Premier Li Keqiang delivered the Government Work report to the third session of the 13th National People’s Congress today. China will work to make sure they are achieving their development goals of winning the battle against financial condition and completing the building of a moderately prosperous society in all respects this year, though setting no specific economic growth target for 2020, according to Li’s report.
It is expected a high target might place impossible expectations on policies, given uncertainty over the duration of COVID-19 outbreak and the potential for spillbacks from the worldwide recession. We project China’s economy to grow 2% in 2020, down from 6.1% in 2019. The Government in any case ratcheted up fiscal and monetary policy. This should help to stabilize expectations in the absence of a certain growth target.
Widening the budget deficit target to 3.6% of GDP for 2020. This is mostly in line with our expectation and 0.8 percentage point higher than last year’s target. Aside from 2016-2017, when the targets were each set at 3% of GDP, China’s budget deficit has stayed below 3% since its reform and opening-up started in 1978. Breaking the traditional deficit floor highlights the urgent need to revive the economy as external headwinds mounting and domestic demand struggling to completely recover from the COVID-19 outbreak.
Most planned public spending has been frontloaded, as well as increased spending to mitigate the health effects of the pandemic, accelerated unemployment insurance disbursement to support households, and offered income and value-added-tax extensions to companies with cashflow shortfalls. In contrast to previous downturns, the government’s priority is to make sure the labor market and income stability will be hitting growth targets.
Fiscal impulse is larger than deficit target implies. The official deficit solely refers to the overall budget account, which excludes a substantial amount of liabilities that are ultimately the state’s responsibility. By taking off-budget financing and government funds into consideration, our analysis indicates that the actual fiscal impulse are going to be bigger than the headline deficit target, at 9.6% of GDP in 2020. This is 1.8 percentage points on top of the fiscal impulse that we had estimated for 2019 supported by last year’s budget and bigger than the final outturn (4.9% of GDP). Driving this larger fiscal impulse are plans for local governments to issue RMB3.75tn in special bonds, a major increase from RMB2.15tn last year. The Government will issue RMB1tn of sovereign bonds for COVID-19 control.
Government-led infrastructure investment will stay as the principal growth driver. Already, a total RMB1.2tn worth of special bonds were issued as of end-April, up 50% from a year earlier. Of which, 64% have been earmarked for ongoing projects and 36% for brand new projects. according to the Ministry of Finance, all proceeds from special bond issuance are to be used on infrastructure investment (<30% of special bond issuance were used for infrastructure in 2019).
The State Council has additionally lowered the minimum capital ratio requirement for ports and shipping infrastructure projects earlier by 5 percentage points to 20%. Infrastructure funding can therefore receive a boost given additional investment projects can now be leveraged, in our view. As such, infrastructure investment is poised to rebound to single-digit growth in 2020 after its virus-driven slump of 19.7% in 1Q.
Debt risk is manageable. Overall, the budget projections and the authorities’ measures all point to ongoing fiscal stimulus on and off-budget by the Government. The stimulus risks increasing public sector indebtedness and reversing progress in deleveraging. We project general Government debt-to-GDP to rise to 63% in 2020 from 54.4% last year. Nevertheless a meaningful fiscal expansion at this juncture is secured to put a floor on economic growth. Assuming a timely withdrawal of the distress-relief measures once the health outbreak dissipates, the debt increase will unlikely cause a significant risk to the Government financial resilience.
China’s public debt is supported by domestic savings. National savings rate stands at 46%, compared to the global average of 20%. Wealthy individuals are capable to snap up Government bonds, which offer higher interest rates than commercial banks’ saving benchmarks. Foreign demand will also help. As of end-April, the total amount of bonds owned by overseas institutions rose 30.5% YOY over RMB2tn. Relatively high yield and also the country’s liberalization policies will keep interest alive. With just about all the sovereign bond denominated in yuan, China is less exposed to currency mismatch risks facing several other economies. After all, China’s public debt-to-GDP ratio is not excessive compared to the G20’s average of 86.2%.
The Government pledged to guide money supply and combination financing “significantly” more than last year. It affirmed recent signals coming from the PBoC’s 1Q monetary policy report, in which the authority deleted the word “prudency” that normally described its monetary stance. Officials also reiterated its intention to guide interest rates lower once the average loan rate fell 36bp to 5.08% in 1Q. Keeping monetary policy accommodative is crucial to prevent borrowing costs from spiking as more LG bond supply hits the market, in our view. We tend to project at least another 30bps of LPR cuts and 150bp of RRR cuts for the rest of the year. The PBOC’s recent cut in the interest rate on excess reserves ought to additionally encourage banks to further step up lending. We expect aggregate social financing to register double-digit growth in the coming months, and coupled with subdued GDP growth, would result in a higher leverage ratio ahead.
Reach for some CGB duration
Details from the National Party Congress that the Government will run a deficit of 3.6% of GDP (higher than the previous cap of 3%) and issue special local Government bonds worth CNY3.75tn appears broadly in line with what the market was expecting. Taken together, the total Government deficit is likely to be closer to 10% of GDP, but we do not think this could derail a rally in CGBs. Much of the supply has already been anticipated and 10Y CGB yields fell modestly post the announcement. We have been bullish on CGBs since the beginning of the year and reiterated our call recently after the selloff in early May. With the NPC providing some clarity on the bond supply, we predict that this lifting of uncertainty plus a highly challenging macroeconomic outlook ought to be supportive of CGBs in the coming months.
We think that investors are going to be inclined to extend duration risks out to the intermediate tenors (5Y and 7Y) given that the curve is steep. We predict that the key reason why CGBs haven’t rallied as much as their DM counterparts is because of the lack of quantitative easing (QE) from the PBoC. QE tends to suppress term premium, resulting in flatter curves in much of the DM world. In selected EMs (including India and Indonesia), their central banks have additionally embarked on asset purchases to keep a lid on longer-term Government borrowing costs. Viewed this way, PBoC seems to be relatively more restrained in easing, even as it notched down shorter term policy rates and keeps liquidity relatively flush. However, investors can take advantage by supplying liquidity to the longer tenors, in place of central bank action. In any case, we think that additional international diversification into CGBs is inevitable. Within the G10 / Special Drawing Rights (SDR) space, yields are largely floored at zero. there’s no alternative (TINA) could well take hold.
We also assessed the relative performance of 10Y Asia govvies compared to the United States of America through the COVID-19 crisis in the chart above. under benign conditions, 10Y Asia Government bonds should have a tight spread over 10Y UST (the tightest spread would be 100%). The converse is true when risk aversion strikes (the widest spread would be 0%). From the chart, it’s clear that CGBs have underperformed even as China is one in all the first economies to have COVID-19 under control. We tend not to think that CGB underperformance is warranted.