China’s sudden reopening has spooked markets, in a case of being careful what you wish for

Markets have been clamouring for Beijing to end the zero-Covid policy for some time, well aware that the exit would not be a smooth one
Now that China has opened up much faster than anticipated, causing major business disruptions, investors have taken fright

Nicholas Spiro

Published: 11:00pm, 22 Dec 2022

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Do financial markets really want China’s economy to open up? Just a few months ago, it would have seemed absurd to even ask such a question. Beijing’s zero-tolerance approach to the Covid-19 pandemic, which relied on frequent lockdowns and mass testing to suppress the virus, was viewed as the biggest impediment to stabilising asset prices and allowing stimulus measures to work more effectively.

The relaxation of some of the restrictions, and rumours that others would soon be lifted, caused Chinese offshore equities to soar last month as the “reopening trade” took hold. Many Wall Street firms, which had been looking for reasons to be more optimistic about China, turned bullish on the country’s shares, enticed by their historically low valuations.

Yet, since the government unexpectedly scrapped nearly all of its internal controls at the beginning of this month, sentiment towards China has soured. While even bullish investors acknowledged that the reopening process would be bumpy and perilous, the shift in the tone of many investment banks’ research reports over the past few weeks is remarkable.

In a note published on December 13, Morgan Stanley, which recently lifted Chinese stocks to an overweight position in its portfolio, said it no longer viewed the reopening process as attractive and recommended that clients hedge against mounting risks.

These threats stem mainly from anecdotal evidence pointing to a deadly exit wave, exacerbated by Beijing’s lack of preparation for a major reopening. The failure to ensure that the elderly population is fully vaccinated, and that the healthcare system can cope with a dramatic rise in cases, has come home to roost.

While the trajectory of the outbreak is uncertain, many who had hoped that China would learn to live with the virus now fear the consequences of a hasty retreat from zero-Covid.

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Hospital in China overwhelmed with patients after Covid controls eased

However, while fears of a public health catastrophe were bound to intensify following the rapid dismantling of controls, it is the sudden change in the economic narrative around China’s reopening that is more striking.

Having produced reams of research on the deleterious impact of lockdowns and other draconian restrictions on household and business confidence, investors and analysts – particularly those in the West – are now fretting about the economic costs of reopening.

In a report published last Sunday, JPMorgan said it was concerned about “transitional pain, i.e. both production (due to temporary loss of labour supply) and demand (due to self-imposed mobility restrictions) may be weak when China moves from low infection to herd immunity”.

Not only are there worries that a chaotic reopening could precipitate the next phase of supply chain disruptions, there is speculation that the opening up of China’s economy will eventually spur demand for commodities, fuelling inflationary pressures.

Much of this has to do with the timing of China’s reopening. Not only is Beijing ditching its zero-Covid policy as the winter season gets under way, allowing the virus to spread more easily, China is opening up just when global monetary policy has reached an inflection point.

People in Shanghai following the relaxation of Covid-19 restrictions, on December 21. Photo: EPA-EFE

There are indications, particularly in the United States, that inflation has peaked, allowing central banks to slow the pace of interest rate increases. However, these signs are open to interpretation – while the prices of goods are falling, services inflation continues to rise – and are a hot-button issue in markets, mainly because of fears that aggressive tightening is inducing a recession.

International investors look at China’s reopening through the prism of US monetary policy. Bond markets are already pricing in rate cuts in the second half of next year despite the Fed’s reluctance to loosen policy. Equity and corporate debt markets, meanwhile, believe a full-blown recession can be averted. This leaves plenty of room for further turmoil if inflation does not come down fast enough or if global economic activity deteriorates more sharply in the coming months.

China’s reopening is the wild card. At a time when investors have been blindsided by sudden shifts in policy the world over – the latest example was the Bank of Japan’s surprise decision on Tuesday to adjust its so-called “yield curve control” measures – the unpredictable consequences of China’s abrupt exit from zero-Covid have become one of the biggest risks for 2023.

This is because the global economy and asset prices are caught between the Scylla of inflation and the Charybdis of recession. In the same way that investors are hoping for “immaculate disinflation” – bringing prices under control without crushing the economy – markets want China to exit zero-Covid in a more or less orderly manner.

This is wishful thinking, and a case of investors wanting to have their cake and eat it. Markets have been clamouring for China to reopen for some time and were well aware that the country was not ready for a swift exit. Now that Beijing has done away with its pandemic controls, allowing the virus to spread unchecked, investors have taken fright.

The reality is that China has opened up much faster than anticipated, precipitating an uncontrolled outbreak and causing widespread disruptions. Time will tell whether a chaotic reopening is preferable to no reopening at all. What is clear, however, is that whether it is the end of zero-Covid in China or the battle against inflation, painful trade-offs need to be made, something markets need to accept.

Nicholas Spiro is a partner at Lauressa Advisory