Gradually Returning to Pragmatism

This issue of Sinology, Andy Rothman outlines reasons for longer-term optimism, and explains that the key short-term risk is the degree of pragmatism in China’s response to the BA.5 subvariant of Omicron.

"Economic activity is recovering, and should be boosted by significant monetary and fiscal policy easing, in contrast to continued tightening in most of the rest of the world." Andy Rothman, Investment Strategist

China is gradually returning to pragmatism. I expect Beijing to continue revising its COVID policies to strike a better balance between preventing deaths and facilitating a healthy economy. It is difficult to predict when zero-COVID will be adjusted enough to support a full economic recovery, and there are likely to be setbacks along the way, but odds are high that this more pragmatic approach will come within the next several quarters.

The terrible second quarter economic numbers were caused by short-term, Omicron-mitigation policies, not by structural faults. As the COVID controls were relaxed in recent weeks, economic activity has begun to recover and should be boosted further by significant monetary and fiscal policy easing, in contrast to continued tightening in most of the rest of the world. 

This issue of Sinology outlines reasons for longer-term optimism, and explains that the key short-term risk is the degree of pragmatism in China’s response to the BA.5 subvariant of Omicron.

Omicron Vs. The Economy

Until the arrival of the Omicron variant, China’s zero-tolerance for COVID policy worked well, balancing public health with economic growth. 

Since the start of the pandemic, China experienced only four COVID deaths per one million population, while the U.S. has seen 3,154 deaths per million. And China’s economy was healthy last year. The recovery in inflation-adjusted (real) private consumption was greater in China, compared to 2019 levels, than in the U.S. and the Euro Area. The incremental expansion in the size of China’s nominal GDP last year was the largest in the country’s history, and China accounted for 25% of global economic growth.

The early-2022 arrival of Omicron, however, led to dramatic lockdowns and mobility restrictions, which prevented deaths from rising sharply, but which created a huge, negative impact on Chinese society and economic activity.  According to Communist Party chief Xi Jinping, this was a deliberate tradeoff: “We would rather suffer temporary losses in economic development than harm people’s lives and health, particularly the elderly and children.”

Xi likely endorsed widespread lockdowns out of fear that China’s weak health care infrastructure and vaccination shortfalls—its domestic-produced, inactivated whole virus vaccines are not as effective as foreign-developed mRNA jabs; he has refused to approve mRNA vaccines for use in China, presumably for nationalistic, political reasons; and too few older people are fully vaccinated—created a large public health risk which, in his mind, outweighed the social and economic costs.

In March, a government health official reported that only 20% of the 30 million Chinese (larger than the total population of Texas) who are aged 80 and above had received a booster shot, which would provide strong protection from COVID. That statistic has not been updated, and there is little reason to believe the share has increased significantly. 

The recent experiences in Hong Kong and Taiwan may also have been on Xi’s mind.

When Omicron hit Hong Kong in February, only about 14% of people aged 80 and above had received three jabs, and although that cohort accounted for only 5% of the total population, they represented 48% of COVID hospitalizations and 71% of COVID deaths. Over more than three months, over 8,300 people died of COVID in Hong Kong.

Taiwan, like most of the rest of the world, relaxed many of its COVID-mitigation policies earlier this year, and since the mid-April start of its Omicron wave Taiwan experienced over 7,000 COVID deaths, or 310 deaths per million population. A similar rate on the mainland would have been equal to over 43,000 deaths during that period, in contrast to the actual 588 COVID deaths in China. Moreover, the vaccination rate in Taiwan, including for its older population, is much higher than in China, and Taiwan has been using the more effective mRNA vaccines.

A More Pragmatic Approach To Omicron . . .

In China, widespread lockdowns ended in early June, and since that time the government has moved incrementally towards a more pragmatic, science-based approach towards managing COVID.

After understanding that the average incubation period for Omicron is much shorter than for earlier variants, China cut the quarantine period for entering the country by half, to seven days in a designated facility followed by three days of home isolation. The frequency of mass testing has been reduced, and restrictions on domestic mobility have been relaxed. COVID outbreaks have been met with much narrower lockdowns: a specific restaurant or apartment building, rather than an entire neighborhood or city. These changes have allowed the Chinese economy to gradually recover from the impact of the earlier lockdowns.

. . . Has Led To A Modest Economic Rebound

It is important to recognize that the terrible second quarter economic numbers were caused by short-term, Omicron-mitigation policies, not by structural faults. This is reflected in the strong 2021 economic performance described earlier in this note.

As the COVID controls were relaxed in recent weeks, economic activity began to recover. 

Car sales rose by 41% year-over-year (YoY) in June, as production recovered and pent-up demand was supported by government incentives.

People and goods were on the move again. Subway and airline traffic has steadily improved, as has domestic freight traffic.

Restaurant sales in June rose 25% from May, although they were still down 4% compared to a year ago. Online sales of goods strengthened in May and June, as lockdown-related logistics problems were reduced.

“Global supply chain pressures declined in June,” the New York Fed reported, “mostly due to a large decrease in Chinese supply delivery times.”

Property Starting To Recover

New home sales have also begun a gradual recovery, as the government allowed banks to resume mortgage issuance (a severe limitation on new mortgages in May 2021 precipitated a collapse in sales) and cut mortgage interest rates.

The central government has also allowed dozens of cities to relax a range of local restrictions on new home purchases. 

I remain optimistic about China’s property market, because of policy easing and strong fundamentals. 

The fundamentals include that most new home sales are to owner-occupiers, and buyers are required to put down a lot of cash. Chinese homebuyers who use a mortgage must put down at least 20% cash for a primary residence (and much more for an investment property), in sharp contrast to the 2% median cash down payment in the U.S. in 2006, prior to our housing crisis. 

Prices have remained healthy, rising roughly in line with income growth through last year. Over the last five years, home prices rose at an average annual pace of 7.7%, while per capita urban household income rose at an average annual rate of 7.1%. Over the last 10 years, home prices increased at an average annual rate of 7.6%, compared to average annual income growth of 8.1%.

There is plenty of pent-up demand that wasn’t met during the last four quarters, so new home sales are likely to continue a gradual recovery . . . unless the government uses widespread lockdowns to deal with the next wave of COVID cases.

Short-Term Opportunities and Risks

In the short term, there are clear opportunities for investors in China.  Economic activity is recovering, and should be boosted by significant monetary and fiscal policy easing, in contrast to continued tightening in most of the rest of the world. 

The first stage of easing began last month, with augmented total social finance (the broadest measure of credit) up 10.8% from 10.4% YoY in May and 10.1% YoY in April. Mid and long-term new loans to households, largely a reflection of stronger demand for mortgages, rose almost 300% month-on-month (MoM), although still 19% lower than a year ago. Mid and long-term new corporate loans increased 161% MoM and 73% YoY. Government bond issuance hit a record high last month, and Beijing may frontload next year’s government bond quota to the second half of this year, reflecting plans for a large infrastructure stimulus.

That easing will not be constrained by inflation, which has been at a healthy level in China, in contrast to much of the rest of the world. China’s consumer price index (CPI) rose at an average pace of 1.7% during the first half of the year, compared with an average rise of 8.3% in the U.S. This follows the 2021 experience, when CPI rose 0.9% in China and 4.7% in the U.S.

Rising global oil prices have had much less impact on CPI in China, because energy is a smaller share of the consumer basket, and because when global oil prices rise, the Chinese government has a mechanism in place which forces state-run oil companies to absorb some of the increase above a certain level, rather than pass it on to consumers. 

Food prices, especially for pork, China’s main protein source, are likely to inch higher in the second half, due to base effects and increasing demand as restaurants reopen, but I do not expect CPI to rise to a level high enough to interfere with the Chinese central bank’s plans to further boost credit availability, at a time when the Fed plans to keep raising rates in the U.S.

The key short-term risk is the degree of pragmatism in China’s response to the BA.5 subvariant of Omicron.

The BA.5 Risk

BA.5 became the dominant subvariant in the U.S. in early July, and Eric Topol, a professor of molecular medicine at Scripps Research, said it is “the worst version of the virus we’ve seen. It takes immune escape, already extensive, to the next level, and, as a function of that, enhanced transmissibility.”

Dr. Ashish Jha, the White House COVID response coordinator, says the experience from other countries with BA.5 is mixed. In South Africa, it became dominant in mid-April, but deaths remained low. In Portugal, however, where the vaccination rate is higher than in the U.S., “a sizeable wave of infections [was] followed by a sizeable wave of serious illness and death,” according to Jha.

BA.5 has recently begun circulating in China, and a team of Chinese researchers, writing last month in The Lancet, a peer-reviewed medical journal, said that this and other, new COVID subvariants “could cause a new wave of infections.”

I expect that the Chinese government will respond to a rise in COVID cases with narrower, localized lockdowns, rather than the city-wide lockdowns used in April and May, in order to avoid severe disruptions to the gradual economic recovery now underway.

Reasons For Longer-Term Optimism

I expect the Party leadership to continue to gradually adopt a more pragmatic approach to managing COVID, one that strikes a better balance between preventing deaths and facilitating a healthy economic and social environment. But, it is difficult to predict when zero-COVID will be revised enough to facilitate a full economic recovery, and there are likely to be setbacks along the way.

Odds are high, however, that this more pragmatic approach will come within the next several quarters, following the 20th Party Congress in the fall. Both because recent adjustments to the Party’s zero-COVID policies are more pragmatic, and because the Party has a track record of pragmatism and of changing course after adopting policies which prove inefficient.

Last fall’s electricity shortages are a good example. Several “common prosperity” policies were launched last year, all with admirable objectives: improving coal mine safety; reducing corruption in the coal industry; raising energy efficiency; and reducing emissions. But the impact of local officials pushing hard to meet their performance targets in all of these areas at the same time, combined with rising demand for power as manufacturing rebounded from the initial stages of the pandemic, while weather conditions limited production from hydro and wind generators, created a perfect regulatory storm, resulting in widespread power shortages.

Once the negative consequences of this regulatory storm became clear, central officials responded by instructing local governments to soften implementation of new regulations and prioritize coal production and electricity generation. The admirable objectives have not been abandoned, but are being pursued less aggressively, and power shortages have not recurred.

In the financial sector, a decade ago many analysts were worried about the rapid rise in shadow banking loans. The government responded with significant curbs on that business, and shadow loans have since declined YoY for 49 consecutive months, and now account for only about 5% of total outstanding credit.

Some investors have been concerned that last year’s broad regulatory crackdown was an effort to roll back China’s private sector, but in a recent issue of Sinology, I explained why that is unlikely. In my view, Xi is attempting to address the same socio-economic concerns that most democracies are wrestling with, although initial implementation has been chaotic. If the regulatory process is improved, and Xi succeeds in reducing inequality and strengthening corporate competition, he could lay a foundation for the next phase of China’s market-based development. If he fails, it would be because of poor implementation of policies designed to create “common prosperity,” not because he is anti-entrepreneur. Last year, we saw some negative consequences of poor implementation, but Party leaders have acknowledged these mistakes and pledged more practical enforcement in the future. I expect the regulatory environment to be less difficult in the future.

Addressing Challenges

China does face significant challenges, but the government is attempting to address them.

Fighting pollution is a good example. “In most areas of China, pollution has fallen to levels not seen in more than two decades,” according to researchers at the University of Chicago. “To put China’s success into context, these reductions account for more than three quarters of the global decline in pollution since 2013. Once the United States started to focus on reducing pollution in the early 1970s, it took several decades and recessions to achieve the same pollution reductions that China has accomplished in seven years.”

China last year accounted for about 36% of global growth in solar capacity, and about 40% of new global wind generation capacity. China now generates more renewable electricity than Europe.

Demographics are another challenge, including a shrinking working-age population. One effort to address this has focused on increasing the skill level of the workforce, and college enrollment rose by 46% from 2010 to 2020, and the share of people aged 20-29 with a college education rose to 46% from 23% in 2010.

The urbanization ratio has continued to rise, to 65% in 2021 compared to 52% a decade ago and 38% two decades earlier. There is still room for this share to increase further: the average urban share of populations in OECD member countries is 81%.

There have also been significant changes to the structure of employment in China. In 2021, 48% of jobs were in services, up from 36% a decade earlier. (In the U.S., services accounted for 80% of jobs in 2020.) The share of jobs in agriculture has fallen in China, from 35% in 2011 to 23% in 2021, but remains far above the 1.5% share in the U.S. so there is room for additional rebalancing, supported by the rising education level of younger workers.

Finally, the rise of China’s private sector has continued under Xi Jinping. Since he became head of the Party in 2012, private firms have continued to drive all net, new job creation. Real income growth has risen at an average annual pace of 6.6%, compared to 2.2% in the U.S. and 1.6% in the UK. China’s per capita GDP, on a purchasing power parity (PPP) basis, was 28% of the U.S. in 2021, up from 19% in 2012. Entrepreneurial, privately owned companies have fueled this growth, and have been responsible for all of China’s innovation.


Andy Rothman
Investment Strategist
Matthews Asia


OECD: Organisation for Economic Co-operation and Development



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