A shift from emergency to economic support

The PBoC has been leading the battle to support the economy against the COVID-19 shock — by injecting ample liquidity in the financial system and encouraging wide access to that liquidity. The bank has used a variety of measures, including MLF injections, RRR adjustments, and rate cuts. Policymakers have leaned on banks to lend to businesses that have needed emergency and bridge loans to get through this crisis. So, total social financing (TSF) rose from 10.7% y/y in February to 11.5 y/y in March – the fastest pace since August 2018 – with bank loans rising from 12.1% y/y in February to 12.7% y/y in March – the fastest since September 2019. More will be required, though, as the shift from re-opening China’s economy to reported business resumption and then to actual revenue generation has been stunted. In March, a Peking University survey of small- and medium-sized enterprises (SME) showed that revenues were still down 58% y/y in March.

Even as COVID-19 risks linger, the broader policy emphasis has shifted from emergency interventions towards supporting economic growth; this will be carried by a larger fiscal impulse. The policy shift occurred a couple of weeks ago, emphasized by the past few Politburo and State Council meetings bluntly stating that China would step up the implementation of a proactive fiscal policy in order to ringfence employment.

Clearly, China will continue to rely on banks to extend credit but will encourage corporates along with central and local governments to issue bonds – typically purchased by banks, too. Already, CNY1 trillion has been added to the already issued CNY1.2 trillion by central government. The NDRC has stated that this additional allocation must be used by end of May. In addition, the quota for local government bond issuance for infrastructure development is also expected to be increased from CNY2.15 trillion in 2019 to around CNY3.5 trillion in 2020.

The deficit to GDP ratio is going to increase materially in 2020. Part of this story is falling revenues which contracted by 14.3% y/y in Q1:20 due to depressed revenue generation combined with tax cuts. The situation has been compounded by bigger outlays for health care, consumption vouchers, subsidies, and so on. Revenues were already growing at just 3.8% y/y last year, down from 6.2% y/y in 2018, and the augmented fiscal deficit was already 5.6% of GDP – a 30-year high – from under 1% in 2014.

Weak domestic demand is now a critical variable for businesses normalization, and the focus of domestic policy – especially now with the rest of the world lockdown and heading into recession. In recent weeks, the front pages of the mainstream media in China have spoken clearly about the importance of supporting domestic demand. Indeed, the most concerning macro data point in March was the deeply negative retail sales. Evidently COVID-19 has hit sentiment at a time when confidence was already low and household indebtedness at an alltime high. With potential job losses and firm closures, even as the infection threat passes, spending will be held back for a while to come.

The reality is that COVID-19 magnifies existing demand-side challenges, which is being exemplified by the low share of GDP that is controlled by households, leaving the state to play a relatively oversized role in the economy. Now, the headwinds confronting consumption, manufacturing and the external sector limits private investment, which generally is incentivized by increases in export capacity or expanding consumption. The bottom line is that manufacturing sector investment, which was CNY19 trillion in 2019, now confronts a number of headwinds.

In addition, real estate investment, which amounted to CNY14 trillion in 2019, still seems to face additional policy scrutiny. Granted, real estate investment was up 1.1% y/y in March, but new home sales volume was still down 14% y/y in March. Interestingly their most recent move to lower the one-year rate by 20bps was not matched by a reduction in 5-year money, which is typically the base rate for mortgages. And, the CBIRC is actively investigating banks to ensure the easy funding available to banks are not finding their way to the real estate sector.

Overall then, the more proactive in fiscal policy intends to support domestic investment (which plunged 23.3% y/y in Jan and Feb – the lowest on record – and contracted by 16.1% y/y in March). Without policy support, infrastructure growth would have – at best – remained underwater this year. The cold reality is that annual domestic investment in infrastructure is already enormous, tallying CNY15 trillion or USD2.154 trillion in 2019. And, the growth rate is structurally trending towards zero, increasing by just 3.8% y/y in 2018 and 2019 respectively.

Nevertheless, China has hit the wall in being able to replace non-productive investment with productive. Exemplifying this, the story of “catch-up” potential of the interior has dissipated. Last year, projects in three provinces (Guangdong, Jiangsu and Zhejiang) along with Beijing and Shanghai received half of the funds for projects – from bank loans, bond issuance and trust investment – precisely due to China concentrating resources on the better-performing provincial and municipal governments. Herein lies the rub: some key cities and clusters are the platform of growth and development, and only investment in infrastructure there is commercially viable.

In a departure from the past, China now has taken on significant debt, and its banks do not have the capacity to extend credit at the pace of before. Consider that since the global financial crisis, bank assets have increased fourfold, from USD9.4 trillion to USD41.8 trillion. In contrast, the economy has only increased by USD9 trillion. COVID-19 means NPLs are only going to rise rapidly. Recall that the PBOC itself estimated that, should GDP growth slide to 4.15% in 2020, the volume of NPLs would increase by a factor of five.

China’s banking system is too unprofitable to continue growing lending by double-digits, but now they will have too. To this end, banks will need capital and because most bank capital growth in China comes from bank profits themselves this will prove challenging. Any recognition of loan losses will require provisioning or write-offs, reducing profitability further, limiting bank recapitalization out of retained earnings, and slowing future growth.

The ultimate impact of COVID-19 is that it further exposes weaknesses within China’s banking system. The immediate challenge, already problematic in the trade war, is that the financial system is more effective at getting credit to large SOEs rather than smaller businesses that have faced the brunt of COVID-19. More profoundly, vulnerabilities in the liquidity chain, and the now weaker balance sheets of smaller banks, which also already tested the agility of policymakers in 2019, are likely to become more problematic in 2020. Indeed, given the deterioration in China’s fiscal position, and bank’s role in providing credit to the economy and purchasing a large chunk of central and local government bonds, the size of the infrastructure stimulus is limited. The financial system quite simply is unable to generate anywhere close to the same volume of credit as it could in the past. Greater loan losses will require write-offs, hit profitability, and limit bank recapitalization through earnings.

China’s debt prospects for 2020 and beyond are trending in an undesirable direction. Even last year, whilst the PBOC still stated a policy preference for credit and nominal GDP to expand at the same speed – a condition the policy makers have done away with in response to COVID-19, total leverage increased by 6 percentage points of GDP to 254%. Already this year, total social finance has expanded by 11.4% and is likely to accelerate further, dwarfing the expected 5% rise in nominal GDP growth in 2020. In other words, by the end of this year, the debt to GDP ratio is likely to move beyond 270% of GDP. It is critical then that most of this credit is allocated to parts of the economy able to boost productivity.

Beijing realizes this, but it is also attempting to dovetailing this need to support the economy (and employment) via investment outlays with its broader agendas – on this occasion of emerging as a global leader in 5G. Therefore, unlike in the past, the focus is not on roads, bridges and real estate but rather on “new infrastructure”. New infrastructure was defined by the NDRC last week to be spearheaded by 5G bases and data centres, but also to include big data, artificial intelligence, cloud computing, blockchain, intercity high-speed rail and industrial internet. The idea is that the state can encourage the build of hard infrastructure, which will lay the foundation of the growth of new industries, accelerating the adjustment and upgrading of China’s economic structure.

To this end, according to the Ministry of Industry and Information Technology (MIIT), the total investment connected to new infrastructure will tally as much as CNY1.9 trillion in 2020. As mentioned, the focal point is 5G network construction. To this end, China’s mobile operators are expected to build over 500,000 base stations in 2020 – up from 130,000 base stations in total. Direct expenditure on 5G base stations planned by China Unicom, China Telecom and China Mobile in 2020 is expected to increase 338% y/y to CNY180bn. Huawei and ZTE are expected to  secure around 80% of the 5G infrastructure contracts for base stations, standalone baseband units and active antenna units.

As the threat of COVID-19 passes, the policy orientation is attempting to shift towards supporting economic growth. Unfortunately, COVID-19 magnifies the existing demand-side challenges, with the state having to play a hefty role in the economy. The government has made it clear that it will be more proactive in fiscal policy, but the specific shape of the impulse isn’t clear.

However, unless authorities decide to ease scrutiny on the real estate sector, the only viable lever remains infrastructure and the recently defined “new” infrastructure will serve as the focal point. Yet, Beijing is acutely aware that China’s debt prospects are heading in the wrong direction and that banks lack the requisite capacity to extend credit as before. Clearly, the ultimate impact of COVID-19 will be further exposing the weaknesses inside China’s banking system.

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