China's bounce-back may prove limited

China’s GDP bounced back to positive territory in Q2 with year-on-year growth of 3.2%. But I doubt the accuracy of the data (as always) and also question whether China can continue to recover quickly. China faces a raft of problems. There are the ones I have highlighted for some time, including high debt, overcapacity and a weak financial system – all now made worse by the Covid-19 crisis. And there are new ones, including ongoing fears among consumers about the virus, the risk of a second wave in China, weakness elsewhere in the world and deteriorating relations with the US.

China’s data suggest that GDP fell about 10% in Q1 compared with Q4 2019 and then rose about 11% in Q2, essentially back to where it was. So, with growth running at 6% last year, Q4 2019 was up about 3% on Q2 2019 – hence the 3.2% y/y figure for Q2 reported today.

The GDP data overstate the rebound

But the official GDP data seems to flatter the picture. Retail sales were reported 1.8% lower than a year ago. Without Covid, they should have been about 7-8% higher, so consumer spending seems to be lagging. Particularly badly impacted were oil and oil products, together with autos, signalling that Chinese are still not travelling about much and cautious about a big-ticket item like a car. Some categories did show good gains however including cosmetics, personal care and home appliances. But meanwhile many service businesses are reportedly still operating below capacity.

The driver of Q2 growth seems to have been the industrial sector as the big state-owned enterprises ramped up production again, supported by a surge in new infrastructure spending, much of it paid for with increased local government borrowing. Industrial production rose 4.8% y/y in June, only slightly below the 5-6% rates seen last year. Of course, some of this may been catch-up growth after the disruptions of early Spring. Reportedly, export industries are still struggling as foreign orders remain weak.

China is clearly in a better position now than the UK or US, where output in June was still probably 10% below December levels. Moreover, China is reporting only a handful of new Covid cases each day while the US is at 70000 per day, while the UK’s daily cases seem to have levelled off at about 500-600. Presumably it will be easier to encourage the average Chinese to go back to normal life than the average American or Brit, unless of course there is a second wave.

I have long been sceptical of China’s outlook, believing that the economic model is broken and Covid has almost certainly worsened the picture. I expect growth will level off in the second half of the year and China will struggle to push it back up to the 5-6% y/y range which they hoped for before Covid. The financial system, already weak because of over-investment, has been weakened further by rising bad debts due to Covid. This has contributed to jitters about bank safety among some consumers, with runs on some small banks reported in recent days. The government should be able to manage such fears, but it will struggle to restore economic growth.

Overall then, the Covid crisis is accentuating the economic slowdown that began several years ao, and aggravating the underlying debt crisis. With China also now facing an increasingly antagonistic US, the outlook is more difficult than at first sight.