Policymakers continue to take an incremental approach to easing, unlikely to spark a meaningful upturn in the economy in the near term.

Summer slumber continues

China’s economy continued to grow at a sluggish pace in July, further dampening the prospect of policymakers achieving their target of “around 5%” growth in 2024. The latest activity data flow shows that our China Activity Indicator (CAI) continues to move lower (Chart 1).

Early indications from the July PMI surveys were somewhat disappointing, with only the Caixin Services PMI surprising to the upside and improving in the month (+0.9 pts to 52.1). Both manufacturing business surveys fell, with output and new orders weakening, and the official non-manufacturing survey continued to struggle amid ongoing problems in the property sector.

Similarly, hard activity data were mixed. Industrial production expanded 5.1% year over year, below consensus expectations of 5.2%. Fixed asset investment was also disappointing, coming in at 3.6% year to date in year-over-year terms, against an expected 3.9%. This was in part due to the continued real estate sector drag, with investment falling and new starts continuing to drop. However, investment was weak across the board, with manufacturing and infrastructure investments scaled back in July.

Even in what has been the economy’s strong point, exports and growth have stalled. Stripping out seasonal patterns, exports fell for a second consecutive month, down 1.9% month over month in July. Retail sales surprised on the upside, growing 2.7% year over year, slightly above the 2.6% consensus forecast. That said, we estimate they were up only a tepid 0.1% in July.

Soft credit demand is a concern

If there is a silver lining, the real economy is doing better than credit demand would suggest. Chinese credit fell below consensus expectations in July, coming in at RMB 0.7 trillion vs. an expected 1.1 trillion. The miss was driven by a rare RMB 77 billion contraction in new bank loans, the first decline since 2005.

Corporate lending continued its sharp drop, with the three-month average flows to July falling RMB 0.1 trillion. Combined with close to zero household lending, it reflects a lack of appetite for credit across the private sector (Chart 2).

However, stripping out seasonal patterns, the flow of credit was better than the headlines imply. Total social financing (TSF) bounced to RMB 2.8 trillion in July – its strongest level since March. This was partly due to a pick-up in local government special bond and corporate bond issuance (Chart 3).

Nevertheless, this stimulus is not yet boosting activity to the level policymakers are targeting. Indeed, in an interview following the July data disappointments, People’s Bank of China (PBoC) Governor Pan Gongsheng signaled that implementation of already announced stimulus measures would be strengthened and that further – although not “drastic” – steps would be taken.

The PBoC then surprised markets in July by cutting interest rates earlier than expected. The seven-day reverse repo and one-year and five-year loan prime rates (LPR) were cut 10 bps, down to 1.70%, 3.35%, and 3.85%, respectively.

Still, these rate cuts follow the incremental approach policymakers have adopted, and there is little indication of a move to “big bang” stimulus.

Accommodative financial conditions continue

Ongoing easing helped improve our China Financial Conditions Index (CFCI) for a second consecutive month in July, edging up to 0.62 standard deviations looser than average (Chart 4).

Marginal improvements in market volatility and risk premia, alongside strengthening the yuan, helped ease financial conditions.

However, a more notable improvement would have occurred if not for the continued drag from the money supply, weak credit demand, and the slump in equity markets. The M1 money supply disappointed again, shrinking 6.6% year over year in July, worse than the 5.0% contraction in June.

While a crackdown on fraudulent loans and depositors shifting money to wealth management products has factored into this, soft credit demand remains a major drag.

Another explanation for why the policymakers’ incremental approach to support the economy has failed to gain the sort of traction needed is that China’s real equilibrium interest rate (r*) may be slightly higher than previously thought. Indeed, our estimate for r* shifted upwards, resulting in a weaker contribution from bond spreads and policy rates.

This means that policymakers will need to ease more than expected to support the economy. The CFCI has been in accommodative territory since May 2023, but authorities are finding that this is gaining less traction than in previous cycles.

Markets bet on “low-flation”

Policy announcements, including those from the Third Plenum and the Politburo meeting held in July, have so far failed to turn around market sentiment. Markets remain priced for a weak inflation environment. Bond yields have continued to fall despite efforts by policymakers to intervene both verbally and with policy measures to stem the decline in longer-dated yields (Chart 5).

Chinese inflation surprised to the upside in July. Headline inflation came in at 0.5% year over year, against consensus expectations of 0.3% and up from 0.2% in June.

Core inflation eased 0.2 ppts to 0.4%, but month-over-month moves offered some relief, with services prices rising 1.3% month-over-month annualized. And despite producer prices remaining in deflation (-0.8% year over year), core goods prices expanded, helping to prop up underlying inflation.

China remains very much stuck in “low-flation” – with the GDP deflator still in negative territory in Q2 – but the latest prints show that at least the consumer side of the economy has not fallen into deflation.

Much turns on whether policymakers address the malaise in private sector confidence, particularly consumer demand. President Xi highlighted the need to promote consumption following the Politburo meeting, but policymakers face a challenging task.

Consumers not convinced

According to the latest survey from the National Bureau of Statistics, consumer confidence and expectations remained at historically weak levels in June.

Media reports have pointed to the possibility of introducing consumer vouchers or cash handouts to boost consumption. But there has been a reluctance to use such direct forms of stimulus under President Xi, even in response to the outbreak of COVID.

Indeed, short-term stimulus measures could boost growth closer to the target but are unlikely to tackle the structural issues weighing on consumer confidence.

Households’ saving rates remain elevated, suggesting a lack of household liquidity is not the issue holding back consumer spending.

Instead, the negative wealth effect from house price falls continues to drag on consumer confidence. House prices fell further in July, with prices in Tier 1 cities falling faster than in Tier 2 and Tier 3 cities (Chart 6).

Policymakers hope steps to lower mortgage costs and a program for local governments to purchase unsold properties can address some of the housing drag. Shenzhen became the first Tier 1 city to join the home purchase scheme in August, and traction from such measures may start to yield results in the coming months.

However, given that the purchases are funded through further public borrowing, it remains to be seen how willing some of the most indebted local governments will be to utilize the scheme given the already strained balance sheets.

Final thoughts

Overall, July provided little assurance that China’s stimulus has led to a rebound in the economy. Confidence remains low among corporates, households, and markets, while the incremental approach to easing has only done enough to avoid a more severe slowdown.

However, it appears unlikely that policymakers will diverge from this path and prioritize ‘de-risking’ and national security over near-term growth.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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