Chinese economy smashed to smithereens

The Chinese economy is in deep recession, whatever the official numbers say. The Caixin PMI is in dire straights, via Pantheon:

No relief in sight for China’s service sector
A decent drop was on the cards, given the tightening of zero-Covid restrictions, and the 6.7 point drop in the equivalent official PMI. But the Caixin survey had already fallen further and faster, generating expectations that the pace of decline would be more moderate in April. No such luck.
Alongside the drop in service sector activity, which constitutes the headline reading, there was an even sharper drop in new orders, to 38.4, from 45.9, with new export orders also falling considerably. In fact, every single subindex fell in April, including prices. Output prices, at 48.5, from 50.8, recorded their first sub-50 reading—indicating falling prices—since August.  Employment, meanwhile, shrank for the fourth consecutive month, implying government support for firms is having limited effect.
As a reminder, the Caixin index has a more private sector, SME, and coastal skew than the NBS survey. The situation in Shanghai, in particular, creates a heavy headwind.  So far, only very limited easing is underway, with a goal of zero community transmission creating a high bar for further reopening.  It is unlikely the service PMI will see much, if any, improvement in May.
Our chart shows the key measures of service sector activity, both easily at their worst since the first outbreak, back in early 2020.

The property crash and OMICRON lockdown is the culprit. Nothing will change. Sinocism:

The Standing Committee met today and made clear to anyone still not paying attention that it has decided to continue with the “dynamic zero-Covid” policy. “Persistence is victory 坚持就是胜利” the meeting declared.

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Goldman thinks there may be a middle path for China on OMICRON:

The city of Beijing announced that it would require its residents to do nucleic acid testing at least once a week starting today (May 5th). We have noticed that multiple cities in China have been introducing similar “regular testing” approaches to deal with the more transmissible Omicron variant and to avoid city-wide hard lockdowns that Shanghai experienced most recently. If more cities follow suit and such regular testing succeeds in stopping the virus from spreading too widely early on, this could enable a transition to shorter and more targeted lockdowns. In short, regular testing could be a key part of a strategy for China to adhere to its “dynamic zero Covid” policy with reduced economic costs in the coming months.

That doesn’t sound like much of a recovery to me. Pantheon is equally bearish:

China’s Labour Market is Under Increasing Pressure

April was a terrible month for China’s service sector, after an awful March. The Caixin Services PMI plunged to 36.2, from 42.0 in March, as zero-Covid policies tightened substantially. This is the second weakest reading on record, surpassed only by the depths of the pandemic, in February 2020. ZeroCovid policies now are at their tightest since the first outbreak in Wuhan.

Every subindex within the PMI fell in April, with a particularly sharp drop in new orders, to 38.4, from 45.9 in March. Output prices, down 2.3 points to 48.5, recorded their first sub-50 reading—indicating falling prices—since August. This would be better news if the PBoC were worried about inflation. As things stand, however, the index mainly tells us that demand is in a parlous state.

We see little prospect that May will be much better. China’s service sector is the first in, and last out, when it comes to zero-Covid restrictions. Early measures to limit the spread of the virus—as in Beijing, most recently—focus on reducing social interaction, while leaving factories open. These measures are typically also left in place long after the peak of any outbreak. The pain lasts longer for services, and the scars are deeper. Limited economic support means it is hard for smaller firms, especially, to get back on their feet.

China’s labour market will worry Beijing

Thursday’s data add to evidence that Chinese economic activity shrank in April, as discussed here.

This creates a headache for policymakers, as the 5.5% growth target looks increasingly distant. But it is not the biggest political problem.

Growth is not an end in and of itself, for China’s government. It is simply a handy proxy for what does matter, namely, employment, income, and living standards, all of which provide a degree of legitimacy for a non-democratic government. This matters more than ever, now that legitimacy is tarnished by the failure of zero-Covid.

Unfortunately for President Xi, the employment situation is deteriorating along with the rest of the economy. All of April’s PMIs point to rising unemployment, despite government promises of support for firms hit by zero-Covid policies, as our second chart, on page one, shows.

The job market is struggling across regions, as well as across industries. The ratio of vacancies to job seekers has fallen sharply, according to data from online job portal Zhaopin, shown in our chart above. The fall has been most pronounced in eastern China, the epicentre of the recent Omicron outbreak, and the region under the heaviest policy burden. Unfortunately, it is also the region with the highest productivity and incomes—roughly 30-40% higher than elsewhere—and a key engine of employment.

The threat to social stability is made apparent in our chart below. Worker unrest—as measured by outright strike action, and calls for help—is increasing, according to data from the China Labour Bulletin. We focus on action related to layoffs and wage arrears, which best capture worker discontent connected to the economic downturn. The data currently run only to the end of March, but the trend is unmistakable. Strike action, of course, is itself disrupted by zero-Covid policy restrictions on mobility, workplace closures, and stay-at-home orders, so even this underplays the extent of the problem.

The policy response to the downturn in growth has been heavy on promises and light on action, so far. The Politburo pledged in late April to stabilise the economy, without spelling out specific measures, and reaffirmed its commitment to zero-Covid. Instead, the focus was on the implementation of previously announced measures. For all the headlines about infrastructure, no new spending was announced.

Similarly, optimism on property and the tech sector looks misplaced to us. Property easing is still focused on reducing down-payments and mortgage rates, which has done nothing to shore up sales. This is hardly surprising, given rising unemployment, and low consumer confidence. Developers, meanwhile, are still constrained by limits on borrowing, and face a tough year.

For the tech sector, much has been read into a pledge to promote the “healthy development of the platform economy”, taken to mean that the regulatory crackdown is over. But as we have argued before, antitrust policy that steps back amidst a downturn in growth, or equity markets, can easily toughen-up again at a moment’s notice. Less attention was paid to a WSJ report that the government is set to take a 1% stake in more tech companies, which might obviate the need for tighter regulation, but hardly in a shareholder-friendly manner.

Hopes seem to be pinned on a “reopening rebound”, but restrictions are being lifted only gradually. May is off to a bad start, with tourist spending over the five-day national holiday down 43% year-over-year. June seems the earliest that growth might start to recover, and even that is dependent on good fortune in containing Covid.

The Chinese economy is being smashed to smithereens and while that goes on there is one big problem for everybody else. TSLombard:

CNY is rapidly depreciating. In the last two weeks, USD/CNY has risen 4%, a >4 standard deviation move for the heavily managed renminbi. Every morning the PBoC sets the midpoint of a daily trading band where the currency is allowed to fluctuate +/-2% from the mid-point. In addition to the daily fix, commercial bank intervention, window guidance and FX reserve ratio requirements changes all suggest Beijing is comfortable with a weaker yuan and is managing continued CNY depreciation.

China is stuck. (See here for the full thoughts of our Chief China Economist Rory Green). The desire to prevent a Covid-19 disaster is clashing with the political imperative of generating decent growth in 2022. More stimulus is coming. However, the efficacy of monetary and fiscal easing is heavily constrained by Covid-19 outbreaks and structural headwinds. With policy ineffective during lockdowns, the PBoC has begun a managed (for now) gradual depreciation of RMB. Beijing is desperate to put a floor on growth: for that to happen, the price of credit must fall and its quantity increase. As growth and rate differentials with the RoW widen, pressure on RMB will rise. A look at previous easing cycles shows that the last time the REER had a significant positive impact on monetary conditions was in 2015, when USD/CNY rose 15% (see chart below). We think growth is what is going to give and for this reason we forecast GDP at ≤4% yoy.

USD/CNY to reach 7 in the next 9-12 months. We have been expecting CNY depreciation for some time; in February we wrote “RMB Depreciation – when, not if”. Thus, we believe the recent depreciation is likely only the beginning, as China increases monetary stimulus and uses the currency to support a slowing economy. Headwinds for the currency also come in the form of a falling trade surplus and widening yield differentials to DM, especially the US. We have been long USD/CNY in our portfolio since 30 March and continue to hold a position.

Could we see sharper depreciation? The risk this time comes from portfolio flows: foreign bond ownership is 3% of outstanding vs 1.4% in 2015 and property developer offshore debt amounts to~US$1.2trn (see here for our Asia property specialist Andrew Lawrence’s take), which could challenge PBoC FX management. And no doubt financial outflows have exacerbated the move in CNY – witness the momentous outflows seen in equities and bonds. Investors still seem reluctant to reposition in headline Chinese equities, as they are making the same assessment that we have – that Chinese equities are not an attractive alternative investment to DM equities.

It is unlikely we will see bond outflows of the same magnitude in the coming months. As we have pointed out previously, flows out of Chinese govvies in February may have been a result of demand for RMB liquidity on the back of the Russia-Ukraine war – not dissimilar to the episode in March 2020 when treasuries sold off aggressively because of dollar liquidity needs. After a year of outperformance, it is likely investors saw this pullback as a signal to take profits. We remain long CGBs, as increasing stimulus and a negligible beta to USTs mean they are still relatively attractive. Additionally, while the yield gap to DM has closed significantly, it is important to note that Chinese bonds continue to offer a better return than USTs when adjusting for inflation.

In DM, the antipodeans are most exposed to CNY weakness. We calculate the beta of DM currencies to CNY in the chart below on this page, where it can be seen that NOK, AUD and NZD have the most positive betas to CNY while the dollar is the one DM currency with a negative beta.

It is also interesting to note that the beta to CNY has risen considerably in the past year relative to its average over the past 10 years.

Inherently, a weakening currency goes hand in hand with a weakening economy. China is the world’s second-largest economy. This means that a slowing China has a negative impact on global growth, but more so on the economies from which it imports heavily – i.e., the antipodeans in DM. It thus makes sense that their currencies would weaken along with CNY, as their economic growth is negatively impacted by the slowdown in China.

I can’t put it much more clearly than that. China is the epicenter of the unfolding global recession.

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