■ The Chinese economy slowed dramatically in April amid Covid outbreaks and restrictions under the country’s zero-Covid policy. The PBOC has kept interbank liquidity ample and front-end market rates have fallen notably below the policy rate. The same pattern was observed in early 2020 during the initial Covid outbreak in China. Back then, after the Covid situation became under control and economic growth rebounded, the PBOC drained liquidity and CNY rates rose sharply. This precedent event raises questions whether rates have now bottomed in this cycle.
■ However, comparing the latest Covid outbreak with the 2020 experience suggests some important differences. Although daily new Covid cases have fallen signiﬁcantly, our China Effective Lockdown Index has remained elevated and macro data have been surprising to the downside. It remains to be seen whether the highly transmissible Omicron variant can be contained under China’s zero-Covid policy, whether the depressed property market can be stabilized anytime soon on policy easing, and whether export growth would decelerate sharply as ex-China growth slows and global consumption shifts from goods to services.
■ To summarize, we think it is too early to pay CNY rates, as we still see some downside risk to CNY rates and paying too early would incur a cost (from negative carry). Given China’s near term growth and policy outlook are centered around Covid management, property recovery, and exports, the next few weeks are key to watch in our view, as we look for the May activity data (due out mid-June) and gain more clarity on the Shanghai recovery and outbreaks in major cities such as Beijing.
The Chinese economy slowed dramatically in April on Covid outbreaks and associated restrictions under the zero-Covid policy. The April PMIs registered the weakest prints since February 2020 (Exhibit 1) and front-end rates (7-day repo rates) fell below the OMO 7-day reverse repo rate, which is the de facto policy rate in China. The last time we saw this pattern was in early 2020 and CNY 5Y IRS rates jumped over 100bps from 1.80% to 3.0% (between April and December 2020) as the economy rebounded and the PBOC withdrew liquidity (Exhibit 2). As Shanghai Covid cases have fallen considerably in the past few weeks and economic activities appear to be improving slowly, this raises investor questions whether the early 2020 playbook will repeat itself. However, there are important differences between 2020 and now. Data has been surprising to the downside (unlike in 2020 when it was surprising to the upside), the property market remains very depressed, exports are unlikely to be as much of a tailwind to growth, and it remains to be seen whether the highly transmissible Omicron variant can be contained under the Zero-Covid policy. Therefore, we think the PBOC may keep interbank liquidity abundant for a longer period than in 2020. In our view, we think it is too early to pay CNY rates, especially as paying too early would incur a cost (from negative carry).
We think CNY rates will stay lower for a while. To gauge the timing of policy normalization and rates increases in China, we compare the current experience to 2020. During the initial Covid outbreak, daily new Covid cases peaked on February 12th, 2020. In the current Omicron wave, daily new cases appear to have peaked on April 13th, 2022. We align these two dates to draw lessons from the 2020 experience and to assess whether macro data are about to surprise to the upside (Exhibit 3) and whether interest rates are about to increase (Exhibit 4). We note that in 2020, our GS China Effective Lockdown Index (ELI) peaked in early February at 83, and declined relatively quickly and fell to below 60 by mid-March and economic data was surprising to the upside. This allowed PBOC to withdraw liquidity, which drove CNY rates higher. However, this time around in 2022, we think there are important differences to consider. First, the Omicron variant is very difﬁcult to contain and it remains highly uncertain to assess the magnitude of damage inﬂicted by the Omicron variant on the Chinese economy as the government keeps its zero-Covid policy. Second, the property market has been signiﬁcantly weakened by the tightening measures in 2021 and the latest Covid outbreak has exacerbated the property downturn. Coupled with record high unemployment rates and the lowest expectation for future house prices since 2015, it is an uphill path for the government to stabilize the property sector and the sharp housing recovery that occurred in Q2-2020 also looks unlikely to happen this time around. Despite the ongoing policy easing, given the weak property and overall activity indicators have been, we believe challenges remain in the property market which may prolong the low-interest-rate environment (Exhibit 5). Third, exports are unlikely to be as much of a tailwind to growth as they were in mid-2020, given a slowing global economy and a shift from goods to service consumption ex-China impose downside risk to Chinese exports. Fourth, on the PBOC front, one of the reasons why the PBOC tightened liquidity sharply in late May and early June 2020 was the rising leverage in the interbank market and the central bank’s concern over a potential buildup of ﬁnancial instability. This does not appear to be the case now (Exhibit 6).
We think CNY rates will ultimately rise. Although Q2 GDP is on track for a sequential contraction (-7.5% qoq annualized GS forecast) on Covid lockdowns, we expect a sharp rebound in Q3 on assumptions that the Covid situation becomes more manageable and policy easing transmits into real activity in H2. At the same time, we expect year-over-year CPI inﬂation to rise to above 3% in H2. After peaking at around 40 in April, ELI has declined marginally in the ﬁrst two weeks of May. As more cities introduce “frequent mass testing,” allowing positive cases to be identiﬁed early on and risks of another Shanghai-type lockdown to be potentially reduced, we assume China ELI will gradually move lower in the coming months. Another risk that could drive CNY rates higher is the large amount of upcoming bond supply, including the front-loaded local government special bond (LGSB) issuance and possible central government special bonds (CGSB). In 2020, long-end CGB yields went down notably on the back of growth slowdown and signiﬁcant monetary policy easing before a sharp rebound in May. The upward move coincided with a surge in LGSB issuance (around RMB 1tn in May) and the ofﬁcial announcement of CGSB (also RMB 1tn in May). However, as we discussed previously, the increase in rates was partially driven by the regulatory tightening on structural deposits and leveraged investment in the bond market via the repo market. In our view, the impact from the supply side would be limited as the PBOC could offset the short-term liquidity impact of expected bond issuance via liquidity operations such as the OMOs, as discussed in its monetary policy report in Q4 2021. Lastly, in 2020, both policymakers and investors experienced the Covid outbreak for the ﬁrst time. Two years later and with more experience learning from the Covid situation, policymakers and investors may be more prepared to manage the current situation.
By assessing both lessons from the 2020 experience and the important differences between now and then, we think it is too early to pay CNY rates, as there are still some downside risk to rates and paying too early would incur a negative carry. Given the signiﬁcant uncertainties, we think the potential catalysts to watch include onshore Covid development and macro data surprises. For this reason, the next few weeks will be a key period when we look for China’s May/June activity data and gain more clarity regarding the Shanghai recovery and outbreaks in major cities such as Beijing.