The Deloitte Research Monthly Outlook and Perspectives
15 June 2022
Economic resuscitation contingent on ring-fencing Covid
It is easy to predict China's economic data for Q2. Lockdowns to varying degrees have affected over 40 cities with Shanghai being the focal point owing to the city's reputation as China's leading global city and its position in the center of automotive and semiconductor supply chains (please refer to pieces on these two sectors in this issue). Both auto sales and the property market were been hit significantly in April and May. For example, in April, auto sales dropped by 47.6% year-on-year while transactions of commercial properties plummeted by 39% year-on-year, and tourism revenues during the May holiday shrunk by 42.9% year-on-year. On the trade front, China's exports have held up with moderate growth of 3.9% year-on-year and 16.9% year-on-year in April and May respectively. Another saving grace is that residential markets in major cities have reacted mildly positively to a slew of easing measures from local governments (e.g., lower down initial payment of mortgage), underscoring our long-held hypothesis that consumer resiliency will lend a necessary support to a slowing economy. But nevertheless, downbeat economic data prompted policymakers to convene several high level meetings in May on stabilizing economic growth. Importantly, on May 25, Premier Li Keqiang spoke to over 100,000 officials all the way down to the county level with key State Council members also in attendance. Premier Li acknowledged severe disruptions on employment, transportation and electricity usages since late March, and presented the ongoing shock as a bigger one than that caused by the initial outbreak of the pandemic in 2020. Premier Li also emphasized the overwhelming importance of economic development during this window of opportunity. In other words, drastic measures will have to be taken swiftly in order to reverse this downward trend. Moreover, Premier Li pledged a level playing field for state-owned enterprises, private enterprises and foreign companies. In the end, Premier Li has promised to come up with concrete economic relief measures by end of May.
These concrete measures have included tax relief (e.g., delayed social security contributions by employers have amounted to RMB2trn up to May in 2022) and economic stimulus initiatives such as eased restrictions on purchases of homes and vehicles. One might argue that all these actions are incremental. But such incremental feature are in line with the official stance of "avoiding flood-like stimulus", an analogy to the massive fiscal package unveiled in 2008. The reality is that 2022 marks a starkly different environment from that of 2008. Back in 2008, the global economy was teetering on the edge of a deep recession owing to the sub-prime mortgage crisis in the US and the sovereign debt blowup in the Eurozone. Beijing's stimulus package of RMB4trn was generally viewed with shock and awe, immediately lifting economic growth but with profound side-effects (mainly leverage and over-capacity in a number of sectors). Today, the issue is not whether China has the fiscal means (the central government has ample room for raising debt) but rather the fact that the increased supply of production capacity will worsen the stagflationary storm by driving commodity prices higher. We have been repeatedly making the point that fiscal stimulus should ideally be targeting final demand and titling towards sectors which are more vulnerable to the current dynamic zero-covid policy (on June 7, civil aviation and railways were deemed as sectors which ought to receive more priority for fiscal relief). As such, an incremental fiscal expansion is sensible. But of course, ultimately, an effective economic reflation rests on a more balanced approach between covid mitigation and business resumption.
H2 will be a very different story in terms of growth. First of all on covid, the principle of dynamic zero will remain intact but it is possible to further optimize this strategy by ring-fencing community transmissions without locking down entire cities as has been proven in places such as Guangzhou and Shenzhen this year. Indeed, even before Shanghai's lockdown was eased on June 1, many cities have maintained well functioned logistical systems (e.g., on food delivery) and relied on frequent covid testing to cut off community transmission. Even in Beijing, where the margin for error is thin, a city-wide lockdown has been avoided. Meanwhile, the decision taken by the State Council to have local governments pay for covid testing will drastically change incentives which have been overwhelmingly skewed in favor of mass testing so far. Second, subsequent decrees issued by the State Council on not imposing unnecessary restrictions (e.g., taking a one-size fits-all approach such as lockdowns or excessive policy steps based on the central government's general principle) send a strong signal on the need to resuscitate the economy at a time when millions of fresh graduates are about to flock to the job market (surveyed urban unemployment rate has claimed to 6.1% in April from 5.5% in February).
Chart: A trough behind us?
If economic activity rebounds on the back of a more optimal ring-fencing of covid transmissions and well-targeted fiscal support, how vigorously the economy bounces back will also depend on external factors. The Fed's tightening remains the chief threat to many emerging economies, especially those who have to import commodities and food. The PBOC has been bucking the tightening trend but it is more difficult to maintain a stable RMB exchange rate while at the same time guiding short term interest rates lower. This balancing act is further challenged by a floundering Yen which hit a 20-year low against the greenback in early June. There is no reason for China to undertake a beggar-thy-neighbor policy but it is sensible to see a more flexible RMB exchange rate when the dollar's strength has become rampant. The outlook on global inflation is also a function of the evolving Ukraine-Russia crisis. What if a political settlement becomes more elusive while energy demand becomes a more thorny issue when the ECB is compelled to raise interest rates?
Chart: Global inflation risk edges on exchange rate misalignment
It is time for us to revisit our 2022 forecasts of growth and inflation for the region (Voice of Asia and China's economic and industry outlook for 2022 issued in Dec 2021). So far we see a reduction to GDP growth rates of around 1 percentage point for most regional economies and an additional 1 percentage point for inflation in 2022 due to the Fed's tightening and geopolitical tensions. Healthy capex spending in major industrial economies and the fact that more economies are opening-up on falling covid cases are mitigating factors. In conclusion, it is in China's best interest not to repeat a flood-like stimulus as in 2008 while lending more support to SMEs and the service sector which are absorbing more jobs than infrastructure building.
The Covid impact on consumption patterns
The implementation of Covid containment measures since the start of this year, one after another, in the two major economic centres in China, namely Shenzhen and Shanghai have resulted in a noticeable change in consumption patterns. According to data released by the National Bureau of Statistics (NBS), cumulative total retail sales of consumer goods from January to April in 2022 reached RMB 13.81 trillion, down 0.2% year-on-year. But the pandemic’s bite was felt the most in April, when total retail sales of consumer goods for the month plummeted 11.1% from the previous year to RMB 2.95 trillion. Covid restriction measures did not just reduce total demand for goods and services, it changed consumption patterns considerably.
In terms of consumer goods categories，consumer staples required consumption to maintain positive growth while discretionary consumer goods were further under pressure. Demand for consumer staples and essentials showed a steady increase even after restrictions were put in place but discretionary spending on consumer goods contracted quite sharply. Thus, in April we saw demand for grain, oil, food, traditional Chinese and Western medicines, and beverages showing positive growth with staples such as grain, oil and food showing an increase of 10% year-on-year. Demand for pre-made meals, frozen foods and mixed condiments also grew rapidly.
In the consumer discretionary category, demand for clothing and textiles, gold and silver jewellery and automobiles contracted sharply and only office supplies remained relatively resilient. Logistics bottlenecks caused by Covid restriction measures were largely responsible for clothing and textiles consumption to shrink by 22.8% year-on-year. Home appliances, building materials and furniture in the downstream subsector of the real estate sector also came under pressure, the only small exception being sales of home appliances which fell less sharply, down 8.1% year-on-year. Along with other home appliances, sales performance of refrigerators, dishwashers and vacuum cleaners fared a bit better.
Figure: Consumption by category grew year-on-year in April
In terms of consumption types, offline service consumption represented by hotels and restaurants has been significantly impacted. According to NBS data, retail sales of goods only fell by 9.7% in April while catering revenue plummeted 22.7% year-on-year. Commodity retail declined significantly due to factors such as logistics and supply chain chokepoints but contact and experiential businesses such as catering and tourism were impacted much more severely due to epidemic prevention measures. Restaurant revenue declined significantly, while the contribution of take-out business to catering revenue has increased. In the hotel industry, the collapse of demand spurred a wave of consolidations amongst small- and medium-sized individual hotels along with a corresponding increase in the franchise rate. In the tourism sector, people now prefer local tours and trips to surrounding areas over long-distance travel, as fears of not being able to return home dominate. As for the younger generation, ‘glamping’ has become a new way of life.
In terms of consumption channels, logistics and supply chain chokepoints caused sales of online goods to decline as people turned to offline community convenience stores for their immediate needs. NBS data revealed that online retail sales of physical goods in April registered RMB0.76 trillion, down slightly year-on-year, with the growth rate turning negative. On the offline side, amongst retailers with sales revenue above the minimum amount stipulation, retail sales at department stores and specialty stores from January to April dropped by 8.2% and 5.9% year-on-year, respectively, while the supermarket sector showed stronger resilience with its retail sales increasing by 3.6% year-on-year. Sales at convenience and specialty shops also increased by 6.8% and 2.5%, respectively. Due to pandemic containment measures, the daily activities of some residents were reduced, and self-service outlets and community convenience stores became more popular because of their accessibility.
The pandemic impacted both the demand and the supply side of the consumption structure. From the demand side, Covid reduced the current disposable income of most of the labour force, forcing consumers to consume less of everyday non-durable consumer goods; moreover, the uncertainty of economic recovery has had a major impact on their income expectations, dampening current and future consumption. Secondly, the psychological impact of the sudden outbreaks will make consumers save more and consume more cautiously. From the supply side, although the containment policies in Shanghai and other places played a key role in limiting the spread of the virus, the impact on Shanghai, as an economic and logistics centre, will directly lead to a phase of labour shortage in the manufacturing and service sectors in the Yangtze River Delta region. Meanwhile, lockdowns and restrictions on transportation and logistics will affect the normal circulation of labor and raw materials for some time to come, further weakening the majority of small and medium-sized enterprises.
Therefore, for consumer spending to recover, both demand and supply side problems need to be addressed. On the demand side, consumer-specific measures such as issuing consumption vouchers and cutting personal income tax will go some way to boosting consumer confidence. On the supply side, numerous measures need to be taken to avoid bottlenecks and make supply chains more resilient. This could be done by mobilizing more market players, unclogging logistics channels, providing better consumer products and creating innovative consumption channels. With the initial and subsequent success of the pandemic prevention and control measures in Shanghai and other places, the orderly resumption of work and production is starting along with the active introduction of a series of government policy measures to stimulate domestic demand and to assist businesses and protect supply chains. With the '618' mid-year shopping festival right around the corner, delayed consumption in April and May is expected to get a much-needed boost in June, and consumer spending is expected to recover in the second half of the year.
Has the pursuit of semiconductor independence been disrupted?
China’s total production of integrated circuits (ICs) plunged 12.1% from the same period last year to 25.9 billion units in April 2022, the lowest since December 2020, according to the latest figure from the National Bureau of Statistics (NBS). Two main factors contributed to the result. First, Covid containment measures have resulted in some semiconductor plants halting their business operations due to serious logistics and production problems. Second, the pandemic has also dampened chip demand downstream. For example, during January-March 2022, China’s smartphone shipment decreased by 14.1% year-on-year to 74.2 million units.
Automotive and Hi-tech sectors hit hardest
The current Covid outbreaks across the nation are hampering the operation of chips and components manufacturers in China. The chip shortage has had significant impact on the production of automotive OEMs, and it is likely that China’s automotive production will decrease by 15%-20% this year. The hi-tech industry is also suffering from insufficient chip supply. Sub-sectors such as terminals, core network equipment (e.g., 5G base stations) and IoT equipment have also seen chip supply disruption, which is certainly having negative impacts on both production and R&D activities.
Negative impact on assembly & testing and wafer production
The negative effects of the pandemic vary across the semiconductor industry value chain, and companies are taking different measures to minimize its impact.
- Assembly and testing (high-impact): Due to the labor-intensive nature of this segment, companies are facing logistics as well production issues due to Covid restrictions on goods and labour and delivery at some factories has plunged by at least 20%.
- Wafer production (moderate-impact): Companies with large capacity are adopting a closed-loop operation system and work-from-home for support functions in order to minimize the impact of Covid restrictions on production. Nevertheless, no-one has emerged unscathed and some of the leading wafer manufacturers expect a revenue decline of 2%-4% in Q2 compared with Q1 2022.
- Chip design (low-impact): Though there is some compromise on efficiency, overall, business has not suffered too much. Also, delivery has not been impacted by logistics challenges.
- Equipment and material companies (low-impact): Companies have adopted effective measures to guarantee business operation and production, and have controlled the negative impact of Covid outbreaks.
A mere hiccup to China’s pursuit of semiconductor independence
Although China’s semiconductor industry has been hit by the Covid lockdowns, the impact is expected to be temporary. There are several good reasons for this. First, the Chinese economy is already recovering after a series of containment measures have gradually been lifted. Companies in different geographic regions are resuming normal operations and production. For example, major chip companies in Shanghai, a key semiconductor industry base which contributes one-quarter of China’s total IC production, are now functioning at 90% of capacity and some leading players are even running at full capacity. This also encourages companies across the industry value chain (including equipment, material, assembly and testing) to resume their operations at near full capacities. Second, semiconductor companies adopted measures that shielded them from the worst of the pandemic’s impact, for example, shifting their production to other production bases in areas not under lockdown conditions. Some companies have also made plans to increase and accelerate the production of chips to make up for the loss from Covid lockdowns. Hence we feel confident that China’s semiconductor development should be back on the track before long.
The myth of long-standing weakness of automotive supply chain
Few industrial supply chain are as complex as those in the automotive industry with every original equipment manufacturer (OEM) relying on a large network of supply chains comprised of hundreds or even thousands of suppliers to support it. At the top of the supply chain pyramid are the big tier-1 suppliers, i.e. companies that directly supply parts or systems to the OEMs. Each of these tier-1 companies have many levels of sub-suppliers under it who are responsible for the production and assembly of the required raw materials, sub-assemblies, and integrated components. These parts and components need to arrive at the OEMs’ warehouses in a certain order to ensure that production goes on in a smooth and timely manner. This is why the automotive industry requires that supply chains move at high speed, with all working links closely and efficiently synchronized. The industry places extra emphasis on just in-time inventory maintenance, minimum waste and least constrained cash flows.
The lean supply chain system that the industry took so much pride in used to be an important means for OEMs to control operating costs, but the sudden and almost simultaneous emergence of various unexpected incidents has exposed its fragility. As a result, the automotive industry experienced severe supply shocks and bottlenecks as early as the virus outbreak in Wuhan in 2020. But when the pandemic hit Shanghai in late March 2022, these underlying structural problems surfaced one after another, revealing the “chronic illness” of the supply chain that the auto industry has been reluctant to tackle.
In contrast to the first wave of Covid, the latest outbreaks in China have taken a heavier toll on the automotive industry. Above all, Shanghai is a major automotive hub, as reflected in both vehicle production output and economic value. The city itself accounts for 10% of China’s total car production and as much as 23% when also accounting for the rest of the cities in the Yangtze River Delta region. Moreover, as the world’s largest container port and an important gateway for exports and imports, Shanghai has seen a concentration of auto-parts suppliers, not only the big global parts companies but also their mid-sized local counterparts. These companies, taken together, account for 30% of the total industrial added value generated by the auto industry in the country. In addition, parts companies are highly concentrated in certain areas of the Yangtze River Delta region. For example, for electric engines and auto electronics, about half of the suppliers originate from the Yangtze River Delta region. Thereby, OEMs that are located far away but dependent on parts manufactured in this area are also exposed to the risk of stoppages in production. The ripple effects on parts sourcing and logistics are being felt far beyond China’s borders. For instance, Japanese auto OEMs including Toyota and Honda have announced halts in production in their domestic plants due to Shanghai’s lockdown.
The vulnerability of the automotive supply chain can also be attributed to the prevalence of single sourcing in the supply chain, as well as the uneven progress of digitization across it. Although OEMs generally adopt a dual-sourcing system for key components in order to increase nimbleness and flexibility, the supply of a few high-tech components is still firmly concentrated in the hands of single suppliers. For instance, Bosch, the giant German auto supplier, has no less than 70% of the market share of ESP (electronic stability program) equipment in China. As a result, when production is suspended at Bosch’s factories in Shanghai and Suzhou, it has knock-on effects on auto manufacture across the country.
In addition, the uneven deployment of digital tools across the auto supply chain has also added to its fragility. Some of the local auto-parts manufacturers still use outmoded, and therefore inefficient, methods of inventory management. Even suppliers equipped with inventory management systems tend to rely on manual processes. This not only causes an information lag but also delays the raising of red flags when problems emerge.
When Shanghai rolled out plans to resume production, it issued two White Lists that contained a total of 1854 companies. Still, there were a large amount of small-and-medium sized suppliers haven’t been given the green light to resume operation. Being left out of the list meant that information on their location, workforce conditions, stock of finished goods, flow of materials and financial state could not be shared with upstream companies in a timely and transparent manner.
Shanghai’s lockdown will become an inflection point at which OEMs will start making a series of adjustments in their supply chain management. To start with, OEMs are likely to establish a dual sourcing practice for parts with a high strategic importance. This will mean that there will be more supply opportunities for local high-performing component makers who can meet the technical requirements, quality standards, and delivery cycles of the OEMs. The geographical distribution of suppliers will also get diversified. This will create hedges against future uncertainty. OEMs are also likely to reduce the proportion of single sourced components by cultivating back-up suppliers for non-core components as well.
OEMs are also likely to increase the inventory levels of their core components. After the Fukushima tsunami, Toyota rolled out a Business Continuity Plan (BCP), which listed 500 parts that needed stockpiling. For products with longer lead times, such as chips, Toyota required their suppliers to reserve two to six months of stocks as a buffer against catastrophic shocks. Some leading OEMs are also expected to integrate vertically - building their own production lines for key components. Tesla managed to avoid the chip crisis by rewriting software and switching to alternative chips when the whole industry was beset with a shortage of chips. Finally, supply chain management is likely to adopt a longer-term planning horizon. OEMs are likely to be asked to map out potential threats to the supply chain, identify key risk points and design contingency plans. Digital technology will be an important tool in spotting threats to the supply chain in real-time, provide an early warning and suggest a response mechanism that will shorten the response time of upstream companies and enable a more rapid recovery.
Medical services respond to pandemic needs
Since early 2020, the world has been caught up in a seemingly never-ending Covid pandemic, and countries all around the world have had to come up with their own pandemic prevention and control strategies. Since the beginning of the Covid outbreak, the timely delivery of medical resources has been an issue. This has been partially mitigated by an increased reliance upon online delivery of medical services. This has been steadily reinforced by the successive waves of infection caused by Covid variants (such as Alpha, Delta, Omicron, BA.2). The E-medical services user group recorded new growth, reaching a new peak at the end of 2021. (Figure 1)
Compared with the outbreak in Wuhan in early 2020, the outbreak in Shanghai has had a far greater impact on the LSHC industry as Shanghai is both an export/import hub and a major player in the national health ecosystem:
- Export restriction and supply of medical consumables: As a major export center of medicines, medical devices and medical products, the lockdown had made it difficult for Shanghai companies to continue operating production lines. This has had a major impact on the global supply chain. For instance, Shanghai is the biggest producer of contrast agent, a product used to enhance the contrast of structures or fluids within the body in medical imaging. Because production lines have been disrupted, the U.S. is now experiencing a nationwide shortage which is not expected to ease until mid-June when production is slated to resume in Shanghai. In addition, China's market for artificial blood vessels is highly dependent on imports. The shutdown of foreign manufacturers in Shanghai and the restriction of imports has led to a shortage of artificial blood vessels in domestic hospitals.
- Shrinking of national medical resources: According to a study by Fudan University, Shanghai has 19 of the top-rated 100 hospitals in China and is ranked second in the country (after Beijing). It alone accounts for nearly 20% of the country's medical resources. Amongst the Chinese cities whose GDP numbers in the trillions, Shanghai is second only to Chongqing and has more than 160,000 beds at its healthcare institutions; it has 240,000 healthcare practitioners and 80,000 practicing (assistant) doctors and ranks third after Beijing and Chongqing. Moreover, Shanghai’s system is highly efficient - 272 million medical treatments were performed here making it first among the tier 1 cities in 2021. Thus the lockdown of Shanghai has not only affected the medical needs of the local residents, but also strained the medical resources of the entire nation.
The other side of the coin is that the lockdown in Shanghai has accelerated the development of E-medical services and internet hospitals, making Shanghai the model for the extension of such services, and Internet hospitals, across the country.
- As of May 17, there are more than 100 Internet hospitals established in Shanghai. The city's public Internet hospitals have achieved the inter-hospital follow-ups on the basis of inter-hospital access to patients' electronic health records within 6 months.
- Since March 1, these hospitals have carried out more than 1.16 million person-times of online diagnosis and treatment, including the provision of various services such as online appointment, online consultation, online follow-up treatment, online prescription, online medical insurance payment, and online ordering of medicines for delivery at home.
- Internet hospitals with offline outpatient medical insurance settlement credentials are allowed to provide critical illness follow-up services online. Relatives can also order medicines and settle expenses in Internet hospitals by binding purchases to the relative’s health code.
By late May the Shanghai outbreak was generally brought under control and we can expect several opportunities to emerge:
- PCR testing: widespread testing will become normalized, leading to an increase in demand for testing reagents, rapid antigen testing products, and testing and examination services.
- Medical devices: As the demand for medical devices abroad continues to increase, there will be a corresponding increase in orders for domestic manufacturers.
- Consumables and preventive medical services: The pandemic has made consumers more health conscious in general and this will translate into them becoming more active in managing their own health. This will result in an increased interest in and willingness to participate in preventive medicare. Demand for wearable health devices will also increase as a result of epidemic prevention and control measures, which will stimulate the demand for personal health management equipment.
- The functions of chain pharmacies will be further strengthened, and the adoption of omni-channel services will bring about new business development opportunities. There will be greater integration between chain pharmacies and both offline and Internet hospitals.