China's real GDP growth in the second quarter was an upside surprise for us and the markets. At 3.2% compared with the same quarter in 2019, it suggests that China's economy is well on the road to recovery and could grow above 2% for the full year. This clearly poses upside risks to S&P Global Ratings' 1.2% forecast for 2020.

The monthly data paint a more nuanced picture, however. In particular, there is a striking contrast in the drivers of aggregate demand. Consider the higher frequency monthly data such as fixed asset investment, retail sales, and exports. They suggest that investment in infrastructure and real estate has driven the rebound up until now. In turn, this is lifting industrial production. Consumption remains weak. Retail sales are stabilizing but, even in June, remained below the levels recorded at the same time in 2019. Export growth stays patchy given the stuttering recovery in the rest of the world.

Chart 1

In our view a decisive pickup in consumer spending will be needed for the recovery to become self-sustaining. Specifically, we need to see retail sales growing at or above the trend 8% growth rate of recent years. This will happen next year because the annual changes will be compared with the sudden-stop economy of February and March of 2020. But don't be fooled by what might look like a dramatic recovery early next year, especially if spending through the second half of this year remains sluggish by recent standards.

Consumers Are Still Careful

Viewed through one lens, one might think that consumer confidence should be roaring back in China. COVID-19 remains contained, by and large, and the recent Beijing outbreak showed the government's test-and-trace strategy to be effective. The unemployment rate is falling. The housing market, where most household wealth is parked, remains buoyant. Even the equity market is having a good run, albeit with the inevitable ups-and-downs.

Household income growth is only slowly climbing off the floor, however. At just 1.5% for the second quarter for 2020, compared with the same period a year ago, income growth remains well below the near-8% trend to which households had become accustomed. Rural households are doing slightly better at 3.7%, and transfers to households rose by 8.2%. The National Bureau of Statistics (NBS) said price subsidy schemes and other temporary relief efforts boosted transfers. Still, the broad income shock experienced by China's consumers will take time to dissipate.

Chart 2

In part, a sluggish recovery in income reflects a soft jobs market. The surveyed unemployment rate is falling but, despite the efforts of the NBS, it might still be understating the degree of slack in the labor market. Officials have confirmed that migrant workers in cities are counted as unemployed if they are surveyed, but many of these migrants may already have returned to their home towns. Other indicators, such as the employment index of the service sector's purchasing managers' index (PMI) survey, suggested most employers were still shedding jobs in June.

Cautious consumers mean higher saving and less spending. A recent household survey by Southwest University--based in Chongqing, China--found risk aversion had encouraged consumers to save more. Retail sales data point to consumers holding back spending. There are bright spots. Online retail sales are booming, especially for food. This reflects a change in how people spend, not how much (indeed, online sales of goods are included in the NBS sales data.) Cellphones are being upgraded. But overall, consumers are still holding back on many discretionary purchases, such as automobiles, clothes, and furniture.

Chart 3

One curiosity of COVID-19 is its effect on housing markets. China, like the U.S., is experiencing buoyant market activity, driven by sales. If consumers are so worried about the future, why are they buying new property? We still do not know the full answer but we suspect, in the Chinese context, there are a few reasons.

First, consumers need a safe place to park their savings. The obvious and "safe" choice is property, given that deposit rates are so low, racy wealth management products are off the menu, the equity markets are volatile, and foreign assets (largely) are off limits,. Southwest University's survey found that low- and middle-income households expected better returns in property than in equity markets.

Second, mortgage rates have fallen, albeit only slightly. Banks are now required to set the floor on mortgages at a small spread over the loan prime rate (LPR), which has fallen only marginally so far this year. Still, recent surveys of banks across major cities suggest that rates have, on average fallen by about 30 basis points (or 0.3 percentage points).

Stimulus, Property, And Technology Boost Industrial Production

While consumer and export demand is soft, manufacturing supply is strong. This need not create a huge demand-supply imbalance because there are good reasons for a pickup in manufacturing output. First, infrastructure investment and a buoyant residential property market are lifting demand for intermediate goods such as steel and other upstream industrial products. Second, rising demand for technology products is boosting electronics.

Indeed, the output of consumer goods in June remained below the levels seen during the same month last year. Machinery, indicative of capital expenditure, remains soft. Auto production is picking up, albeit off a very low base. This multispeed recovery, reflecting the drivers of demand, was recently highlighted by the S&P Global Ratings China industrials team (see "Carmakers Are A Step Behind In Industrial China's COVID Comeback," July 16, 2020.)

Chart 4

Weak Demand + Strong Supply = Lower Prices

Prices clear markets. If demand is subdued while supply is abundant, the market clearing price will stay low or even fall further. Deflationary pressures in China often start upstream in producer prices. Notwithstanding infrastructure and property-related demand, these prices remained lower in June compared with the same month a year ago with the exception of food (influenced by pork supply problems). There are signs that deflation has bottomed, but stabilizing above zero would require a sustained improvement in final demand (see chart 5).

Chart 5

More important, core consumer price inflation is now below 1%. Core inflation is "sticky" and often reflects the slower moving forces of supply and demand in the economy that take time to change. While inflation is a lagging indicator, it is hard to see a pronounced reversal anytime soon.

A large part of core inflation comes from wages. About half of China's jobs, and most of the jobs growth, are in the service sector. Until services rebound for a sustained period, absorbing unemployed and underemployed workers, there will be little upward pressure on wages (and, therefore, prices). The role that services play in core inflation is apparent from the strong relationship between the two (see chart 6).

Chart 6

Credit Does Not Live In The Real World

Economists talk about the real economy a lot but consumers, firms, and banks think more about the nominal world. This matters because changes in the nominal world, especially low and falling inflation, can have real effects. From a credit perspective, very low and falling inflation can increase debt service burdens if nominal interest rates do not fall and fully compensate.

For now, China's central bank is keeping a steady hand on the interest rate tiller. Actual rates in the most important short-term money markets have edged higher in recent weeks but this reflects some withdrawal of exceptional and temporary liquidity rather than a policy tightening. The People's Bank of China's policy rate corridor has been remarkably stable (see chart 7) and in the past few days, the benchmark loan prime rate was once again kept unchanged. As inflation falls, this means real interest rates are rising.

Chart 7

The PBOC's policy rate is only one ingredient in the final rate paid by public, corporate, and household borrowers. Other ingredients include the premium required by lenders for risk and time (which explains the upward sloping yield curve). Adding to that are issues related to supply of credit at a particular price and other factors that determine financial conditions. That's why we take a broader view with our financial conditions index (FCI).

Our FCI is still bullish for growth. Still, as nominal interest rates have edged higher along the yield curve and inflation has fallen, it has tightened a touch in the past month or so. Real interest rates and bond yields, together with risk prices and credit quantities, are key components in the FCI.

Chart 8

Higher-than-expected growth and a slight tightening in financial conditions may be leading some observers to believe that a policy turning point is upon us. That growth is self-sustaining and policymakers can start tapping on the brakes. China's recovery is encouraging but it is far from "mission accomplished." Stimulus-driven demand has not yet handed over to private consumption as the driver of growth and, until it does, China's recovery will remain unbalanced and vulnerable to shocks. The economy will need ongoing and outsized policy support if it is to maintain momentum and achieve growth above 6% in 2021.

Related Research

• Carmakers Are A Step Behind In Industrial China's COVID Comeback, July 16, 2020.