China enjoys a strong start to 2023 and policy remains key

• Activity data to February points to a very strong quarter-on-quarter growth rate for China in Q1. The sudden abandonment of zero-Covid has unlocked a surge of consumption and services that should set the stage for a strong annual growth rate.
• While the strength of consumption and services was largely anticipated, the sudden pick-up in the property sector was a notable surprise.
• Whether momentum can be sustained across property and services is the key question. The government’s relatively conservative growth target (~5%), its focus on stability and security, and the need to repair substantial holes in local government finances imply a risk that growth could slow more quickly.
• Moreover, our China Financial Conditions Index (CFCI), which has been updated with our latest estimates of real equilibrium interest rates (r*), now suggests policy was tight in an absolute sense in 2022 (consistent with policy struggling to gain traction and the weak growth outturn).
• But policy is now loosening as measured by the latest CFCI, helped by an improving credit impulse. Going forward, the announced RRR cut and, potentially, additional impetus from a further rise in r* as the economy transitions more conclusively to endemic living, should push the policy stance closer to neutral.

abrdn’s China Activity Indicator backs up the picture of a very fast transition towards endemic living

Disentangling the combined January-February data always presents a challenge, but is key for interpreting China’s economic momentum at the start of the year, and this is no less true in 2023.

Headline data showed that the expected consumption-led recovery was clearly in progress. Nominal retail sales rose to 3.5% y/y, up from -1.8% y/y in December, and we estimate that, after stripping out seasonal norms, this translates to a sequential gain of around 12.5% compared to the end of 2022. This backs up the previously released services PMIs - which printed above 55 in February – and rail and air travel data which jumped to around 90% of its 2019 norms.

As a result of surging services activity – which also coincided with strength in industry, trade and property in January – our China Activity Indicator (CAI) implies very strong quarter-on-quarter growth in Q1, perhaps even above 3% q/q.

Source: Haver, abrdn, March 2023

The recovery in property was a big surprise

Difficulties stemming from seasonal adjustment and unpacking the January-February data mean a degree of caution is necessary when interpreting moves in the property sector.

Nevertheless, it is hard to conclude that the sector did not undergo a very sharp recovery at the turn of the year.

Even applying a more cautious form of seasonal adjustment, we can see that real estate grew very strongly. New starts, building sales values and volumes rose over 60% from their November-December lows, while fixed asset investment and developer funding flows – aided by improvements in self-raised, advance payments and mortgages – rose by around 20% (see Figure 2, top panel).

Source: Haver, abrdn, March 2023

Moreover, prices for both new and existing houses rose for the first time in February (as did those in Tier 3 cities). And while month-on-month moves are only roughly in line with pre-pandemic norms (between 0.2 to 0.3% m/m), the proportion of cities recording price rises has recovered very notably after a period of protracted weakness (see Figure 2, bottom panel).

There are questions about the durability of the recovery and the degree of policy support we can expect

The recovery to date is encouraging, potentially suggesting some further upside to our above-consensus growth forecast. However, its sustainability remains uncertain.

For a start, the government’s growth target of around 5% is relatively modest and the new Premier Li Qiang noted that this “wouldn't be easy” (even though it should be). This added to a cautious tone at the ‘two sessions’ which emphasized resilience: “it is essential to prioritize economic stability and pursue progress while ensuring stability”. Indeed, US-China tensions and other domestic policy priorities have meant that growth is increasingly competing with other aims, a point hammered home by President Xi who stated that: “security is the foundation for development, stability is the prerequisite for prosperity”.

It is difficult to rule out a false dawn in property, and the repairing of fiscal holes by local governments could weigh on growth by more than we anticipate. But authorities are willing to provide more support, as illustrated by the 25bp Reserve Requirement Ratio (RRR) cut, which will go into effect on 27 March.

Financial conditions are heading towards neutral

Judging the policy stance in China remains a fraught affair.

Last year we changed the methodology for our Chinese Financial Conditions Index (CFCI) to account for the estimated decline in the real equilibrium interest rate (r*).

The equilibrium rate of interest isn't directly observable, fluctuating alongside the growth, inflation and policy environment. The weak growth outturn for 2022 hinted that r* may have fallen and indeed our latest estimates point to a path for r* that was lower than we thought (see Figure 3), consistent with a sharp impact from the Shanghai lockdown and generalized economic weakness.

Source: Haver, Refinitiv, Bloomberg, abrdn, March 2023

This in turn has led to a revision of our CFCI, suggesting that policy was tight in an absolute sense in 2022, even if policy actions taken by the authorities were successful in pushing financial conditions in the right direction (see Figure 4).

Source: Haver, Bloomberg, abrdn, March 2023

The latest CFCI estimates show a modest rise from recent lows, helped by an improving credit impulse. Yields and 3m Shibor continue to weigh on the index via Policy & Duration, but going forward we should expect a boost from the announced RRR cut and potentially additional impetus from a further rise in r* as the economy transitions more conclusively to endemic living.

Our latest China forecasts:

• Activity: China’s sudden abandonment of zero-Covid and its rapid transition towards endemic living led to a substantial upward revision of our forecast at the start of 2023. The latest data are consistent with a ‘V’-shaped activity path, driven primarily by a rebound in consumption and services activity, which more than offsets drags from net trade and fiscal retrenchment. Risks from real estate remain, despite the surprise pick-up in the latest data.
• Inflation: Unlike the rest of the world, inflation has not been a problem for China until now. Reopening is likely to drive services (and core) inflation notably higher, but China will benefit from the ongoing recovery in global value chains and the relative weakness within developed markets, which should mean core goods inflation remains low. We continue to condition on a US recession that leads to a marked fall in oil prices in H2 2023.
• Monetary policy: The People's Bank of China (PBOC) is highly unlikely to ease substantially as the economy rebounds. The US recession is however likely to cause an abrupt change of tack, leading to resumption of marked policy easing across a range of instruments, which drives financial conditions back firmly into accommodative territory.

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