In Brief:

• China’s money market and stock market experienced large volatility recently, reflecting investors’ worries about a normalization of monetary and fiscal policies this year.
• The potential unwinding of stimulus can be justified by China’s V-shaped recovery after the COVID-19 outbreak. Moreover, the recent rebound of property prices in major cities exacerbated concerns about an asset price bubble and further deepened investors’ worries about policy tightening.
• We believe it is realistic to take a gradual and modest approach to policy adjustment, and there should be some flexibility given the uncertainties in global economics and geopolitics.
• The People’s Bank of China (PBoC) might sit tight in terms of policy rates and required reserve ratios this year, while relying on macro-prudential measures to manage asset inflation risk.
• The central government might also revert to a path for fiscal consolidation, taking efforts to strengthen fiscal discipline and control local debt levels.
• During the process of policy normalization, valuation re-rating could be less of a driver for market performance. Long-term structural earnings growth drivers are more important, and they require active management.
• The implementation of the 14^th Five-Year Plan might bring long-term opportunities in a variety of themes, including consumption, self-sufficiency in cutting-edge technologies, carbon neutrality and alternative energy, and digital infrastructures.

Introduction

Within the last week of January 2021, the PBoC withdrew RMB 230billion via its open market operation, triggering a sharp tightening in the money market. As a result, the 7-day interbank collateral repo rate jumped from 2.52% to 4.39% during this week. At the same time, the stock market experienced high volatility, as the CSI300 index declined 4% in one week.

The market reaction reflected investors’ worries about a normalization of monetary and fiscal policies this year. Since China’s economy already normalized in 4Q20, the exit of stimulus policies appears more frequently in policy debates. Moreover, as housing prices pick up in top-tier cities, the asset bubble concern is also rising. In the past few months, local governments, as well as banking regulators, introduced a variety of policies to cool down the property market. After a year-long bull market, all these factors have made investors increasingly sensitive about a sudden turn in policies.

Exhibit 1: Interbank rates hiked at end-January due to liquidity concerns
Key interest rates
Per annum

Source: CEIC, National Interbank Funding Center, PBoC, J.P. Morgan Asset Management.
*In August 2019, the PBoC started to release 1-year and 5-year loan prime rates (LPR) on a monthly basis, which are based on quotes from 18 large banks. LPR has become the benchmark for commercial loans and floating rate loan contracts.
Guide to the Markets – Asia. Data reflect most recently available as of 04/02/21.

In our view, market concerns about overtightening might be overdone. After the temporary liquidity strain, the PBoC returned to its normal operation with liquidity injection before the Chinese New Year. Moreover, at the Central Economic Work Conference (CEWC) held last December, a tone for gradual policy normalization was set, which implied the exit of stimulus policies should be in a slow, controlled style. Hence, macro-prudential policies and fiscal consolidation will be the major measures this year. Against this backdrop, investors need to be more focused on fundamentals and long-term investment themes in China. 

Background: Bubble concerns amid the recovery

China achieved a V-shaped recovery in three quarters after the COVID-19 outbreak. In 4Q20, China’s real GDP growth rebounded to 6.5% year-over-year, back to its pre-pandemic growth path. Meanwhile, the latest economic activity data suggested that the major growth driver has shifted from state-led infrastructure investment to demand from consumers and private enterprises. Supported by rising confidence among consumers and private businesses, consumption and private corporate investment continued normalizing in recent months. In addition, normalization of the global economy supported export growth of China. All these factors point to a broader-based and more resilient growth outlook for China in 2021.

Counter-cyclical policy had played an important role in China’s recovery. On the monetary front, the PBoC cut the lending rate by 30bps and required reserve ratio by 150 percentage points from January to April, prioritizing the rescue of the corporate sector and public investment. Meanwhile, the augmented fiscal deficit increased to 16.4% of nominal GDP in 2020, when the government ramped up its borrowing to finance pandemic control and boost infrastructure investment. As a result, total social financing rose by 13.3% in 2020, far above the growth rate of 10.7% in 2019.

While stabilizing the economy, the counter-cyclical measures also had the side effect of driving up debt levels and asset prices, particularly housing prices in top-tier cities. According to the National Bureau of Statistics, the average price rose by 14.1% and 6.3% over a year ago, respectively, in Shenzhen and Shanghai’s secondary property market, while actual increases were even higher in good locations. As a result, since last December banking regulators and local governments ramped up control measures to cool down the market. The most significant policy change is to set the up-limits for the proportion of property-related loans in each bank’s total lending portfolio. For instance, the largest seven banks could have 40% exposure to property development loans and 32.5% exposure to mortgage loans.   

Exhibit 2: Rebounding property prices in top-tier cities raised the bubble concern
Residential price in secondary market
Year-over-year change, average sale price per square meter

Source: CEIC, National Bureau of Statistics, J.P. Morgan Asset Management.
Data reflect most recently available as of 04/02/21.

Against such a backdrop, the asset bubble has appeared more frequently in recent academic and policy discussions. On January 26, Dr. Jun Ma, a PBoC Monetary Policy Committee member, expressed his concerns about asset price bubbles and suggested that monetary policy should be adjusted accordingly. Although this is more likely a personal and academic view, it was interpreted by the market as a hint for monetary tightening, which triggered a wave of sell-offs in the stock market. 

Monetary policy: Macro-prudential measures to be strengthened

Against the backdrop of sustained economic recovery and rising risk of an asset price bubble, policy makers have to maintain a delicate balance between multiple goals. The market volatility in late January also gave a warning on the risk of a sudden turn in policy. Therefore, it is realistic to take a gradual and modest approach to policy adjustment, and there should be some flexibility given the uncertainties in global economics and geopolitics.

The CEWC delivered the message about a gradual policy normalization, which was reiterated at various occasions. In his Davos speech on January 26, PBoC Governor Gang Yi reiterated that monetary policy will maintain stability and continuity, and a policy cliff should be avoided. On February 2, Chinese Premier Li Keqiang also emphasized the continuity, stability and sustainability of macro-economic policies.

Under these circumstances, we expect to see the PBoC sit tight in terms of policy rates and required reserve ratios this year, while relying on macro-prudential measures to handle structural risks in the economy.

Regarding the interest rate decision, support for the real economy, particularly small and medium-sized enterprises, is still the top consideration. The PBoC might hold its 7-day standing lending facilities rate steady at 3.2%, so as to set the up-limit for interbank lending. Hence, LPR, the benchmark lending rate for borrowers, could remain stable. Meanwhile, differentiated funding supports, such as targeted medium-term lending facilities, might be used to encourage banks to provide low-cost funds to small enterprises. 

In order to contain an asset price bubble, macro-prudential measures are being strengthened. Banks will be subject to more stringent scrutiny in their lending activities, especially to property developers and homebuyers. Property development loans and mortgage loans together accounted for 39% of outstanding bank loans. According to the new rule to cap these loans, the outstanding value should almost stop rising this year. In addition, as local government bond issuance returns to its normal level, credit expansion might further slow down. We expect to see total social financing (TSF) growth decline to around 10% in 2021 from the 2020 peak. 

Exhibit 3: TSF is decelerating as the economic recovery continues

Source: CEIC, People’s Bank of China, J.P. Morgan Asset Management.
Guide to the Markets – Asia. Data reflect most recently available as of 04/02/21.

Fiscal policy: Fiscal consolidation to curb government debt

Large-scale fiscal stimulus has pushed up the debt levels of the Chinese government. The budget deficit reached RMB 8.7trillion in 2020, compared with RMB 5.5trillion one year ago. To raise funds for infrastructure investment, local governments issued RMB 4.14trillion in special bonds. The central government also had an additional issuance of RMB 1trillion in a special COVID-19 bond to support local pandemic control. Moreover, local governments raised RMB 4.5trillion through bond issuance by local government financing vehicles.

In 2021, as the pandemic is under control and economic growth remains on track, it is reasonable for the government to exit its counter-cyclical stimulus. Before the pandemic, the central government took great efforts to strengthen fiscal discipline and control local debt levels. We expect the debt control measures might resume, and the budget deficit might be controlled at 3% of nominal GDP as in the pre-pandemic years. Meanwhile, special local government bond issuance might also be lowered to RMB 3trillion.

Given the fact that private investment and consumption are picking up, the gap left by fiscal consolidation might be offset. The lower government bond issuance might also partially relieve the liquidity pressure as the PBoC ramps up its macro-prudential measures. From a long-term perspective, this is helpful to shift the Chinese growth driver from state-led infrastructure investment to private investment and consumption, which is a key policy goal in the new five-year plan.

Exhibit 4: Government bond issuance might decline after peaking in 2020
Government financing
RMB billions, bond issuance 

Source: CEIC, China Central Depository & Clearing Co. Ltd., Ministry of Finance of China, J.P. Morgan Asset Management.
General local government bonds are issued to raise funds and offset fiscal deficits so as to maintain the ordinary operation of local governments. They are backed by the future fiscal revenue of the local governments. Special local government bonds are issued to support specific infrastructure and public projects. They are backed by the future revenue generated from the projects.
Guide to the Markets – Asia. Data reflect most recently available as of 04/02/21.

Investment implication

During the process of policy normalization, it might become more challenging for investors to manage their China portfolios. In 2020, stock valuation was supported by low interest rates and loose liquidity conditions. When the central bank returns to a balanced stance, the upside might be limited for valuation expansion. Hence, it is more important to have active management and seek alpha in equity investment by exploring long-term earnings drivers. Moreover, at relatively high valuation, market volatility tends to increase, which points to a more balanced allocation between equity and fixed income.  

Exhibit 5: Market volatility might rise at high valuation
CSI 300 Index valuation
Forward PE

Source: Wind, J.P. Morgan Asset Management.
Data reflect most recently available as of 04/02/21.

Despite the short-term uncertainties, investors still need to focus on long-term investment themes. 2021 will be the first year to implement the 14^th Five-Year Plan and 2035 objectives, which lay out the roadmap for China’s long-term development. With these plans to achieve high-quality growth, opportunities are emerging in a variety of long-term themes, including consumption, self-sufficiency in cutting-edge technologies, carbon neutrality and alternative energy, and digital infrastructures.

For global investors, the policy normalization might imply further opportunities from higher yields and stronger renminbi. Since the U.S. Federal Reserve and European Central Bank are expected to maintain super low interest rates for years, the Chinese bond market is offering attractive cash income. In addition, the low correlation between Chinese and foreign bond markets provides the further benefit of diversification. Renminbi appreciation might continue, albeit at a slower pace this year, which will also enhance the return for foreign investors. To manage the exchange rate, the PBoC recently further loosened its quota control to overseas investment. This might help slow down the pace of renminbi appreciation, but the currency is still expected to appreciate modestly against a weak U.S. dollar.      

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