While we await the annual National Peoples’ Congress and the ensuing announcement on growth targets and other reform initiatives, China’s economy has been on a steady path of muddle-through deceleration for the last couple of years especially given the high base in GDP it has attained. We believe the market currently underappreciates to what extent China’s economy is domestically led. Three relevant threats loom large over the next 3 to 6 months:
Tighter fiscal conditions: Fixed asset investment (FAI) in projects newly started, a key leading indicator of capital formation, has been slowing as local governments are cash-strapped following a collapse in land sales and property-related tax collections, which constitute 36% of local government revenues. In addition, local governments now face scrutiny and stricter regulation of projects. Although the central government is expanding its fiscal deficit to provide more support for infrastructure spending, this alone will not be enough to offset the drop in local government FAI spending as central government FAI is much lower – only 5% of the amount of local government FAI.
Financial and monetary conditions are restrictive: Repeated measures to loosen liquidity through targeted and wider easing measures have been inadequate. The O/N and 7-day repo rate continue to stay elevated since January and are yielding above levels two rate cuts ago. This compounds the upward pressure on real rates with the prevailing disinflationary environment and will worsen debt repayment capacity for borrowers. Non-performing loans are increasingly realized by larger state-owned banks indicating rising financial stress levels. On the FX front, despite slightly weaker USDCNY fixings by the PBOC, the CNY real effective exchange rate (REER) has appreciated markedly due to the moves from the EUR and JPY weights in the basket.
Property sector overhang: Looking at a simple average of property prices in 70 major cities, we estimate property prices have declined ~5%yoy in February, driven in part by ongoing oversupply and inventory pressure. Floor space under construction has been exceeding floor space sold and the adjustment here will have macro implications.
Our investment view expects a gradually weaker CNY vs USD, but it should remain an outperformer against other major currencies. Broad stability is still needed as a policy to instill confidence in the internationalization of the currency. This will lead to more pressure on export related industries and credit trends in this area will face deterioration. Overweight duration positions in local rates should perform once liquidity conditions ease further. For China USD-denominated credit broadly, we find valuations attractive vs US and other Asian investment grade credits. Even for cyclical sectors like industrial and property, we are able to identify quality issuers from our bottom-up analysis where margins can provide adequate cushion against these headwinds. Some may also benefit from policy relaxation in targeted areas.