Beijing’s ideological battle to stamp out COVID-19 appears increasingly misguided as the rest of the world learns to live with the virus. But the impact of China’s approach will be felt far beyond its borders.

Read this article to understand:

  • The growing economic toll of fighting the pandemic
  • Why disruption of supply chains could further fuel global inflation
  • The implications for emerging-market debt and other asset classes

On April 5, Chinese authorities locked down Shanghai, home to the country’s biggest port and financial district, after widespread testing and various other measures failed to control an outbreak of COVID-19 that had begun two months earlier.

The effective closure of Shanghai, along with several other major Chinese cities, caused serious problems for the country’s economy and further weakened already fractured global supply chains.

China’s economic output contracted 2.6 per cent in the three months to June compared with the previous three months and was just 0.4 per cent higher than the corresponding period in 2021.1 The weakness of the economy was largely explained by China’s zero-COVID policy. Japanese financial services firm Nomura estimated that at one point in April, about 373 million people (more than a quarter of the population) were living under some form of lockdown.2

Restrictions in Shanghai were eased at the end of May, much to the relief of the city’s 25 million residents. But within weeks, the appearance of the BA.5 coronavirus strain led to fresh restrictions and quarantines across the country, and sparked speculation Shanghai’s reprieve might be short lived.

While the total number of infections in China remains low compared with many other nations, Beijing is worried the highly transmissible subvariant’s arrival will lead to a mass outbreak and wave of deaths, especially among the under-vaccinated elderly population, many of whom do not trust domestically produced jabs.

Figure 1: Booster uptake among China’s elderly has ground to a halt (per cent)
Source: Bloomberg UK, March 18, 20223

Nomura recently estimated 41 cities were still under full or partial lockdowns, affecting 264 million people in regions accounting for close to 20 per cent of the country’s economic activity.4 As the economic costs intensify, criticism of China’s zero-COVID strategy is mounting, and not just from the country’s long-suffering population.

Political disquiet

Premier Li Keqiang has been a frequent critic. At an emergency meeting in late May between the central government and thousands of local officials, Li warned serious consequences were in store for the country’s economy if it could not balance its zero-COVID policy with economic growth targets.5

Criticism of China’s zero-COVID strategy is mounting

Signs of growing public frustration at Xi Jinping’s dogmatic approach, and possible disharmony within the government, has even fuelled speculation opponents might look to topple the Chinese leader at October’s 20th Party Congress and foil his bid for an historic third term in office.6

However, Michael Hirson of Eurasia Group, a US-based political risk consultancy, says rumours of dissent within the senior party leadership are overstated.

“Xi is not under significant political pressure. He is extremely likely to secure a third term,” he argues.

As a result, David Nowakowski, senior multi-asset and macro strategist at Aviva Investors, sees little prospect of an early change in tack despite growing concern over the economic toll.

“They’re trying to fine tune their response to shield the economy. But while they may be able to avoid locking down quite so harshly, it looks like zero-COVID is here to stay, at least until the end of the year. It’s a gigantic policy error,” says Nowakowski.

Policymakers’ difficulties are being compounded by the low take-up of booster jabs

He argues Omicron and more recent variants of it are much milder than previous strains, making them harder to detect and easier to spread. Policymakers’ difficulties are being compounded by the low take-up of booster jabs, the fact China’s vaccines are less effective than those developed elsewhere, and their own refusal to authorise vaccines made in the West.

In June, China’s increasingly autocratic leader described zero-Covid as the most “economic and effective” policy for China, adding that relaxing controls would risk too many lives and China would rather endure some “temporary” impact on economic development than let the virus hurt people’s safety and health.7

A familiar playbook

To try to boost the economy, Xi has been forced to reach for a familiar playbook, calling for an “all out” effort to lift construction and other forms of infrastructure spending. Few, however, believe that will be enough to offset the impact of repeated lockdowns and allow China to come close to meeting its growth objective, especially with no end in sight to the deep malaise plaguing the nation’s real estate sector.

China recently abandoned a pledge to grow the economy 5.5 per cent this year, which came as little surprise given economists were forecasting growth of just four per cent.

Infrastructure spending is likely to be less effective at getting the economy moving

Swiss investment bank UBS reckons growth will be weaker still. It expects the economy to expand just three per cent, as lasting COVID restrictions and lack of clarity on an exit strategy dampen corporate and consumer confidence.8

Nowakowski says infrastructure spending is likely to be far less effective at getting the economy moving in the face of drags from elsewhere, whether consumption, manufacturing output, or real-estate investment.

While this may not be the first time Beijing has turned to infrastructure spending in times of economic distress, the move casts fresh doubt on its ability to deliver a long-standing goal of rebalancing the economy towards higher household consumption. Perhaps more worryingly, it raises concerns on other fronts.

Several bodies, including the International Monetary Fund, have warned there are waning benefits from traditional infrastructure spending, with the most transformative deals having long since been completed.

“The whole reason China wanted to boost consumption is because it was becoming obvious it was getting less economic growth from each additional unit of debt-funded infrastructure investment. The marginal impact on growth from investing in water sanitation projects is not as large as building a high-speed railway,” says Nafez Zouk, emerging-market debt analyst at Aviva Investors.

Charles Parton, senior associate fellow at the Council on Geostrategy and the Royal United Services Institute, a defence and security think tank, says while demand for manual labourers may rise, Beijing is failing to address a far more pressing problem: finding suitable employment for China’s growing legion of unemployed university graduates.

China’s problem is that its economic model is broken

A record 10.8 million graduates, more than the entire population of Portugal, are about to enter one of China's worst job markets in decades at a time when youth unemployment, at a record 18.4 per cent, is already more than three times the national average.9

“China’s problem is that its economic model is broken. We may see a short-term boost, but the government won’t be able to prop up the economy for ever,” says Parton. 

Beijing has traditionally relied on local and regional governments to implement its strategy, both in terms of selecting which projects to give a green light to and which to fund, thereby ensuring infrastructure spending is compatible with its growth targets.

Real estate woes

The problem is local government financing vehicles (LGFVs) – investment companies set up to fund infrastructure and real estate projects on behalf of local governments – have historically relied on selling land to property developers to raise sizeable funds for infrastructure projects. With the property market in a deep slump, land sales have been falling precipitously. UBS estimates land sales revenues fell 24 per cent in the three months to May compared with a year earlier.

As a result, both local governments and LGFVs are being forced to issue more debt, despite Beijing’s desire to reduce leverage and systemic risks. According to a September 2021 report by Goldman Sachs, local government debt had swelled to a staggering 53 trillion renminbi ($8.2 trillion) by the end of 2020, more than half the size of China’s economy.10

At the same time as local governments, and the off-balance sheet financing vehicles they spawned, have been accumulating potentially explosive debt loads, the central government’s finances have been battered by the property downturn, COVID-related expenses, and a series of tax breaks. That is prompting fresh warnings over Chinese debt. However, Zouk believes such concerns are overblown.

People have been talking about China's Minsky moment for years

“People have been talking about China's Minsky moment for years, but it is more likely to be a Minsky decade. Debt levels are problematic, insofar as they have become a symptom of China’s unsustainable high savings, high investment growth model. The danger lies in how that debt is handled during the transition to a more sustainable growth model, which will inevitably be bumpy and will likely lead to losses in key sectors,” says Zouk.

Nonetheless, he rates Chinese sovereign debt no better than ‘neutral’, even if this is largely down to the uncertain outlook for economic growth rather than excessive debt, as well as there being little prospect of interest rates being cut to support economic activity at a time when they are rising in the US and elsewhere.

The impact on domestic markets

It is not just sovereign bond investors who are closely monitoring the slowdown in China’s economy and policymakers’ response to it. Amy Kam, emerging-market corporate bond portfolio manager at Aviva Investors, says while the portfolios she helps oversee are overweight Chinese corporate debt, the holdings are concentrated in a small number of less heavily indebted sectors best able to withstand a tougher economic climate.

“Nearly 60 per cent of these holdings are either in debt issued by companies with strong fundamentals or by strategically important state-owned enterprises,” she says.

2022 was always going to be a challenging year for Chinese equity markets

Meanwhile, Jonathan Toub, global and emerging markets equities portfolio manager at Aviva Investors, says 2022 was always going to be a challenging year for Chinese equity markets. Given the leadership’s primary focus on stability heading into the party congress, the zero-COVID policy was likely to persist largely intact until then.

Although Chinese equities fell sharply at the start of the year, the partial re-opening of the economy and easing of regulatory scrutiny has led the market to outperform international peers more recently. This trend could be maintained in the near term given monetary and fiscal policy is moving in a different direction to elsewhere, he argues.

Toub sees value in e-commerce and internet platform firms should regulatory scrutiny continue to subside, given the country’s reliance on them to support consumer-driven economic growth. Although share prices have risen sharply, he still sees value in certain companies set to benefit from a significant increase in demand as China steps up efforts to hit climate goals.

Julie Zhuang, global equities portfolio manager at Aviva Investors, sees the potential for a step change in Chinese consumers’ spending patterns.

Expect people to stock up on essential items and think twice when it comes to old discretionary spending habits

“People’s mentality may have changed. Rich people were fighting to get bread during indiscriminate lockdowns. Younger people too have never experienced shortages before. For some, who have been literally starving for three months, expect them to stock up on essential items and think twice when it comes to old discretionary spending habits,” she says.

While the government may be looking to prop up activity in the short-term with infrastructure investment, such a policy is untenable over the long term. It is likely Beijing will eventually be forced to resume its effort to boost consumption. For this reason, Zhuang is attracted to the auto sector.

“If the government wants to increase Chinese consumption in a way that most directly benefits the Chinese economy, and sectors where production takes place locally given quasi-closed borders, it would be logical for policy support to focus on autos rather than, say, luxury goods, especially since China sees an advantage in getting ahead of the rest of the world in developing electric vehicles,” she says.

Local problem, global impact

Given China’s size and its importance to the global economy, international investors are taking a keen interest in developments. Amid growing concern developed countries could be heading towards recession as central banks try to combat the highest rates of inflation in 40 years, Zouk sees little prospect of China coming to the rescue as it did in the wake of the global financial crisis.

Events in China look like leading to an intensification of the problems facing the rest of the world

“The scale of the challenges it is facing means China is not going to come back as the marginal provider of global growth,” he says. On the contrary, Nowakowski says it is more likely events in China lead to an intensification of the problems facing the rest of the world.

“Even though some of the blockages are easing now, it is a case of two steps forward one step back, which will continue to be disruptive,” he says.

If companies fear they will be unable to obtain key components, the tendency will be to order as much as possible whenever stock is available, which will exacerbate inflation.

With China accounting for around 15 per cent of global merchandise exports, the repercussions of the country’s zero-COVID policy are already rippling across the globe. Multinationals, including Apple, Amazon, General Electric and Airbus, have warned of disruption to their supply chains due to the lockdown of Shanghai, which handles 20 per cent of China’s international trade.

US automaker Tesla recently disclosed it had delivered 18 per cent fewer vehicles in the second quarter than the previous three months thanks to production shutdowns in Shanghai and parts shortages.11

Richard Saldanha, global equity fund manager at Aviva Investors, says the general view among multinationals at the start of the year that China would ease back on zero-COVID in the second quarter and supply-chain disruptions could be managed, is being replaced by a more damaging reality.

It feels like global supply chains are more dependent on China than ever

“Despite all the talk of deglobalisation, it feels like global supply chains are more dependent on China than ever. This is becoming a massive issue and affects a whole range of companies, not just because of the widely-documented shortage of semiconductors,” he says.

“It’s a double whammy because we are not going to see an offset via stronger Chinese growth that we might have expected in the past.”

China’s zero-COVID policy is not just hurting companies reliant on China for intermediate goods or those with manufacturing bases there. Global firms that rely on Chinese consumers to buy their products are also feeling the effects. For example, luxury goods and apparel companies such as Nike, Adidas and Estée Lauder have all warned of a hit to revenues.

However, with share prices having “sharply de-rated” in response to events in China, Saldanha believes some valuations have begun to look attractive for investors prepared to take a long-term view and ride out short-term volatility.

“Sentiment is weak, but we don’t think business models are impaired. The economy will re-open eventually, at which point we’ll see these brands have still got pricing power,” he says.

China’s economic woes could be especially problematic for emerging-market countries

China’s economic woes could be especially problematic for emerging-market countries, many of which are heavily reliant on Chinese consumption of commodities and manufacturing components.

“Whether the fresh wave of infrastructure spending spills over positively or negatively to other emerging markets is an important question. Should the extra money go on manufacturing, digital and telecoms infrastructure and water, it is unlikely to boost demand for raw materials by anywhere near as much as in the past,” says Zouk.

Time for a rethink?

While there may seem little prospect of China charting a new course until October, there is little doubt the economic costs involved will force it to find a way to learn to live with the virus eventually.

“When we talk about the zero-COVID strategy, we don’t think it’s sustainable,” WHO director-general Tedros Adhanom Ghebreyesus said in May.12

Eurasia’s Hirson says China’s confidence it can avoid large numbers of deaths and serious illness, and the completion of the leadership transition that begins with the 20th Party Congress this autumn, should eventually lead to a change in strategy in 2023.

However, he warns, it will be “a very cautious and gradual pivot”.

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