October data do little to change China's recovery story. Our GDP proxy suggests that the final quarter will record the highest growth of the year and leave activity for 2020 about 2% higher than the previous year. Given the hole China found itself in during the first quarter, this is a remarkable achievement. S&P Global Ratings believes the recovery will continue into 2021 but that its pace may disappoint consensus expectations.

We have yet to see the convincing rotation in demand needed for a self-sustaining recovery. Three engines continue to power the pickup: infrastructure investment, property, and exports (see chart 1).

Chart 1

These areas are all enjoying growth well above average levels. In each case, we believe that their momentum will slow moving into 2021. Policies should provide a weaker impulse (or tighten) affecting infrastructure and property. One-off purchases of healthcare equipment and office electronics that have boosted exports are unlikely to be repeated next year.

Manufacturing is a bright spot with output now expanding at over 7%. Autos are providing a boost as demand is lifted by tax incentives and a desire to upgrade private transportation in a pandemic. This is offsetting the waning surge in electronics output driven by work-from-home demand. Heavy industry is booming with output of steel and other basic materials well above five-year averages, lifted by infrastructure and property investment (see chart 2).

Chart 2

For now, supply is running ahead of demand and this is pushing down producer and consumer prices. Producer price deflation remains entrenched across categories, including manufactured goods and consumer durables. Further upstream, deflation will have a depressing effect on corporate revenues in raw materials. Consumer price inflation also remains low--even at the headline level--now that pork prices are normalizing. We would highlight core and services consumer price inflation now at 0.5% and 0.3%, respectively, as indicative of soft demand but also weak wage growth. This time last year, these prices were rising by about 1.5%.

The big cyclical story in China, as it has been all year, is the cautious consumer. Retail sales growth rose again in October and is now at 4.3% year on year. Better than no growth at all, but only a little more than half the 8% trend sales growth that existed pre-COVID. Some categories are improving, including clothing, while others remain buoyant, such as autos. But many consumer durables such as appliances and furniture, are struggling, as are restaurants (catering).

Chart 3

Optimists point to a blow-out November "Singles Day" as a sign the consumer is back. The now two-week online shopping festival saw sales on the Alibaba Group Holding Ltd. and JD.com Inc. online platforms of almost Chinese renminbi (RMB) 770 billion (or 0.8% of annual GDP), up about 62% on 2019. Is this the pent-up demand some have been waiting for? Maybe, but it could also signal cautious consumers stockpiling at bargain basement prices. Our sense, based on the broader data flows, is that it is more the latter, but we will only learn more when sales data for December are released.

If the government began to widely distribute a vaccine in China, this could be the genuine lift the consumer needs. Prospects for a safe and effective vaccine ready for distribution in China appear to have risen. The Chinese firm Fosun International Ltd. is a partner in the Pfizer Inc./BioNtech SE vaccine and there are at least four other Asia-developed vaccines in late-stage trials. While only partial data are available, few serious adverse effects have been reported so far.

On balance, though, the macro data tell the same story and are consistent with full-year real GDP growth of about 2% (our forecast is 2.1%). The bigger question, now, is what factors will determine the momentum of recovery in 2021.

Financial Conditions Are Now Biting

We have flagged the tightening in financial conditions for some time as a headwind for growth. Since peaking in May, our financial conditions index (FCI) has tightened a lot and is now moderately restrictive in terms of its effect on growth (see chart 4). The tightening has come through two channels: a decline in the quantity of credit (measured as a share of GDP) and a rise in the price of credit (measured by real interest rates and credit spreads).

Chart 4

This tightening likely reflects deliberate caution from policymakers keen to avoid the excessive stimulus of previous cycles. While prudent, this stance is not cost-free in terms of short-term growth. Large changes in our FCI, especially when it signals a sustained tightening, tend to foreshadow slower growth momentum, all else being equal. This was shown during the 2012 and 2014 tightening cycles.

Tighter financial conditions will strain weaker credits. As conditions tighten and lenders discriminate more, defaults will rise (see "Rising Funding Costs May Tip China's Weaker SOEs Into Default," published on RatingsDirect on Sept. 15, 2020). If the authorities step away from providing blanket implicit guarantees, this process can intensify, causing greater polarization in credit fundamentals (see "China's Post-COVID Conditions Polarize Fundamentals," Nov. 15, 2020).

Of course, this is now playing out with a number of defaults by locally owned state-owned enterprises (SOEs) in recent weeks. We expect that extraordinary government support is not a given for all distressed SOEs, suggesting more defaults may come see "China Recovery Could Bring More Defaults," Nov. 17, 2020.

The macro takeaway is that tighter financial conditions and higher credit risk will constrain credit more broadly and depress spending by corporates on hiring and investment, slowing growth. Again, curtailed spending by weak firms or outright exits by nonviable firms that had been propped up by implicitly guaranteed credit is good for long-run growth. But it will mean a more gradual GDP normalization next year.

Macro Policy Response To Credit Stress

The repo market is the fulcrum of China's financial system. This is the clearinghouse for excess reserves and the arena in which the People's Bank of China (PBOC) makes its most significant policy moves. Turnover in the average month is usually about 50% of annual GDP. In the immediate aftermath of the SOE defaults, banks have become more cautious about accepting corporate bonds as collateral in repo transactions, according to media reports.

Without getting into the mechanics of repos, recent credit stress reduced the liquidity of this market and increased precautionary demand for excess reserves. This pushed up the benchmark repo interest rate, the DR07. If left unchecked, monetary policy will tighten.

The PBOC responded as any interest-rate-targeting central bank would do--it injected liquidity into this market to push the repo rate back down to its target (see chart 5). The PBOC does not set an official monetary policy rate but, over time, it appears to guide the market rate toward the rate it sets on its reverse repo operations, currently 2.20%.

Chart 5

This means that monetary policy did not change. Unless policymakers believe that these credit stresses pose an unacceptable risk to growth, inflation, or financial stability, we do not expect monetary policy to change.

The Macro Takeaway

Policy stimulus has been restrained post-COVID and financial conditions tightened once the economy started to regain its footing. This approach should continue through 2021, at least. We do not yet know what the growth target will be for next year (some sort of target is likely) but this approach suggests greater flexibility on economic growth outcomes. This suggests only a moderate recovery off a low base in 2021 but also more sustainable growth in the medium term. For now, we stick with our 2.1% and 6.9% growth forecasts for 2020 and 2021, respectively.

Related Research

• China Recovery Could Bring More Defaults, Nov. 17, 2020.
• China's Post-COVID Conditions Polarize Fundamentals, Nov. 15, 2020
• Rising Funding Costs May Tip China's Weaker SOEs Into Default, Sept. 15, 2020).
• Are Bailouts On The Way Out For China's Local And Regional SOEs? Feb. 3, 2020