By most measures, China's recovery from COVID-19 is a success. Activity is back above pre-pandemic levels and, in the third quarter, 4.9% higher than a year ago. No other G-20 economy is likely to match the speed of this rebound. Most impressive has been the resilience of China's industrial sector. Supply chains were quick to resume operations and manufacturing output is now expanding at the fastest pace since early 2019. Fears during the early stages of the pandemic that China could trigger a global supply outage have proven misplaced.

Real GDP growth for the third quarter was a touch below expectations but still robust and on target for S&P Global Ratings' full-year 2.1% forecast. Consumption, including government spending, contributed 1.7 percentage points (ppts) to total growth of 4.9%. This is less than half the contribution consumption made for the two years before the pandemic but at least it is positive. Investment again contributed most at 2.6 ppts but this is down from the previous quarter. Net exports contributed 0.6 ppts to growth, underscoring the key role foreign demand is playing in China's rebound.

We see the glass as half-full but not yet overflowing with good news. The softness of consumer spending remains a niggling doubt about the underlying strength of the recovery. Many market observers have suggested that China's consumers are roaring back--photos of overflowing tourist attractions during Golden Week fed that meme.

Chart 1

However, it is remarkable how much expectations for household spending have been marked lower. Retail sales growth reached 3.3% year on year in September but this should be measured against pre-COVID levels of 8%. China's retail sales have recovered more slowly than those in Australia and Korea, two economies that have also shown relative success in containing the virus. Indeed, China's tourism ministry reported that Golden Week tourist revenues were down 30% from 2019 despite the holiday lasting one day longer this year. An improvement over mid-year, certainly, but no obvious sign of pent-up demand yet.

The breakdown of retail sales tells a revealing story of patchy demand. Autos sales are strong, helped by incentives and the desire to upgrade private transportation in a post-pandemic world. Demand growth for smaller ticket items remains weak, however, with clothing, electrical appliances, and furniture well below five-year averages. This suggests that many households are still holding back on discretionary purchases.

Chart 2

Better Economic News But Still Deflated

Overall, owing to lagging consumption, demand remains suppressed and this is showing up in subdued inflation. Underlying inflation in September either continued to ease lower or remained very low. Producer price deflation remains stubbornly entrenched with prices of most products, from raw materials to manufactured goods, still falling (see chart 3). A similar story emerges for consumer prices once we strip out food, especially pork. Non-food price inflation was zero and core inflation was stuck at 0.5% in September. In turn, this is keeping a lid on the economy-wide deflator, which came in at 0.6% in the third quarter. This left nominal GDP growth, measured in renminbi and useful when considering corporate revenue growth, at 5.5%, up from 3.1% previously.

Chart 3

Looking ahead to the rest of this year and into early 2021, much will depend on the policy stance. Here we see signs of a tightening that may result in slower growth than many expect.

Tighter Financial Conditions To Weigh On Growth In Early 2021

Financial conditions have tightened since May when policy easing reached its crescendo. Our index tracks 22 financial variables, including real interest rates and credit flows, and it has tightened by about 1.5 standard deviations since peak easing. This is a large move. We estimate that financial conditions are now moderately tight relative to the average levels since 2005.

Chart 4

Real interest rates continue to climb higher. The real one-year loan prime rate, the benchmark for lending to the real economy, is now at its highest level for five years. A similar story can be told for the real effective lending rate (based on loans actually priced) and corporate bond yields in the secondary market. While nominal rates are either steady or edging higher, low inflation is raising the real cost of borrowing.

Chart 5

Credit flows have also weakened. We track the net new flow of credit as a share of trend GDP as it provides a timely indicator of macro-credit conditions (the change in this variable is often known as the credit impulse). In May, as banks extended credit to cushion the first quarter COVID shock and local governments issued special bonds, credit picked up strongly. Through the third quarter, however, new credit has shrunk to just 6% of GDP, a decline of about 4ppts from the peak earlier this year.

Chart 6

When financial conditions are tight, growth has typically slowed. Chart 7 shows the relationship with a proxy for economic activity since 2010 and it is clear than when the FCI is below zero (tight), growth either slows or remains subdued. This cycle is different because there is a natural upward pressure on growth from reopening the economy. However, if financial conditions remain tight through year-end, reflecting policymaker caution regarding financial risks, we see a high probability that growth momentum could be weaker than widely expected in 2021.

Chart 7

Stronger Renminbi Is A Double-Edged Sword

With real yield differentials rising so quickly, it is not surprising that the renminbi has appreciated. The good news is that the People's Bank of China is tolerating ever more flexibility in the exchange rate, especially against the U.S. dollar. This is essential if China is to safely open its capital account and integrate financially with the rest of the world. A rigid exchange rate would result in market imbalances and one-way expectations that could prove destabilizing. A stronger renminbi is also helpful for the rest of the world as it may encourage China's households and firms to buy more imports.

If the currency strengthens too quickly, however, it could add to the drag on the economy from tighter financial conditions. By worsening net exports before a substantial rotation to private domestic demand has been achieved, a stronger renminbi would slow growth momentum going into 2021. For now, the renminbi is trading on the strong side of the range we have observed for the semi-official trade-weighted index since 2016. The PBOC has begun to adjust policies to take some upward pressure off the renminbi (such as eliminating reserve requirements on foreign-exchange forwards) but greater challenges will come if pressures continue to build.

Chart 8

China's Trade-Ooff Between Managing Risk And Growth

China has faced this trade-off since the 2009 stimulus began to wane about a decade ago. In subsequent cycles, policies have tended to tilt toward growth rather than controlling risks and this allowed imbalances to build in the system. This cycle may prove to be different. For now, policymakers are maintaining a cautious, calibrated approach to policy easing, which is reflected in tight financial conditions for this stage of the recovery.

Our forecasts have assumed such a stance from the start of the recovery and it explains why we have remained toward the lower end of the consensus range for 2021. Our real GDP growth forecast for 2021 growth at 6.9%, for example, is some way below the International Monetary Fund's forecast at 8.2%. One assumption that seems to underlie the IMF forecast is that the fiscal impulse will remain positive next year with a further rise in the cyclically-adjusted primary balance. [1] In contrast, we see a return to smaller deficits (see "China Debt After COVID-19: Flattening The Other Curve", June 4, 2020.)

Overall, this should help China achieve a more sustainable and balanced growth path over the medium term. This stance does not come without downside risks to growth, however, especially if consumers remain cautious and household spending remains disappointing through the rest of this year.

[1] International Monetary Fund Fiscal Monitor, October 2020.

Related Research

• Asia-Pacific's Recovery: The Hard Work Begins, Sept. 24, 2020.
• China Debt After COVID-19: Flattening The Other Curve, June 4, 2020.