March has brought high volatility, widening credit spreads and negative returns to the Asian markets. The SEC’s potential delisting of some Chinese ADRs has additionally rattled equities. Mostly, however, recent market volatility reflects three major worries surrounding China: its relationship with Russia, now cast in the new light of Russia’s invasion of Ukraine; idiosyncratic news affecting China’s property sector; and a spike in COVID-19 infections that puts China’s economy at risk. Here’s our take on all three concerns.
China’s Relationship with Russia
Russia’s war on Ukraine has sharpened the focus on China’s close relationship with Russia. On the one hand, the European Union and US hope that China could play a bigger role in easing the conflict. On the other hand, escalating Western sanctions against Russia and bans on its commodity exports have led to speculation that China might ramp up its oil imports from Russia to help lessen Russia’s economic pain.
As a base case, our analysis points to China maintaining the status quo throughout the crisis, preserving its trade and diplomatic relations with both Russia and the West. China may not be willing or have a strong incentive to take action that could tilt it decisively toward either side. This means that China is unlikely to help Russia escape the West’s sanctions—but it also means China is unlikely to condemn Russia or reduce trade.
As for oil, China already buys around 30% of Russia’s oil exports. That makes Russia the second-largest provider, after Saudi Arabia, of China’s oil imports, at around 16%. Will China further ramp up imports of Russian oil to fill the gap left by the West’s sanctions, at the expense of imports from other countries? We don’t think so. A meaningful increase in the very short term is unlikely, as the West could view it as intentionally undermining its sanctions against Russia. Furthermore, Saudi Arabia has good relations with China and recently strengthened its collaboration with China in supplying oil.
For these reasons, we think there’s only a slim chance that China will aim to fully absorb Russian oil exports to the West by sharply increasing its imports of Russian oil. However, we do expect that China will maintain close collaboration with Russia and continue to increase its import share of Russian oil at the same steady pace as recent years, though there could be technical frictions in the short term.
Upheaval in China’s Property Market
China’s property sector has been under pressure in recent months, with property developers’ equity and debt now under severe market stress. The bond market is currently pricing in an implied default rate of more than 50% for property developers, and many bonds are being traded indiscriminately, despite wide variety in fundamentals.
But investors should bear in mind that the housing sector is systemically important to China, which in our view will not allow the sector to collapse, given the risk of severe adverse impact on China’s broader economy.
For years, China used its property sector as a growth engine, making the asset class a one-way bet and leveraging its economy around it. But more recently, Beijing shifted its broad policy paradigm from growth as its solitary objective to multiple objectives, including growth stability, financial stability and the environment. This new paradigm has reduced Beijing’s inclination to use the housing sector as a cyclical tool for driving growth.
Instead, policymakers have adopted a highly localized policy approach that effectively reduces moral hazard and excess risk-taking and allows the sector’s growth to slow in favor of stability. In other words, the central government has indicated it is now inclined to let some property developers fail, but it’s not inclined to let the whole sector go under.
Recognizing the potential stress to the broader economy, Beijing has promoted favorable policies to support home sales. So far, we’ve seen local relief measures such as lower mortgage rates, reduced down-payment ratios and the easing of restrictions on purchase eligibility. These measures should help reduce drag from the property sector on China’s overall growth.
While we expect the offshore Chinese property bond market to remain volatile in response to idiosyncratic headlines and unsettling global risk sentiment, we believe that the acceleration of policy support across China paints an incrementally better picture for the rest of the year. Investors should therefore remain selective while awaiting signs of stabilization in property sales.
Rising COVID-19 Infections
COVID-19 infections in China have increased sharply in March and could continue to rise in coming days. Some major cities, such as Shenzhen, Dongguan and Changchun, have been effectively locked down for at least a week, and Shanghai has significantly tightened COVID restrictions. What does this mean for economic activity?
To answer that question, we need to first examine what makes this outbreak different from earlier ones. First, the number of asymptomatic cases in the current outbreak is much higher, likely due to a combination of omicron’s milder symptoms and vaccinations that reduce the severity of infection. Second, the share of imported cases has been comparatively high, especially in Shenzhen and Shanghai. Third, more provinces have been affected, posing a bigger challenge in controlling the outbreak.
There’s been speculation that China may relax its zero-covid policy, but we don’t expect that anytime soon. In fact, China’s highest health authority recently urged regions experiencing severe outbreaks to control the epidemic quickly by taking strict measures. Difficulties getting most of the population effectively vaccinated (largely via third doses) presents further constraints around relaxing zero-covid policies.
To gauge the potential economic impact, we can additionally look at traffic congestion, subway passenger volume and daily coal consumption. The first two may be affected not only by imposed restrictions but also by individual risk aversion, and they can tell us something about services and consumption; meanwhile, measures of coal burned helps shed light on industrial activity. All three indicators dropped notably during past outbreaks of COVID-19 and are showing some negative effects now. Purchasing Managers’ Indices further indicate that activity held up relatively well in January and February but may weaken in March.
The bottom line? COVID-19 is the biggest risk to our growth forecast in 2022. We expect the current outbreak to weigh on economic activity in March and the first quarter. What the path looks like after that depends on how quickly Beijing controls the outbreak and how much additional policy support it delivers to counteract the hit to growth. For now, we have maintained our GDP growth forecast of 5.3% for 2022. In our analysis, the odds are low that China’s government will allow growth to fall below 5%, as it still has a growth target of around 5.5% for the year and many policy tools to make it happen. Given the uncertainties around the outbreak, however, we will continue to closely monitor the situation.
