The K-shape structure of Chinese economy becomes more prominent entering third quarter (Q3), with monthly export growth remaining above 20% year-over-year (yoy) while FAI (fixed investments) and consumption staying in slowing trends. Unfavorable weather and subdued fiscal deployment pin down the domestic picture, while strong exports partially offset the weakness. We expect accelerating fiscal deployment in Q4 to reverse the falling trend of FAI and bring GDP growth back to target range.
Contrasting external and internal economic momentum
Chinese export growth increased further to ~24% yoy in the first two months of Q3 (Q2: 20%) – continuing to be on back of artificial intelligence (AI) and green energy related exports – and year to date exports grew by 19.3% as of August. In particular, semiconductor exports grew by over 100% yoy in the first eight months of the year, and green energy related exports increased by ~40% yoy. China continued to be one of the major beneficiaries of the current global tech cycle driven by AI development and also the beneficiary of energy diversification demand since the breakout of the Middle East tension. But, on the other hand, long-lasting heatwaves, extreme rainstorm and above-average typhoon formation particularly weighed on outdoor activities such as traditional construction and tourism, and dragged on already weak FAI and consumption, which also dampened the effectiveness of fiscal policy and slow down its implementation in Q3.
Decent fiscal space calls for accelerated implementation
Based on our estimate, the remaining fiscal space for the rest of the year accounts for ~2% of GDP, including CNY2.1trn of local government special bonds, CNY0.8trn quasi-fiscal backed by policy banks and CNY60bn subsidies for goods and services consumption backed by special central government bond. We believe a full deployment of the remaining fiscal space is enough to push GDP growth back to the target range of 4.5-5% in H2, while the key is implementation. After two quarters of slow fiscal deployments driven by policy maker slackness in Q2 and unfavorable weather conditions in Q3, Q4 will be the key window to leverage remaining fiscal arrangements. We note that policy makers became more keen in boosting up FAI since mid-August, and the National Development and Reform Commission (NDRC) has convened more than eight meetings with different parties (including collaborating government departments and potential investors) to drive up the momentum on manufacturing and infrastructure FAI.
Reconciliation of fiscal support with AI development
In the past, when China mentioned about leveraging fiscal backed infrastructure investment to support economic growth, traditional infrastructure was always the key driver, such as railway, expressway, airport, port and etc. This year, the government proposed Six Networks (i.e., water conservancy system, advanced power grids, computing power network, next-generation telecommunications, urban utility tunnels and logistics networks), which also accommodates the rising infrastructure demand from AI development as the new driver to boost up FAI. The Six Networks integrate traditional infrastructure with AI and new infrastructure, becoming a key deployment to stabilize investment, expand related domestic demand and also as key components of the new economy. The Six Networks are expected to bring in ~CNY7trn investment in 2026 and ~CNY25trn in five years, which can fix the decreasing return issue of traditional infrastructure FAI and better fit in the new structure after the economic adjustment in past five years.
Investment Implications
The domestic economy will be in a mild recovery, especially against the backdrop of subdued housing and consumption. Meanwhile, potential monetary policy easing and asset scarcity due to weak loan demand will provide a favorable backdrop for bond investment. On the other hand, as the People’s Bank of China (PBoC) repeatedly voiced vigilance over a rapid decline of the long term yield, a sharp rates move down is also unlikely. As we expect the liquidity condition to remain loose in general to support fiscal implementation, we see China rates stay in the range-trading scenario with slight bias to receive in the long-end. The CNY/CNH continues in its appreciation path against the USD. We see room for further CNY/CNH appreciation unless the broad USD movement discloses a visible rebound, and we reckon the bias from authorities (in CNY fixing) will favor gradual appreciation vs. the USD (which may result in weaker CNY/CNH vs CFETS basket in the case of broad USD weakness).