China set to advance stimulus efforts

As governments around the world step up their fiscal packages to counter the economic fallout from the COVID-19 outbreak, the Chinese government is also following the same path. On March 27, the Chinese Communist Party Politburo meeting committed to strengthen anti-cyclical measures, including further proactive fiscal policies, a higher fiscal deficit, and lower market interest rates, given the rising risk of a sustained recession.

This latest move reflects the widening concerns over a sustained weakness in the Chinese economy, despite the success in taking COVID-19 under control domestically. China is now facing two major risks from the global virus outbreak. Firstly, in order to prevent a second domestic outbreak caused by imported infections, China has stopped most international flights. Social distancing measures have also been strengthened in major cities after a transient loosening. Businesses are still facing challenges in terms of cash flows and employment, particularly in the service sectors. Secondly, as international economies are widely impacted by lockdowns, Chinese exporters are facing risks of large-scale order cancellations. This will lead to under-utilization of capacity and layoffs in manufacturing sectors, especially in the coastal provinces.

Given these challenges, expanded fiscal and monetary stimulus is necessary to prevent further slides in growth and employment. The next stage of stimulus may include:

1) A higher budget deficit ratio (3.5% in 2020 vs. 2.8% in 2019) to support tax reduction, consumption subsidies, and transfer payments to the impoverished population. Given the low debt ratio of the central government (below 17% of GDP in 2019), the deficit will be financed by issuance of special central government debt.

2) More infrastructure investment financed by issuance of local government special bonds. Net special bond issuance may reach RMB 2.5trillion in 2020 (vs. RMB 2.05trillion in 2019). Meanwhile, financing conditions may loosen to help local governments and their financing platforms borrow in the financial market.

3) Further monetary easing to support government and business financing. Subject to legal restrictions, the People’s Bank of China (PBoC) cannot directly purchase government and corporate bonds from the market. To support banks' bond purchases, the PBoC introduced a variety of relending schemes (Medium-term Lending Facility (MLF), Standing Lending Facility, Priority Sector Lending (PSL), and Short-term Liquidity Operations), which are mainly collateralized by banks’ holdings of government and corporate bonds. Contrary to the clear purchase targets set by the U.S. Federal Reserve and the European Central Bank, the PBoC keeps the scale of its liquidity injection discretionary. So far, these operations remain moderate, although the PBoC may ramp up volume and lower rates when faced with rising growth pressure.

EXHIBIT 1: China’s fiscal balance*

Source: Agricultural Development Bank of China, CEIC, China Development Bank, China Trustee Association, People’s Bank of China, Wind, J.P. Morgan Asset Management.
*Actual deficit = fiscal revenue - fiscal expenditure (Fiscal revenue includes taxes, government funds, which are mostly derived from local government land sales, and other government revenues. Fiscal expenditure includes government spending of funds raised from taxes, government funds and general bond issuance.) Budget deficit = actual deficit adjusted with the fiscal stability fund. Augmented deficit is an estimate of all the fiscal resources mobilized by the government to support economic growth (fiscal balance plus investment via local government financing vehicles, policy banks and other channels). Figures for 2019 and 2020 are J.P. Morgan Asset Management estimates.
Data reflect most recently available as of 31/03/20.

On March 30, the PBoC cut its 7-day reverse repo rate by 20 basis points (bps), which lowered short-term financing cost for banks. Since Loan Prime Rates (LPR) are still above 4% (4.05% for 1-year and 4.75% for 5-year), the next step may be further cuts to the MLF rate (probably up to 50bps this year), so as to guide LPR rates down and support long-term lending. Meanwhile, the PBoC may also cut the Reserve Requirement Ratio and expand its MLF or PSL operations to provide sufficient liquidity and facilitate banks’ government bond purchases and loans for small and medium-sized enterprises.

As a result of the escalated stimulus, Chinese augmented fiscal deficit, an indicator to gauge the resources mobilized by the government, could reach 14.2% of nominal GDP in this year, in comparison to the ratio of 12.5% in 2019. On the other hand, to allow policy flexibility and avoid excessive stimulus and debt building, the authority may tolerate a lower growth rate this year. As a result, a specific qualitative growth target may not be announced as usual during the annual National People’s Congress session. Instead, qualitative targets, such as to “maintain stable economic growth and employment”, may be stated.

Investment implications

Given the high uncertainties in global virus transmissions and economic growth, a defensive portfolio diversified across regions and asset classes is still essential for investors to control risk. During the policy easing cycle, Chinese government and quasi-government bonds may continue to benefit from declining interest rates. In addition, as risk-free rates have dropped towards zero in the U.S., Chinese bond yields are increasingly attractive for foreign investors. These factors may enhance the function of Chinese bonds as a defensive and income-generating asset.