China’s reflation still runs second to national strategy

Key takeaways

• Despite new steps to boost bank lending and equity markets, Chinese authorities seem unlikely to deliver catalysts that would sustainably reverse negative investor sentiment
• Beijing’s focus on national strategy points to deflationary dangers ahead as the country builds capacity against global decoupling and refrains from genuine reflationary measures
• Piecemeal and less effective attempts to stabilise growth are a feature not a fault of China’s more conservative policy framework. ‘Bazooka’ stimulus might never be delivered
• We have removed strategic portfolio allocations to Chinese assets. China’s deflation is helping developed markets’ central banks, reinforcing our preference for core portfolio holdings such as US equities and high-quality fixed income.

Despite recent measures by Chinese authorities to support growth and markets – including fresh cuts to banks’ reserve requirements – we retain our cautious strategic view on Chinese assets.

The sustained sell-off in Chinese equity markets in recent years suggests that global investors have made up their minds on China’s long-term challenges. Despite repeated attempts by Beijing’s policymakers to boost local markets, investor pessimism remains pervasive. In our view, this is unlikely to change for the foreseeable future even if intermittent ‘market rescues’ produce short-term bounces. Chinese indices have trended down despite previous such efforts, including somewhat ineffectual market interventions in 2015. A durable turnaround would require a credible reflationary package and structural reforms, which we think policymakers are unlikely to deliver.

A different China

China’s economy today looks very different from the pre-pandemic era. Experiences since 2021 seem to have profoundly reset the outlook of the private sector. Data clearly suggest this. Despite numerous pro-growth measures, including the lifting of pandemic restrictions, household data show little change in their cautious assessments of their economic circumstances, unlike the pre-pandemic period. We also note that foreign direct investment inflows are contracting for the first time since the 1990s.

There are many explanations for such pessimism. Pandemic restrictions and industry crackdowns may have triggered a widespread re-assessment of the social contract underpinning economic life since the 1990s and geostrategic tensions and property sector turmoil also contribute.

In our view, the causes of the recent shift are not limited to an ageing population. We do not believe that China’s ageing is insurmountable for development, because the country could mitigate the problem by raising its urbanisation ratio, or using technology more effectively. The real challenge lies in the emerging feedback loop between geopolitics and macroeconomic policy, as it could become detrimental to long-term growth.

Feedback loop between geopolitics and macro policy

Amid global decoupling, China faces even greater pressures to achieve self-sufficiency across multiple, instead of a few strategic industries, as originally planned in its ‘Made in China 2025’ programme. China has the capacity to scale-up manufacturing; the auto and clean energy industries show just how quickly it can do so. In other sectors, however, the same kind of success may be impossible or extremely costly to attain.

The leadership’s focus on national security and strategic resilience, however, means that the drive for industrial self-sufficiency continues regardless of cost and efficiency. The result is an intensifying trade war. This dynamic is clear in the semiconductor sector, where the US and allies’ tighter, multi-lateral export controls are thwarting China’s investments to catch up. Emerging auto-sector trade disputes with the European Union offer another example.

This backdrop of mistrust slows the diffusion of global technology and best practices into China’s private sector and redirects economic resources inefficiently. Furthermore, China’s closed capital accounts mean that the push to achieve self-sufficiency carries the risk of perpetuating excess savings and investments while postponing the long-promised transition toward a more open financial system that facilitates the market-driven allocation of capital. ‘Tapping’ captive savers might be seen as a more expedient option than opening markets that could lead to outflows and tougher funding for state-owned enterprises.

Deflationary dangers

The immediate result of this spiral may be persistent deflationary threats in China, as even more capacity is built with help from household savings. We believe that Beijing has the policy tools to stabilise domestic inflation, but other considerations inhibit their use. Whether the country breaks out of this self-imposed restraint matters for China’s medium-term economic and market outlook, not the ‘national team’ market rescue attempts have not worked that well in the past. We do not see signs of anything different this time around.