The Deloitte Research Monthly Outlook and Perspectives

Economy

Gradual comeback awaits in the second half

China's Q2 economic growth rate came out at 0.4% y/y, noticeably lower than our initial estimates of around 1.5% y/y. Still, this is not hugely surprising given the costs generated by China's overly restrictive covid containment policies and city-wide lockdowns over the past few months. Upon recognizing that the economic picture wasn't going to be pretty this quarter, Premier Li Keqiang himself even warned the National Bureau of Statistics not to conceal the truth. With H1 growth of 2.5%, 2022 on the whole is more likely to see the economy expand in the range of 3.5% to 4% instead of the targeted "around 5.5%" set out during the Two Sessions.

The property sector has taken the most obvious hit owing to the zero-covid policy and restrictive measures imposed on developers last year. Real estate investment fell by 5.4% y/y in H1, while property sales declined by 22.2% y/y during the same period. Until the Evergrande saga blew up last summer, the property sector had been growing faster than GDP growth. It is now certain that the property sector will instead be a drag on growth this year and beyond, given that it accounts for roughly one quarter of the economy. A decline in land sales by 48.3% y/y in H1 has also reinforced concerns over the state of local government coffers. How will the authorities plug the gap in terms of growth over the next few years? In our view, the key to raising the medium term growth trajectory lies in reform. For example, even a limited relaxation of the hukou system (resident permit system) and delaying the retirement age could make the labor market more robust. Financial sector liberalization will also allow consumers to diversify their wealth (please see chart below).

Chart: Chinese consumers' love of brick and mortar

Source: Huatai Securities, Deloitte Research

Meanwhile, we continue to hold the view that China has is now off its cyclical trough (Q2) but the external environment, which has got more challenging in recent months, could become even more unfavorable in H2 of 2022. The policy responses we have been long advocating remain intact – 1) target fiscal support to sectors which are affected by the zero-covid policy; 2) a more flexible RMB exchange rate; and 3) striking the right balance between ring-fencing covid cases and unlocking economic activity. Challenges from the external environment warrant a more potent policy reaction for sure.

Besides, the challenge of how to cope with financial sector distress stemming from a slowing property sector has presented a stern test for policymakers. Confidence among homeowners in many Tier 2 and Tier 3 cities has been shaken, and many believe that developers are now unable to finish uncompleted projects due to dried up cash flows and that there is a perception that banks have released funds too quickly to developers. From a macro standpoint, if these demonstrations become more pervasive across the country, developers will face far greater difficulties selling apartments, raising the risk of a protracted slowdown in H2 due to a stagnant property sector. Ultimately, bearish sentiment which is plaguing property under construction will spread to broader market. Given many property developers' high leverage, a mismatch between assets and liabilities could become a solvency issue should transactions dry up for a prolonged period. Despite the risks, the situation remains far from a Lehman moment owing to 1) a high saving rates of about 40%; 2) current account surpluses projected 1.5% of GDP in 2022; and 3) a relatively strong RMB which is now arguably the strongest currency after the USD. More importantly, transmission mechanisms of a slumping property sector into the broader economy in China are different from that of most developed countries. Specifically, defaults and delinquencies of mortgages remain rare in China. The general public's faith in the banking sector remains strong, despite the recent scandal surrounding banks in Henan (at the time of writing, depositors whose account balances are below RMB50,000 will be covered at the initial stage).

If we dissect Q2 data, what we have is a mixed bag. The bulk of the weaknesses has been evident in activities linked to transport and mobility. This is despite the extremely strong performance of the external sector (e.g., exports of May and June) in the face of supply chain disruptions such as around semiconductors, the automotive sector and the Shanghai port. An avalanche of FDI has more than understored investor confidence in China when supply chain calibration or China plus one are frequently discussed and debated. Growth prospects in H2 are expected to be more promising as draconian covid mitigation measures are being adjusted incrementally. The principal argument to support the zero-covid policy remains avoiding a large number of fatalities among the elderly population whose full vaccination rate is relatively low (83.8% have had two shots). So whether a vaccine mandate would be a precondition for opening up the economy is a valid hypothesis. The trial of allowing only vaccinated citizens to enter crowded venues in Beijing lasted less than a day (the mandate was announced on July 6 and then dropped on July 7) due to a backlash from the public. Again, this is not unexpected. Given China's large population and inadequate medical facilities, no policy can please everyone. That is why the zero-covid policy, notwithstanding its significant economic and social cost, still receives support from the majority of people. It is clear that ramping up vaccination rates, especially among the elderly, is a key objective. Perhaps higher vaccination rates could even go hand in hand with less mass testing. The fact that China's itinerary code or travel card has been shortened from 14 days to 7 days suggests that the overall direction is to shift the balance between ring-fencing covid and opening up the economy towards the latter. We think Q2 data (e.g., rising youth unemployment rate and collapsing housing sales and investment) will accelerate such a trend.

On the external environment, a number of headwinds could be daunting in H2. First and foremost, the Fed's continued tightening (the market expects 100bps of hikes on the Fed Fund Rate in July's FOMC meeting) has dealt many emerging markets a perfect storm when prices of food and energy are high. The debt crisis in these economies has reinforced risk aversion and "flight to quality", causing the USD to go from strength to strength. China does not have to worry about its balance of payments and is a net creditor, but the USD's overwhelming strength and chorus of rate hikes by most central banks are making the PBoC's targeted easing less feasible. Second, with a political settlement in Ukraine nowhere in sight and a harsh winter looming in Europe, inflation may not be arrested while recession risks are surfacing. The EU is China's largest market but has run a sizeable trade deficit (with US$223bn in 2021 and has widened by over 70% H1 of 2022 comparing to H1 of2021). The economic slowdown and geopolitical flashpoints may well result in more inward-looking actions and populism. In short, in order for China to ensure a sustainable economic rebound in H2, the RMB exchange rate should be a policy tool but potential protectionism and heightened considerations of stability (upcoming Party Congress) will present additional constraints.

Financial Services

Rigid and flexible: credit easing to intensify

In the financial sector, the focus has been on credit easing to support steady growth of the real economy. The hope is that though better credit and debt relationships, increased consumption, and investment by enterprises, the economy will rebound. However, as of April this year, a phenomenon commonly known in financial circles as the "scissors differential" between the growth of broad money (M2) and total social financing (TSF) appeared to be on the rise, thus indicating that the financing is still less than expected in an environment of abundant capital. Recently, in its "China Monetary Policy Report Q1 2022", the People's Bank of China (PBOC) explained in an editorial that the market adjustment mechanism of deposit interest rates would "flexibly" guide banks to overcome competition in the collecting of deposits, lowering the cost of debt and boosting credit demand all at the same time.

Financing still less than expected under rigid rate cut and monetary easing

Faced with pandemic prevention and control measures, steady economic growth continues to be under pressure. In the first half of 2022, the loan prime rate (LPR) was reduced twice, and on May 20, the 5-year+ LPR was cut by 15 basis points to 4.45%, the largest single reduction since the LPR reform in August 2019. The market has adequate liquidity, as capital is abundant while broad money (M2) continues to grow. However, the growth of credit is still weak even with rigid interest rate reduction and monetary easing. These are the reasons behind why the TSF scale hasn't grown to the expected level. Since April, TSF growth was 0.3 percent points lower than M2, and the "scissors differential" continued to increase to 0.6 percent points in May.

The below par growth of TSF is mainly due to the lack of credit demand. The pandemic and the pandemic prevention and control policies in Shanghai and other cities in April weakened consumer demand and hence held back investment by enterprises, putting a brake on the growth momentum of the real economy. At the same time, for banks, the continuous LPR reduction means that interest rate spreads are narrowed. And in the macro context of a weak real economy, even if capital is abundant, bank enthusiasm for lending is limited as they worry that too much easy money in a weak economy could lead to an increase in non-performing assets. Therefore, it is necessary to make more efforts to boost bank credit issuance and unblock the transmission channels, moving gradually from "monetary easing" to "credit easing" in order to support steady economic growth.

Chart: M2 growth is higher than the TSF

Data source: PBOC

Flexible cost cuts lead to stable spreads and increased credit lending

The interest rate spread is the source of every banks' profit and loss. It is determined by the difference between interest income from loans and interest payments to deposits. For some time, competition for attracting deposits has been fierce with interest rates on fixed deposits and large certificates of deposit close to the upper limit of self-regulation (PBOC deregulated deposit interest rates in October 2015 and implemented a self-regulatory mechanism for market interest rate pricing instead). Against a background of declining lending rates, banks will have to deal with narrowing interest rate spreads, hence "cost reduction" with be an important guiding principle for PBOC’s credit easing measures.

After lowering the required reserve ratio (RRR) by 0.25 percentage points on April 25, PBOC also launched a market-based adjustment mechanism for deposit interest rates which helps banks to reasonably adjust deposit interest rate levels with reference to 10-year Treasury yields and 1-year LPRs. The new mechanism focuses on promoting further marketization of deposit interest rates, the guidance to banks is flexible, and the PBOC has promised that it will provide appropriate incentives to financial institutions for their timely and efficient adjustments of deposit interest rates.

While it is still early, the effects of the deposit interest rate pricing reform have already begun to be felt. China's six major State-owned banks and most joint-stock banks reduced interest rates on fixed deposits and large certificates of deposit with a duration of over 1 year in late April, so that by the last week of April, the weighted average interest rate on newly incurred deposits nationwide was 2.37%, down 10 basis points from the previous week. The decline of deposit interest rates will help banks stabilize the costs of debt and manage their interest rate spreads. This will lead to a further decline in real loan interest rates.

In short, because of the pandemic, the financial system is facing an asset shortage because traditional high-interest assets (such as those from real estate and urban investment platforms) have, in the past few years, become less plentiful. This has restricted economic growth. Recently, house buyers announced they will stop repaying mortgage loans due to the delayed delivery of property projects, immediately inspiring similar calls across the country. Overseas investors continued to sell US dollar bonds of Chinese property companies, reflecting the declining confidence of home buyers and investors in China's real estate market. Also, the events in Henan village banks reflect the accumulating financial sector risksunder the current situation. In this context, "credit easing" is essential to stabilize growth, to reduce financial institutions' costs of holding debt (interest payment on deposits) and give real loan interest rates the opportunity to go down. On the one hand, credit easing can stimulate residents' consumption and enterprise investment. What’s more, the stabilization of interest rate spreads and incentives of review and assessment by the PBOC will encourage financial institutions to increase credit lending. For banks, in cooperation with the "delivery guarantee of house properties", they need to provide credit supply with adequate conditions, promote the resumption and delivery of projects, as well as support the construction of rental housing and the acquisition and reorganization of projects, which may also be an opportunity to transform the real estate model from old to new.

Logistics

From smoothness to efficiency

The China's Logistics Industry Prosperity Index (LPI) has begun to warm up. Since May 2022, production and supply began to rise as the overall domestic epidemic prevention and control situation kept on improving. Domestic demand has recovered and foreign trade import and export have significantly accelerated. The LPI registered 49.3% in May, up 5.5% from the previous month.

Chart: China's Logistics Industry Prosperity Index (%)

Source：Wind

The pandemic has greatly affected enterprises development and it is imperative to further enhance the efficiency of supply chain. Despite the LPI rebound and the recovery of domestic production and normal life, the never-ending pandemic impacted numerous enterprises in numerous ways such as blocked sales, high input costs, tight cash flow, and shrinking profit margins. On top of all this, enterprises should also take into consideration the implementation of the decarbonisation goals –the "3060 goal" and "carbon peaking and carbon neutrality strategy" -- proposed by the State. Enterprises should actively consider factors such as cost reductions, efficiency increases and carbon emission reductions and weave these into their business strategies. Considering both pandemic and environmental concerns, we see that Chinese enterprises are now faced with a very complex and challenging work environment. In the short run, however, maintaining efficiency and continuity of production, distribution, and delivery lines against a backdrop of normalization of pandemic prevention and control measures is the main challenge for supply chain management.

Ensuring smooth logistics while promoting efficient operation of the supply chain. Recently there has been a shift in emphasis from fully opening the main transport arteries and unclogging microcirculation within the country to accelerating the efficient operation of supply chains. For only with strong, highly efficient and flexible supply chains can the Chinese economy’s resilience be sustained. To achieve this goal, improvement needs to be made in the following areas.

• The application of digital technology to the entire supply chain.
  The pandemic has accelerated the development of the online logistics ecosystem because more and more transactions and production decisions are now taken online. However, the turbulent and uncertain economic environment that seems to have no definite end in sight makes demand forecasting more and more difficult. As a result, logistics enterprises need to react fast and for this they must accelerate the application of digital technology, integrate cross-departmental data, establish AI-enabled flexible workflows, and improve end-to-end visibility of their supply chain. This will make the supply chain more easily able to adjust to unforeseen events and enable enterprises to solve key problems more comprehensively and in a more timely manner.
• Improve the flexibility of the supply chain through a well distributed supply chain. Although the lean supply chain model reduces waste, it lacks flexibility and has little room to manoeuvre in case of impact. Therefore, it is imperative to establish a well distributed supply chain. As the pandemic situation has gradually come under control, the return-to-work and production rate of key customers has increased significantly. The pressure of transporting products stuck in other places due to pandemic lockdown measures and export demand has been greatly alleviated. In this case, many enterprises have begun to consider `re-localizing ‘ their supply chains and adopting strategies of "local consumption, local production" to increase production capacity in major consumer market areas. This can effectively improve transportation efficiency and market reaction speed. When the "pause" button is pressed for a factory in a certain region, another nearby factory can be used to supply goods to the region to reduce the risk of products going out of stock.
• Industrial integration, cost reduction and risk protection.
  In the process of following the pandemic control measures, leading logistics enterprises, with their strong network deployment and resource support capabilities, have demonstrated their capacity to respond proactively to emerging pandemic situations as well as their resilience in coping with fluctuations. However, in the next few years, it will be more difficult for logistics companies to rely on the strategy of continuously expanding production capacity and scale to promote growth. Hence, they will have to opt for other channels such as resource integration and process optimization in order to reduce costs , increase efficiency and improve their capacity to respond to risks in the supply chain. The trend of integration within the logistics industry will continue to grow because there is no other way to tackle the challenges facing the sector. Leading logistics enterprises will merge with others and gradually become bigger and stronger in the process. For example, on June 7 this year, the highway freight service provider G7 and Yiliu Technology announced a merger. After the merger, the company's business will cover vital vertical markets from production logistics to consumer logistics. This will enable them to further develop the upstream and downstream business of the industrial chain, form in-depth advantages, and enhance the efficiency of the overall supply chain.
  
  

Government and Public Services

Fiscal system renewal at the sub-province level is on its way

Since 2018, reform of the administrative responsibility divisions of the central and provincial governments has been accelerating while revamping of the fiscal system below the provincial level has lagged. As a result several imbalances have emerged. For example, the fiscal gap between different regions within a province has widened, as provincial finance departments have transferred part of their responsibilities to the central government as the pandemic led to a greater financial squeeze at the grassroots level. To bring back an equilibrium in the fiscal systems of provincial and sub-provincial government levels, the General Office of the State Council on June 13 issued a set of “Guiding Opinions on the Renovation of the Sub-Provincial Fiscal System” (Document No.20, published by the General Office of the State Council in 2022), which is intended to provide clear directives on the provincial financial system revamp.

According to Document No.20, the administrative responsibility and regulatory capacity of the provincial government will be enhanced moderately, in order to narrow development gaps between different cities or counties within the province. Document No.20 also stresses that provincial governments should be more responsible for education, pension insurance, medical insurance and infrastructure. In other words, what this means is that, in order to reduce the burden on the city-level and county-level governments, the provincial governments will bear more responsibility when it comes to expenditure on education pension insurance, medical insurance and infrastructure. When the gap in fiscal resources between different areas is too large, the provincial government will share more tax revenues with poorer regional administrations in order to insure greater parity within the province. Fiscal support will be extended especially to those regional administrations under great pressure in three important areas: employment, basic living needs and operations of market entities.

In exchange, the provincial government will take a greater hand in preventing local government debt risks. Municipal and county governments are under increasing fiscal pressure as a result of the current economic downturn and tax cuts. Document No.20 emphasizes that the expenditure allocation of provincial, municipal and county governments should be determined as per their fiscal self-sufficiency rate, which measures the percentage of how much general public budget expenditure can be covered by general public budget revenue. When a county with a low fiscal self-sufficiency rate comes under fiscal strain, the county can ask for provincial government support to cover its debt risk exposure. However, the amount of fiscal support should also depend on the fiscal self-sufficiency of the provincial government. Provinces with higher fiscal self-sufficiency such as Shanghai, Beijing and Guangdong, could provide more fiscal support, whereas provinces with low fiscal self-sufficiency such as Gansu, Qinghai and Tibet may not be able to do so.

Data source: National Bureau of Statistics

To sum up, Document 20 recognizes that provincial governments should carry more responsibility in expenditure allocation as this will reduce the burden on community-level government’s budgets. Community-level government spending on public health and social governance increased significantly since the pandemic, and the financial burden on community-level governments has increased commensurately. Document No.20 proposes that the provincial government be the provider of financial assistance of last resort for social security in three areas (employment, basic living needs and operations of market entities). When provincial governments take on more fiscal spending in these areas, the fiscal pressure on community-level governments is therefore reduced. In addition, having an assured source of finance would help community-level governments address social instability and optimize the routine COVID-19 prevention and control measures.

Climate & Sustainability

'A just transition' to the ESG strategy

In the first half of 2022, various industries and regions have issued supporting policies and documents relating to the "Dual Carbon" strategy. While there is a clear consensus on the importance of transforming the economy into one that is green, low carbon and circular, concerns have emerged on how to address the development gaps between regions and groups and how to balance efficiency and equity, i.e. how to ensure a "Just or Fair Transition". The United Nations Principles for Responsible Investment (PRI) suggests the inclusion of a Just Transition clause into ESG investing strategies, as well as formulating a relevant disclosure framework to ensure a just transition for the labour force. This is not an easy job. Ensuring a Just Transition places challenges of more than human capital planning and management for companies, it also involves issues relating to upstream and downstream supply chains, end products, local communities and regional economies etc. The inclusion of the idea of ‘justice’ puts additional requirements on all three dimensions of companies' ESG strategies. For companies, understanding the idea behind `a Just Transition’ and making efforts to incorporate the idea will play a big part in pushing forward China's green transition in an orderly manner.

Moreover, the idea of a Just Transition is very much in line with China's aim of facilitating high-quality, well-coordinated regional development along with environmental protection during this 14th Five-Year Plan period: under the "Dual Carbon" strategy, energy transition and industrial reconfiguration on the one hand may put additional pressure on natural resource-reliant regions in terms of their income, employment and livelihood prospects. But, on the other hand, improved local ecological environment and regional assets repurposing offer new opportunities for these regions. Therefore, the ‘Just Transition’ idea is a key strategic shift under four key domains: citizens & community, employment, environment and regional economy.

Chart: Just Transition key domains and issues

Meanwhile, investors are waking up to the realization that regions, industries and groups undertake differentiated costs for green transition and failures in ensuring a just transition would generate systemic risk and, in the longer term, threaten assets value. Globally, over 160 investing institutions with more than USD10 trillion assets under management (AUMs) have signed the “Investor Statement for a Just Transition”. This ground-breaking document suggests that investors should support a just transition through their investing strategies, asset allocation, information disclosure and so on. Also, policy makers such as the European Union Commission have tried to push the `Just Transition’ concept by allocating funding and making an information disclosure index among other things. The French electricity company, EDF, launched its Just Transition report in 2021, detailing its performance in relevant areas such as employee welfare, job opportunities created and customer beneficiaries.

Companies are facing evolving expectations by various stakeholders during their green transition journey, including requests by employees for jobs and skill development, pressures of local communities at livelihood, capability deficiency of suppliers to achieve sustainability, and demands for green products by customers. Companies should plan to act early and incorporate `Just Transition’ strategies into their overall ESG strategy so as to remain competitive in the long term.

Chart: Key stakeholders for companies' Just Transition

From an employee perspective, carbon-intensive companies with greater transition stress should fully align their actions with regional industry development strategies, and plan to deploy human resources early and proactively by providing skills training and redeployment opportunities to employees. From a supply chain perspective, while embedding Just Transition elements into sustainable supply chain standards, companies should strengthen coordination with suppliers and provide place-based support, and investment, to upstream & downstream vendors to reinforce their ESG capabilities. From a local community perspective, companies should accelerate communication and conversation with policy makers in terms of corporate transitional targets and plans, to create a joint force in balancing regional efficient decarbonisation and equitable development. From a customer perspective, companies should improve their information disclosure, and also, to explore possible linkages between private business and national strategies such as rural revitalization, to develop and provide inclusive green products and to realize corporate social responsibility.