China may be heading for a real recession unless it comes up with a forceful policy response

China’s industrial activity is recovering from the Covid-19 shutdown, but consumer spending is not. If a lack of demand is indeed slowing China’s economic recovery, Beijing must act fast to avoid a technical recession

Aidan Yao

Published: 7:30pm, 22 Apr 2020

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The first quarter of 2020 has officially gone down in history as the worst quarter for the Chinese economy, and the record book is unlikely to be rewritten for a long time.

To put the first-quarter numbers in proper context, one must consider the condition the economy was in before the coronavirus crisis hit and the country entered what could be the first genuine recession in decades.

The 6.8 per cent contraction in the first quarter of 2020 followed a 6 per cent expansion in the last quarter of 2019. This translates as a slump of 12.8 percentage points in sequential year-on-year growth, which is almost three times the size of the peak-to-trough decline during the global financial crisis.

The scale of the economic shock is therefore unprecedented and Beijing must issue an extraordinary response if it is to prevent a temporary shock from morphing into something permanent that disrupts the fundamentals of the economy.

Zooming in on the latest data, we see a mixed bag of news.

On the positive side, the first-quarter out-turn was slightly better than our projection of a 7.5 per cent contraction, and far better than a number of forecasts of double-digit declines. A less-severe drop makes it easier for the economy to bob back to the surface, reducing the chance of a technical recession, which requires two consecutive quarters of negative growth.

While the geeky specifics of recession measurement probably matter only to economists, the data does have a genuine silver lining. Comparing the monthly activity data for January to February and March, there is unequivocal evidence that the economy has passed its trough and is starting to recover.

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This recovery is more evident in industrial production, where the gap relative to the same period last year narrowed from minus 13.5 per cent to minus 1.1 per cent. Mining and hi-tech manufacturing rebounded strongly, supported by faster work resumption in less-labour-intensive industries.

Other activity indicators also improved from February, even though there were no V-shaped recoveries. Continued supply normalisation and loosening social restrictions should see businesses recoup more of their capital expenditure and losses in the coming months.

The bad news is that the economic recovery was uneven. As alluded to above, while industrial activity seemed to be back on track, consumers were still reluctant to return to their old spending habits. Sales at restaurants, cinemas and shopping malls have continued to struggle as social distancing prevents people from going out and eating out.

Fears of human contact also hindered the recovery in services sectors. A recent broker survey of large services firms showed that while 75 to 85 per cent of supply has been restored, demand is only running at 50 to 55 per cent of normal levels.

Another worrying takeaway from the data is that the economy was still operating at subnormal levels. The official capacity utilisation rate of the industrial sector was only 67.3 per cent in the first quarter of 2020, down from 77.5 per cent in the previous quarter.

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While the monthly reading for March would have improved significantly from previous months, it is doubtful that the utilisation rate, which is different from the resumption rate, would be fully back to normal.

There is corroborating evidence that none of the March activity data was back to positive year-on-year growth, with retail sales and fixed-asset investment still contracting at double-digit rates.

This begs an important question: what is driving the remaining wedge between the current and normal levels of economic activity? If the gap is due to sluggish supply normalisation, then the role for policy stimulus is arguably limited.

Beijing would be better off concentrating on containing the risk of a second wave of infections and supporting migrant workers’ return to work.

But if the wedge is driven by a lack of demand, then countercyclical policies will have an important role to play. I am increasingly of the view that the factor plaguing economic recovery has shifted from the supply side to the demand side, which justifies more forceful policy easing measures from Beijing.

Monetary policy has arguably already turned more proactive, with a slew of rate and reserve requirement cuts, along with targeted lending, helping to lift credit growth to a multi-year high.

However, fiscal support has fallen behind the curve, with only piecemeal measures to date, which will prove insufficient to counter the unprecedented economic shock. More stimulus measures should be forthcoming, possibly before the National People’s Congress session.

With a well-calibrated policy response, China has a chance of keeping its head above water even as the rest of the global economy sinks. But time is of the essence, and Beijing has to act fast.

Aidan Yao is senior emerging Asia economist at AXA Investment Managers

This article appeared in the South China Morning Post print edition as: Beijing must act fast to avoid unprecedented economic shock

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