GDP recovery matures, inflation fuels risks

China’s recovery is entering a more advanced, stable stage -- but one that will require deft policy management to navigate emerging risks. 

This article was written by Bloomberg Economists Chang Shu and David Qu. It first appeared on the Bloomberg Terminal.

The rapid rebound early in 2021 from the COVID shock is set to give way to a slowdown over the rest of the year, restrained by production bottlenecks, softening exports and sluggish consumption.

Imbalances in the recovery are exacerbated by the run-up in producer prices driven by the commodities boom. Private companies, already one of the weakest parts of economy, are squeezed by higher costs, adding to the threat of defaults. With consumer price inflation under control, the People’s Bank of China is likely to keep rates steady while gently tempering credit growth to curb financial risks.

• Bloomberg Economics estimates the economy is on track for year-on-year growth of 8.2% in the second quarter, down from 18.3% in 1Q. We forecast growth to ease to 6.8% in 3Q and 5.6% in 4Q, for a full-year expansion of 9.1% -- the same as our projection in April.

Growth and inflation forecast

 

• Inflation pressures, largely concentrated in upstream factory-gate prices, have probably crested. We see producer prices climbing 6.1% this year, outpacing a tame 1.2% rise in consumer prices.​​​​​​
• This backdrop gives the PBOC leeway to be patient on rates while the commodity cycle plays out. The direction for monetary policy, though, remains toward tapering stimulus, mainly by keeping liquidity tight to slow the pace of credit growth.​​​​​​
• The business environment could become more challenging because of tighter credit conditions and the profit squeeze created by the gap between the producer price index and consumer price index. That points to rising credit defaults, a focus already of the markets as the state-controlled Huarong Asset Management Co., a manager of distressed debt, wrestles with its own mound of bad debt.

Growth stayed strong in the second quarter

The recovery has extended into 2Q after the record 18.3% expansion in 1Q. After taking into account the effect of a higher base for comparison a year earlier, momentum in growth held up on the supply and demand sides in May, though the gap between the two failed to narrow, with demand continuing to lag.

Industrial production and delivery time

 

Production is on track to gradually revert to its pre-pandemic growth rates of about 5% in the second half of the year. Supply-chain disruptions, some of them pandemic-related, have lengthened delivery times. The economy is also bumping up against constraints -- capacity utilization in the mining sector and power generation have reached the highest since 2018.

Capacity utilization

 

On the demand side, investment remains a strong source of support. Special bond issuance by local governments, a key source of infrastructure funding, has been slow, with a quota not announced until the government set out the budget in March this year and closer scrutiny of applications by officials. A gradual pickup in investment after the Lunar New Year in February should give way to stronger support in 2H as more projects get financing.

Exports should remain robust, though the forces that powered shipments in 1H could weaken in 2H. Global manufacturing, which rebounded strongly at first, will likely mature into a slower expansion. What’s more, as the coronavirus is brought under control, production capacity in other exporting economies will come back online and possibly divert orders from China.

Consumption, while continuing to strengthen, will face more constraints in the short and long term. It remains particularly vulnerable to sporadic outbreaks of the virus such as the recent setback in Guangdong province. And if consumers, still feeling the impact of the pandemic, remain worried about the high costs of housing, education, and health care, savings rates could stay above pre-pandemic levels, further slowing recovery.

Inflation

The surge in producer price inflation to 9% year on year in May -- the fastest since 2008 -- was mainly a reflection of higher prices for raw materials working their way through the system. But price pressures have largely been contained in upstream industries, particularly raw materials. Downstream prices, including those of consumer goods at the factory and the CPI, have risen only slightly.

PPI breakdown

 

Prices may stay elevated in 2H, but peak inflation pressure has probably passed. A low base that was partly behind the surge in factory-gate inflation will gradually rise, leading to lower measured inflation. A typical slowdown in construction activity in the summer months may relieve pressures on demand.

The government’s efforts to squeeze out bubbles in the commodities markets may also help put a lid on raw material prices. The fall in pork prices and the unsteady recovery in consumption should restrain consumer prices, limiting any pass-through of producer prices.

Steadfast policy

Monetary policy is set to stay steady for the remainder of the year. The central bank appears to think stronger inflationary pressures are transitory and likely to dissipate as economies around the world reopen after the pandemic, reducing supply chain disruptions.

PBOC Governor Yi Gang signaled a stable monetary policy ahead, a clear sign the central bank won’t use interest rates to address the price pressures. At the same time, it appears the central bank will continue to slow the expansion of credit -- in line with its broader goal of normalizing policy after last year’s stimulus.

Risks

The main risks to the outlook center on the path the pandemic takes and external demand.

• Slow vaccine rollouts in China could lead to more outbreaks of the coronavirus, creating intermittent disruptions to the country’s recovery of consumption and related services sectors. Vaccinations have recently accelerated, a positive for the outlook.
• But growth could stall if foreign demand is diverted to exporters in other countries or consumption in advanced economies shifts to services from goods. Both are likely to occur to some degree. Should exports hold up better than expected, growth would be stronger.
• Private companies continue to lag in the recovery. The pinch on earnings from the gap between PPI and CPI inflation, which would widen further if commodity prices continue to surge, could impede any pickup in private investment. The pressure may also lead to more credit defaults, which are expected to rise further in 2H.

Credit impulse and credit defaults

 

• Current inflation risks are cyclical in nature, but the policy approach China is taking points to longer-term perils. The leadership appears to be opting to use non-monetary means to address the problem. Measures to squeeze out speculation in the commodities market are justifiable, but any attempts to directly control prices would distort markets and reduce economic efficiency.