger Car Tires
Note: Data has been adjusted according to the Lunar New Year calendar. A value greater than one means production has returned to pre-Lunar New Year levels.
Source: Wind.

The reason behind this rebound—which occurred despite widespread restrictions on highway transportation and weak demand for commodities—mainly has to do with demand. Since 2019, the Chinese government has cracked down on trucks overloading their freight after a major accident happened because of it. Since trucks can no longer overload, that means more trucks are needed. So this shift in policy suddenly raised demand for trucks, and therefore has sustained strong demand for truck tires. Meanwhile, passenger car demand has been lackluster for nearly two years, with few signs of recovery even before the coronavirus outbreak.

What this demonstrates is that in sectors with healthy demand, production can ramp up quickly in the current environment. As such, for many firms serving the domestic market, they are holding off largely because of the pessimistic outlook on demand, which was already weak even before the outbreak.

Therefore, leading indicators of consumer sentiment, which will be directly related to final demand, are perhaps more useful than supply-side indicators in gauging progress toward recovery. One such indicator is urban congestion, which can be used as a proxy for willingness to go outside. That behavior change indicates both a reduction of general fear and also affects consumption—major purchases like a car or apartment requires physically visiting and testing the products.

Through February 17, congestion levels in major Chinese cities have remained at Lunar New Year levels, with few signs of improvement (see Figure 3). This suggests that willingness to go outside is still low and consumer sentiment has not yet turned the corner.

Figure 3. Traffic at Major Cities Remains Weak
Note: This compares traffic congestion over the same Lunar calendar dates in 2019 and 2020. A value greater than one means traffic is higher than in the same period last year.
Source: Gaode Map via Wind.

There is little Beijing can do to stimulate demand in the current moment. So its policy support will primarily take the form of helping firms to cope with current difficulties, like temporarily cutting tax and employer social security contributions and lifting production restrictions. Investment stimulus, on the other hand, has remained rather modest.

The situation can evolve very rapidly, however. The consecutive decline of new coronavirus cases in the last week bodes well for continued improvement, and the uptick in congestion data for Beijing and Shanghai on February 17 may reflect the start of a change in sentiment. We will continue to monitor the data and update our assessment. But once consumer sentiment decisively shifts, production constraints will quickly fall by the wayside.

Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.