Xia Le, Senior Research Fellow of IMI, Chief Economist for Asia, BBVA

The annual “two-sessions”, namely the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC), are always on the top of in China’s political agenda. This year’s event especially attracted a lot of market attention not only due to enormous uncertainties associated with domestic economy but also due to the unprecedented volatility of external environment caused by the gloomy inflation outlook and escalating geopolitical conflicts. The observers are keen to learn how the Chinese central government will set the tone for their work of this year.

In the week-long session starting on March 5th, thousands of delegates from around the country reviewed the Government Work Report by Premier Li Keqiang which covered almost all the important topics with respect to the country’s social and economic developments, ranging from the national anti-pandemic endeavors to the reforms of the national judicial system. To the majority of market observes, what interests them most is a number of 2022 key indicator forecasts announced at the event, including this year’s growth rate, inflation, money supply growth, fiscal budget deficit etc. Except for the fiscal budget deficit, these official forecasts only reflect official projections rather than binding targets, reflecting the authorities’ willingness to allow the market mechanism to play a fundamental role in economic development. However, people still expect these official forecasts to reveal the authorities’ overall policy stance.

An ambitious growth target amid escalating uncertainties of the Pandemic

At the “two-sessions”, this year’s GDP growth target is set at “around 5.5%”, which is a little bit higher than the average growth rate of 5.2% during the period of 2020 and 2021. It is also higher than the IMF’s latest growth forecast of 4.8% and the current market consensus projection of 5.2%. Regarding the target, Premier Li Keqiang particularly emphasized that it requires adequate policy support and the efforts of the entire society. In the meantime, the authorities aim to create 11 million of new urban jobs this year and maintain the surveyed urban unemployment rate below 5.5%.

The official growth target of 5.5% is still in line with the current level of China’s potential GDP, which, according to our estimate, falls in a range of 5-6%. In theory, this seemingly attainable target should not meet with such a large extent of pessimism in the market. However, many observers are not sanguine about it at all, worrying that the new wave of the Covid-19 variant, namely Omicron, will break through China’s defense and tip the world’s second largest economy into a severe downturn. More importantly, the situation of Hong Kong added people’s concerns. Over the past couple of years, Hong Kong had been implementing a similar “zero Covid” strategy to battle the Covid-19 before the much contagious Omicron variant swept the city at the beginning of this year.

In our opinion, it is still too early to tell whether the Omicron can sweep through Shanghai as it did to Hong Kong. The grave situation in Shanghai has prompted the central government to intervene with unprecedented efforts. A strict lockdown is to be implemented in a bid to bring the situation under control as soon as possible. In coordination with the lockdown, China’s authorities also mobilize enormous amounts of medical resources from outside Shanghai to support the city.

We don’t believe that China’s authorities will switch to the mode of “co-existence with virus” any time soon. Shanghai has now become a watershed in China’s war against the Covid-19, just like Wuhan at the beginning of 2020. Our bottom line is that the lockdown in Shanghai will last at least until June. The authorities will stick to its “Zero Covid” strategy while they might fine-tune some measures to minimize the social and economic costs. With the time going on, the general public and policymakers will gain a deeper understanding of the Omicron variant. At some time point, the authorities might find that the hygienic risk of the Omicron variant, in terms of its death toll and threat to the healthcare system, is too small to justify the costly “Zero Covid” strategy. By that time, the authorities will make the big decision to switch to the mode of “co-existence with virus”. But it won’t happen earlier than June.

All in all, we find that the difficulties in attaining this 5.5% official target have been on the rise. However, thanks to the strong mobilization capacity of China’s government, we believe that the Omicron virus is unable to break through China’s Wall to cause a nationwide flare-up. That being said, the real growth outturn of this year is likely to fall in a range of 4-5%.

The property sector likely to be a significant drag of growth

The headwinds to China’s growth abound. We tend to believe that the largest headwind to growth is still the real estate sector, which experienced a severe policy clamp-down in the past two years and are showing clear signals of slowdown now. In this respect, not only the housing prices tumbled in many cities, but also the activities relating to real estate sector begin to decelerate significantly.

In China the property sector’s large contribution to economic growth, the real estate and construction sectors account for around 14.5% of the total GDP in 2020. This ratio seems a bit lower than people’s impression but quite comparable with the ratio in the US (16%), Japan (16.9%) and Germany (15.7%). Taking into account its strong linkages to its upstream and downstream sectors, such as construction, architecture raw materials, housing decorations, housing appliance, furniture, etc., these real-estate-related industries are estimated to account for around 25% of the country’s total GDP.

The up-and-down in the real estate sector also has significant impacts on local governments, the banking sector as well as the country’s households. In particular, around 84% of local governments’ total revenues are related to local property market and land sales. Therefore, the slowdown in the real estate sector will unavoidably lead to the decline in local governments’ revenues and consequentially limit the authorities’ fiscal capacity. Indeed, local governments have long played an important role in the economy, not only in form of maintaining the public spending on various social wellbeing programs but also through infrastructure investment.

In China’s giant banking sector, mortgage loans to households and developer loans jointly accounted for around 29% to banks’ total outstanding loans. Not to mention that many other loans also use property or land as collaterals. The negative shock to the real estate sector will directly increase the volume of Non-Performance Loans (NPL) in the banking sector. It will consequentially weigh on the balance sheet of banks and dampen their capability of extending credit to the real economy.

China’s households also have a great exposure to the real estate sector. The latest household survey from Southwest University of Economics and Finance (CFHS Survey) points out that in Beijing and Shanghai, the share of housing to household’s total assets even reached 85%. By contrast, this ratio is only 36% in the United States. Such a great exposure could imply an enormous magnitude of wealth effect for Chinese households in reaction to the movement of house prices. That being said, the consumption of households could plummet remarkably if the property prices have a significant correction in a short time.

Given the importance of the real estate sector to the economy, the “two-sessions” indicated to fine-tune the sector-wide policies and regulations so as to ensure a soft-landing in the sector. Although the authorities will continue its principle of curbing speculations in housing market and improving the housing affordability in the society, they are willing to adjust the pace of policy implementation so as to ensure a soft-landing in the real estate sector. In a couple of weeks after the conclusion of the “two-sessions”, the fiscal authorities announced a postponement of the property tax this year. It reflects that the authorities are well aware of the potential risks associated with the property market, which is a welcome step and helps to engineer a soft-landing in the property market.

Monetary policy has more room for the authorities to maneuver

At this year’s “two sessions”, the market expected to see more monetary and fiscal policy initiatives in support of growth. The government work report announced that the annual growth of M2 and total social financing are set to be in line with this year’s nominal GDP growth rate, which we estimate will be around 8.5%. In addition, the authorities emphasized the monetary policy will be prudent, albeit tilted to the easing side, in concerns of the US Fed’s interest rate hike and domestic vulnerabilities such as debt overhang. The authorities show their strong preference for targeted credit expansion, in particular to SMEs, Covid-19 affected sectors as well as the agricultural sector.

In our opinion, the authorities might overrate the constraints on the monetary policy at this junction. It is true that China’s monetary policy was constrained by a number of factors, chief among which were the concern of housing bubble and the stability of exchange rate. That’s why the authorities preferred to use targeted monetary policy tools to rev up the economy rather than deploy universal interest rate or required reserve ratio (RRR) cuts.

However, the fast change of external environment has substantially relaxed those constraints imposed on monetary loosening. For example, after the authorities’ persistent policy tightening over the past couple of years, the housing market are slowing down at a fast pace. As we discussed in early part, the policy priority for the real estate sector has shifted to engineering a sector-wide soft-landing from curtailing market bubbles previously. Therefore, the deployment of traditional monetary easing tools, such as interest rate cuts, will help to stabilize the real estate sector and boost domestic demand at the same time.

Moreover, we believe that people’s concerns over the China-US interest rate differential might be exaggerated as well. Some people worry that the interest rate cuts in China will further narrow its gap with the interest rate in the United States given that the US Fed is on its way to hike policy rates.  Then it will exert greater pressure on the RMB exchange rate and even introduced another round of fast currency depreciation comparable to the episode in 2015.

However, this argument fails to recognize the current backdrop of the Fed rate hike. In the United States, the inflation rate has elevated to a record high level over the past 40 years. Meanwhile, China’s inflation continues to be tame thanks to both low food prices and measured monetary policy.  That being said, the interest rate differential between China and the USA is narrowing only in the nominal term while widening in the real term.  Under such a circumstance, the RMB exchange rate should have a natural tendency to appreciate instead of depreciate. Of course, the fast interest hikes could generate unpleasant noises in global financial markets and aggravate capital outflows in the short time. But it should not have a long-lasting impact on the RMB exchange rate if all the in-place measures under the capital account are implemented effectively. Put differently, the potential interest rate cuts in China should not become a woe for its currency.

In sum, China’s monetary policy room is still ample for the authorities to deploy more easing measures. Neither housing bubbles nor US-China interest rate differential constitutes a binding constraint for the monetary authorities to further lower social financing cost through policy rate or RRR cuts. We anticipate 1-2 times of LPR and RRR cuts this year. They are better to be front-loaded before the US interest hikes are in full swing.