The Deloitte Research Monthly Outlook and Perspectives
11 May 2022
Leaning on the fiscal lever
The critical question facing the Chinese economy is not just the timing and magnitude of the upcoming stimulus, but rather its composition t in light of Omicron-induced disruptions, the Fed's tightening and a likely protracted conflict in Europe.
On April 29, the Politburo convened a meeting on unveiling more potent and rapid economic reflationary measures. Indeed, comprehensive and partial lockdowns that are impacting over 40 cities have been weighing on the economy since late March with Shanghai being the focal point. Despite stronger-than-expected Q1 GDP data of 4.8% y-o-y, Q2 GDP growth is expected to be much lower due to supply chain disruptions, a subdued housing market (housing sales data in 30 large and medium-sized cities have plummeted by 54% y-o-y in April) and the adverse impact of lockdowns on consumption and business in general. In the absence of meaningful stimulus, the growth target for 2022 of around 5.5% is at risk.
The focus of April's Politburo meeting was largely oriented around fiscal stimulus. Signals of promoting a healthy housing market and relying on platforms to generate investment were cheered by the stock market before the May holiday. On fiscal expansion, the meeting called for additional investment in infrastructure, new energy, water conservation and cloud computing, and reductions to fees and taxes for firms which are being affected by covid. We have been of the view that the fiscal lever ought to take on more of the heavy lifting in the post-covid era. Such a need has become more imperative as the global economy has been reeling from a stagflationary shock from the Ukraine-Russia crisis and investors' perception that the Fed is behind the curve. Unlike previous stimulus packages, policymakers will try to avoid ramping up investments in sectors which are plagued by over-capacity. To front-load projects which were previously earmarked in 2023 and 2024 could boost growth immediately with relatively little side effects. But more importantly, given roaring commodity prices, the composition of a meaningful fiscal stimulus matters because even further rising commodity prices on the back of fiscal stimulus could exacerbate profit erosion as experienced by many downstream sectors. That is why it is best for fiscal stimulus to target final demand.
In this vein, consumption coupons or similar schemes have been touted as sound initiatives. However, even if consumption coupons are being rolled out nationally, following the lead of cities such as Shenzhen and Suzhou, their impact on the economy may be moderate because, for a large economy, a Hong Kong SAR-type experiment in consumption coupons will not be practical (HKSAR has dished out HKD10,000 or US$1,300 per head for two consecutive years). For China, a transitioning economy in the midst of a catch-up phase, consumption upgrades remain a secular trend (e.g., the penetration rate of premium cars has increased to 13.2% in 2021 from 7.4% in 2017). There are ample areas in which consumer demand could be nudged. For example, given that mortgage down payments have been lowered in most cities, why not remove restrictions on home purchases in Tier 1 cities and some Tier 2 cities as demand for "trading-up" has been suppressed for years? Similar restrictive policies in the automotive market, which were intended to alleviate congestion, could be eased as well. Stringent policies of limiting home purchases in Beijing and Shanghai for over a decade, coupled with a complex score system (e.g., Shanghai), were meant to discourage speculation and to bring more equity into a market where demand has been outstripping supply. These lofty goals have received popular support, but if developers are burdened by debt while certain segments of consumers could unlock demand for housing on the back of easing administrative controls, it would be sensible to tinker with housing policy while taxing the well-off.
Emphasizing the dominant role of the fiscal lever does not mean monetary policy plays no part in reflation. But, rising US dollar interest rates have indeed reduced the People's Bank of China's (PBOC) room for maneuver (for the first time in many years, 10-yr US Treasury yields are higher than comparable Chinese instruments). Rising USD interest rates have presented a policy dilemma to most emerging markets – between supporting growth and arresting inflation. China is in a relatively strong position in terms of its balance of payments, being cushioned by a healthy current account surplus and its "almost sealed" borders for travellers this year (we could see resumed business travel on shortened guarantee period soon but outbound tourism will be unlikely). It is true that China may not get a torrid of capital inflows as in past years, but the Renminbi, albeit declining recently against the greenback, remains a strong currency compared to others such as the Yen, Euro and the Pound. A more flexible RMB exchange rate can be an additional tool for boosting growth, but not necessarily for increasing China Inc.’s competitiveness. In follow-up meetings by the PBOC and the China Banking and Insurance Regulatory Commission (CBIRC) around May 4, banks were asked to support SMEs as well as pent-up demand of housing. In essence, banks will be likely to go easy on customers whose business is suffering from temporary liquidity difficulties.
Chart: Surging long term dollar interest rates signal stagflation
Looking ahead, a protracted military conflict in Europe may bring about additional shocks to the global economy. Should the EU impose tariffs on Russian gas, there will be another wave of stagflationary turbulence. That is why China's fiscal expansion should be well calibrated and exchange rate fluctuations ought to be of least concern.
Pandemic outbreaks continue to severely strain logistics
Localized outbreaks of the pandemic have become widespread in China in recent months, hitting Shanghai, Jilin and Guangzhou especially hard. As of May 10, 2022, a total of 7,568 confirmed cases had been reported in the Chinese mainland, while the total number of local newly affected asymptomatic coronavirus carriers was 1,603. At present, the epidemic situation in China remains dire as many cities have tightened epidemic prevention and control measures. This has greatly affected the logistics and transportation industries, resulting in a year-on-year decline. Logistics in Jiangsu, Zhejiang and Shanghai have been most affected by such measures.
The current situation of logistics under the epidemic
- Logistics Sentiment Index (LSI) is at a historic low. According to the relevant data from Wind, China's Logistics Sentiment Index in April 2022 hit 43.8%, dropping 4.9% from the previous month, the lowest point since March 2020.
Chart: China's Logistics Industry Sentiment Index % (LPI)
- Highway freight volume and cargo hub throughput has declined significantly. As of April 18, the year-on-year growth rate of China's vehicle freight flow index fluctuated between -20% and -30%, among which the year-on-year comparison for regions heavily affected by the pandemic, such as Shanghai, plummeted up to 90% in one week. At the same time, the throughput growth rate of cargo hubs slowed down. In March, the average throughput index of major public logistics parks in China was 104.15%, down 18.1% year on year. The average throughput index of major express distribution centers in March was 97.85%, down 18.3% year on year.
- Courier volume declined year-on-year and companies were faced with a shortage of frontline staff. According to the relevant data from the State Post Office, from mid to late March this year, courier delivery in many places affected by the pandemic was delayed or even interrupted while some e-commerce platforms also experienced delays in delivery. Delivery suspension severely impacted express courier services, pushing business volume down 2.5% year-on-year. In terms of frontline labour, there are not enough delivery drivers to meet the surging same-city retail demands that accompany lockdowns in cities like Shanghai and Guangzhou. Even under normal circumstances, the supply of delivery drivers in these localities is generally tight, so regional same-city logistics has been greatly affected.
- Air and port freight have been less affected. Air logistics has been affected by the stumbling blocks on road logistics traffic flow, some routes were delayed or their frequency had to be adjusted, but the overall impact on air freight was less severe because the loading rate of air logistics has greatly improved. Port production operations also remained stable. The efficiency of inbound and outbound ports declined slightly in the early stage of containment but returned to normal levels through the improvement of transit volume and port coordination in the later stage.
Challenges and opportunities for logistics development
- Lockdowns change the dynamics of supply and demand in the national economy, and logistics in the Yangtze River Delta urgently need to be restored. According to historical data, Shanghai's real GDP in 2020 was reduced by about 7.5 percentage points by the pandemic. Since the current outbreak is spreading more rapidly and violently than that in 2020, there will be less time for enterprises to rush back to work than in 2020, assuming that Shanghai can and will lift the lockdown and resume full operations in early May. In addition, given the economic impact of Shanghai's close-loop control on Jiangsu and Zhejiang provinces, the national GDP growth target of 5.5% may face greater challenges than anticipated. Logistics is at the heart of economic and social interactions. Under the current epidemic prevention and control measures, logistics between major cities decreased significantly, which has greatly affected economic production. One possible way to improve logistics connectivity in the Yangtze River Delta as soon as possible while preventing the spread of the virus is to have inter-city mutual recognition of vehicle passes.
- Logistics enterprises have limited profits, and the upgrading of industry challenges are accompanied by opportunities. At present, the decline of the national logistics industry is a foregone conclusion as JD, SF, EMS and other enterprises have extended the logistics cycle leading to a decline in profitability. The limited inflow of operational cash means that the cycle of receivables has been prolonged, and this may lead to bad debts. On the other hand, as the central government signalled its plan to establish a unified national market -- which is intended to break the local protection rings and market segmentation that exists today -- logistics enterprises will face new challenges. But along with the challenges come opportunities. Logistics companies will have to expand and strengthen their domestic logistics network while taking on board local governments’ epidemic control measures. They need to build a modern circulation network and develop a digital third-party logistics delivery platform to support a unified national market and the internal circulation of goods. On April 18th, the People's Bank of China and State Administration of Foreign Exchange issued 23 measures to support the fight against COVID-19 and ensure economic development. These included opening "green channels" (to accelerate credit approval) increasing financial support for the smooth circulation of logistics and shipping. Those leading logistics enterprises with strong network operation capabilities, digital capabilities and good service quality can expect to benefit.
Government & Public Services
Local government bonds: a delicate balance between reflation and risk
This year’s mission for local governments is advancing “stability on the six fronts and security in the six areas” as well as strengthening cross-cyclical and counter-cyclical adjustments to provide economic stability. One measure that some local governments have adopted are local bonds. But the local governments need to monitor these bonds carefully so that they drive investment in a reasonable and effective manner and do not create debt risks.
Local government bond issuance accelerates
As part of the drive to support the economy and provide some degree of protection from external shocks, local governments significantly increased the scale of issue of bonds in the first quarter of the year with a high proportion of them being special bonds and 10-year maturity bonds.
According to Choice Data, a well-known financial data provider in China, local government bond issuance in the first quarter of 2022 reached RMB 1,824.619 billion, over twice as much as the RMB 895.110 billion in the same period last year. Moreover, net financing in the first quarter totalled RMB 1.67 trillion, a sequential increase of 10.07% over net financing in the fourth quarter of 2021.
It is also interesting to note that 80% of the total value issued during the first quarter of 2022 took the form of special bonds. According to Choice Data, 516 issues of special government bonds were launched with a total value of RMB 1,461.978 trillion, accounting for 80.13% of local government bonds issued. 73 issues of general bonds with a value of RMB 362.641 billion took up the remaining 19.87%. As for the maturity structure, while this was tilted towards the long term, the highest proportion of bonds issued were of the 10-year kind, which registered at 23.40% of total value.
Table: Local government bond issuance in Q1 2022
Data source: Choice Data
Local governments in the developed provinces issued a larger scale of bonds than those in more underdeveloped provinces. Governments of Guangdong, Shandong, Sichuan, Zhejiang and Beijing recorded significant increases in the value of bond issuance, reflecting that fact that in the bond market, high quality projects in developed provinces are still preferred over projects in less developed regions. This runs in conformity with the guideline “money follows good projects” - as required by the central government.
Special bonds remain an important source of financing for local governments to expand effective investment in order to implement proactive fiscal policies. Meanwhile, at an April 12th briefing on the use and issuance of government bonds, the central government emphasized that local governments should keep monitoring the risks of special bonds, controlling the scale of new quotas in high-risk areas, and avoiding risk accumulation in high-risk areas. We expect the pace of newly issued special bonds in the second quarter will continue to be front-loading, with a preference for regions with stronger debt paying ability and more high-quality projects.
For local governments with lower quality projects, the strict supervision of special bond issuance has in fact substantially limited the self-financing ability of the governments. With the advent of full digital coverage supported by information technology, the Ministry of Finance’s ability to control the operation of grassroots projects and the flow of special debt funds will be significantly enhanced. This will create greater challenges for some local governments in terms of capital turnover capacity.
Climate & Sustainability
Transition finance to support transformation of high-carbon assets
In early April, the 2022 Working Conference of the People's Bank of China proposed to "support green development as the main line, continue to deepen the research on transition finance, realize an orderly and effective connection between green finance and transition finance, and form operable policies and measures". As a supplement to green finance, transition finance is focused on supporting the transition of high-carbon assets to low-carbon ones and ensuring the solid implementation of the "dual carbon" goal.
An opportunity for high-carbon assets to transition smoothly
The concept of transition finance was first put forward by the Organization for Economic Cooperation and Development (OECD) in 2019 as financial activities that help economic entities to transit towards a sustainable pathway. From an international practice perspective, it mainly involves transition of climate performance, e.g. decarbonisation. In the same year, Enel issued the world's first target-linked bond, aiming at the reduction of direct greenhouse gas emissions and the increase of renewable energy installed capacity within an agreed timeframe. In 2020, the International Capital Markets Association (ICMA) launched the Guidelines of Climate Transition Finance, and Enel's bonds were dubbed instruments of transition finance.
The European Union, Canada, Japan and other developed economies have issued guidelines related to transition finance to create an enabling environment for financing green transition of high-carbon assets. China is rapidly catching up in sustainable financial standards and these continue to converge with international practices: for example, the new edition of Green Bond Supported Project Catalogue issued in 2021 excludes coal related projects. Also, in order to encourage transition to low carbon practices, the financing channels of high-carbon assets have been further tightened. In the same year, the China National Association of Financial Market Institutional Investors (NAFMII) introduced the Chinese version of Sustainability-Linked Bonds (SLB) in reference to ICMA's SLB principles. Unlike the green bonds, SLB does not restrict the usage of proceeds and links the issue of bonds with the issuers' demonstrated commitment to sustainability. Such flexibility provides new financing opportunities for the transition from high-carbon assets.
Opportunities and challenges for transition finance
By the end of 2021, a total of 25 SLBs were issued in China mainly by State-owned enterprises, with a total amount of over RMB 35 billion. As a transition financial instrument, SLBs are characterized by including key performance indicators (KPIs) and mandatory third-party verification. First, SLBs are associated with the overall decarbonisation targets of the issuer, and corresponding KPIs are designed to urge enterprises to implement low-carbon transformation in a well-planned manner. Second, the KPIs must be quantitative and verifiable. If the issuing company fails to achieve the prescribed KPIs, a punishment mechanism (such as an increase in interest rate) will be triggered, and verification is required to be conducted by a third party. NAFMII raises the bar even higher when it comes to who can become a third-party verifier, choosing those with experience in green bond or Clean Development Mechanism project assessment.
Table: Examples of domestic SLB issuers and KPIs
Source: public information
Against the backdrop of China's "dual carbon" initiatives, transition finance creates new opportunities for high-carbon assets to transform themselves into low carbon assets whilst upgrading their technology. In order to benefit from transition finance opportunities, companies need to build up their sustainable development strategies and speed up core capacity building. To do this, they must first accelerate setting scientifically sound short and mid-term decarbonisation targets, and formulate transition roadmaps accordingly. The duration of transition financial instruments such as SLBs is usually 2-5 years, which is consistent with the global and China's near-term decarbonisation target timeline of 2030. Companies can incorporate their near-term decarbonisation targets into the KPI settings when using transition finance. This would not only provide financial support for companies' transition to low carbon, but also improve the transparency of their decarbonisation trajectories through correct information disclosure as required by financial regulators. While the transition process is certainly complicated, the benefits include a better reputation. Second, companies must strengthen their environmental performance management capabilities (including sustainability development planning, implementation and information disclosure). Environmental performance and management capability is a key prerequisite for companies to acquire transition finance. However, these are areas in which most Chinese high-carbon companies fall short. So far, Chinese issuers of transition finance have concentrated upon the power and steel sectors. But this is changing. Municipal pilots such as Huzhou are including other industries such as the textile industry which is also known to be quite polluting. Key capability improvement can directly facilitate the diversification of market participants and better release the potential of transition finance.