China's stimulus struggles to lift economy as key commodity-intensive sectors take backseat

Roughly six months since China lifted its pandemic-related social restrictions, the challenges faced by its economy have started to become clearer. Several data points indicate that boosting the economy this time around won't take a quick fix.

China injected massive liquidity into the market since the start of 2023 in a bid to boost its economic growth. The year-on-year growth of broad money, known as M2 supply, reached an almost seven-year high in February at 12.9%, data from People's Bank of China showed. The growth rate remained high in March and April, before retreating to 11.6% in May. This was still higher than the 11.1% growth recorded in May 2022, but the economy has remained under the likelihood of deflation.

Faltering recovery

China's Producer Price Index, indicator of price changes of industrial products, fell for the 11th straight month in May by 4.6% on the year, data from National Bureau of Statistics showed. The year-on-year growth rates of the Consumer Price Index was only 0.1% in April and 0.2% in May.

China's property prices have also remained on a downward trend. The unemployment rate for 16- to 24-year-olds, another key economic metric, reached 20.8 % in May, the highest level since the NBS began tracking the data in 2018. China's merchandise exports, which typically provide crucial support to China's economic growth, also fell into negative growth in May after a short rebound earlier in the year when China lifted all COVID-19 social restrictions.

The faltering recovery was also reflected in some commodity markets. The Chinese domestic rebar sales profit margins averaged just minus $0.6/mt in the first half of 2023, down from $43.9/mt of a year ago, S&P Global Commodity Insights data showed.

The most active aluminum contracts on the Shanghai Futures Exchange averaged Yuan 18,457/mt ($2,542/mt) in H1, down 14% compared to the same period last year, exchange data showed.

Smaller toolbox

Low inflation and slower economic growth usually suggest a stronger monetary and fiscal stimulus is on the way. In the past, the government could easily stimulate the economy by injecting liquidity into the property and infrastructure sectors.

This was not only because the two sectors were involved in a wide-range of upstream and downstream industries. They were also a credit generator that could quickly help drive the economy back into the fast lane.

The property boom in the past two decades enabled local governments to turn land into valuable assets and capital to finance government-led urbanization, boosting infrastructure and accelerating the migration of rural residents to cities, which – combined with China joining in World Trade Organization in 2001 – fueled manufacturing and consumption.

Higher household income, assets appreciation and rising land prices pumped the flow of national savings into investment, boosting urbanization further. The cycle repeated over the years. But the property-infrastructure combination – an elixir that worked to revive the economy in the past 20 years – is wearing off.

The sharp slowdown in property, starting in H2 2021, brought unprecedented challenges to the investment-driven cycle, and has largely limited the effect of China's monetary stimulus policy. China's population growth turned negative in 2022 for the first time in 61 years, and its urbanization is nearly complete, marking the end of China's property boom.

The downtrend of China's property sector is expected to continue in the coming years, until a balance can be found between the stalled household income and soaring home prices.

Moreover, China's household debt-to-GDP ratio increased from 56.1% in 2019 to 63.3% in the first quarter of 2023, according to the National Institution for Finance and Development. The social restrictions to contain the COVID-19 pandemic from 2020 to 2023 compounded the household debt burden.

With a bleak outlook on the property sector and uncertainties around their own future income, highly leveraged residents have been busy in either saving more or repaying their debts, rather than borrowing more for consumption or to buy homes.

This is partly why the economy remains under very low inflation, despite an already massive liquidity injection in early 2023. Shrinking home buying has hit land sales and prices, compounding already high local government debts.

Local and regional government revenues are highly dependent on land sales and property-related taxes. These account for about 30%-35% of total revenues of LRGs, according to S&P Global Ratings.

As local governments are the main body leading the infrastructure construction, it is not difficult to foresee that China's infrastructure investment growth is likely to be limited in 2023.

Piling up on the pressure, China's export markets are also facing the long-term challenges of a global fight against inflation and the global supply chain restructuring amid the China-US trade tensions.

Road to recovery

Some Chinese economists expected the central government would eventually allow stronger monetary easing to be introduced, as the economic downward pressure had shown no sign of abating. The rapid weakening of the yuan's exchange rate also bolstered such market expectation. The offshore yuan exchange rate breached Yuan7.25 per US dollar on June 28, up from around Yuan7 mid-May and 8.7% higher than at the start of 2023.

But the faltering economic recovery in H1 already demonstrated that injecting more liquidity has sequentially become more inefficient and is unlikely to stop home sales from falling in the longer term.

The time seems to be ripe for a transformation in the economic inner cycle based on a property-urbanization mechanism.

While China's Politburo, the top policy-making body, is expected to announce stimulus packages during its meeting in July, any further stimulus is likely to be just a modest tweak.

Some market sources in the commodities space expect more fiscal stimulus instead of monetary measures to be introduced to ensure a sustainable economic growth. However, they added that the focus might be more on sectors linked to new energy, digital economy and high-end manufacturing, which consume much fewer bulk commodities than property and traditional infrastructure.

China will eventually shift from investment-driven economy to consumption- and high-end manufacturing-driven economy, but this will take years to achieve. During this process – at a time when China is also facing shrinking export markets – oversupply is likely to persist in some of the commodity markets, such as steel, alumina and petrochemical, putting a lingering squeeze on these sectors' profit margins.

With Analysts Oceana Zhou and Lucy Tang