China started 2021 with laudable economic performance after being heavily hit by the COVID-19 pandemic in the first half of 2020.

The export sector continued with its strong momentum, registering a 30.6% y/y growth in March, as vaccination has steadily rolled out in developed countries and the global economy is on the track of a fast rebound. In March, the manufacturing PMI readings for the US and the EU advanced to 62.3% and 59.5%, respectively, signalling an acceleration of economic recovery. According to a survey by the General Administration of Customs (GAC) in February, new overseas orders have further increased in recent months. On the back of strong external demand, China’s export sector is likely to maintain its growth pace in the short term, underpinning the overall economy. In fact, manufacturing and service PMI in March both beat market expectations, standing at 51.9% and 56.3%, respectively. It should be noted that service PMI in March was the highest since 2013, suggesting pent-up demand for catering, travelling and so on, once social distancing and lockdown measures were removed.

The overall consumption is, however, still lacklustre. In Q1 2021, the core CPI, which excludes food and energy prices, remained flat. According to data provided by the Ministry of Culture and Tourism, tourism revenue during the Qingming Holiday was merely half of that in 2019, heralding a sluggish recovery of consumption.

As the central government decided to contain the mounting macro leverage of the public sector, the infrastructure investment is likely to slow down. The property investment is also contained due to the tightening financial requirements for property developers. Therefore, the export sector, which will benefit from a concurrent global economic recovery, is still the engine of economic growth for China.

Money Supply
Since the onset of the pandemic in 2020, the money supply measures all underwent spikes from the end of 2019. The narrowest money supply M0 surged by 10.9% y/y in February 2020, more than doubled from December 2019. Due to worries about the negative shock of the pandemic, people tended to increase their holdings of cash and divested other risky assets. It is interesting to note that booming fund sales in the first two months of 2021 also drained away cash in circulation, leading to weak readings of M0 compared to other money supply measures. The y/y growth of M1, which is mainly comprised of M0 and demand deposits from non-financial corporates (NFC), followed an upward trend starting from January 2020 and topped this year at 14.7% in January thanks to the coordination of the general and structural monetary policy in a “precision irrigation” approach and a proactive counter cycle fiscal policy characterized by enlarged fiscal deficit. In addition, as the economy slowly recovered from the pandemic, increasing financing needs also contributed to the steady money supply growth from the NFC. In contrast to the previous two measures, the broad money (M2) supply y/y in 2020 was much smoother and peaked at 11.1% in April 2020 compared to 8.7% in December 2019. Thereafter, it slowly inched down to 9.4% before going back to over 10% in February 2021, much to the market's surprise. During recessions, household deposits tend to increase out of precautionary savings. Especially during the COVID-19 outbreak, people had to cut back on expenses ranging from tourism to catering due to social distancing. Looking ahead, we think M2 will slowly revert back to its pre-pandemic level, as money supply is mandated by the government to match the nominal GDP growth this year.

The policy rates set by the central bank remained unchanged. The seven days reverse repurchase rate has been at 2.2% and the one-year medium-term lending facility (MLF) at 3.85% since April 2020. The market interest rates, however, underwent a brutal tumble early in 2021 on the back of the central bank's liquidity withdrawal in January and the market's expectation of an immediate rate hike. The seven-day interbank bond collateral repo rate jumped to 4.83%, 263 bp higher than the benchmark policy rate. The long-term rate such as the yield of one-year AAA-rated NCDs also reached 3.17%. A monetary policy implementation report published by the central bank in early February 2021 signalled that the market's bet on the short-term interest rate should be based on the central bank's OMO rate rather than its volumes. With the central bank holding steady on the policy rates, the market gradually returned to normal thereafter

Fiscal Policy
In contrast to previous years, the outstanding local government debt limit (LGBL) for 2021 was not disclosed until March when the annual two sessions kicked out. This year the outstanding LGBL reached RMB 33.3tn with an annual growth rate of 15.5%, of which the outstanding general LGBL reached RMB 15.1tn and the outstanding special LGBL reached RMB 18.2tn. Despite the LGBL's deceleration compared to the record-setting growth at 19.64% last year, it is still the second-fastest in history.

An executive meeting of the State Council in March 2021 called for deleveraging the government sector. In fact, by the end of 2020, the macro leverage of the local government was 25.6%, 4 pp higher than in 2019. The extent to which local governments increased their leverage was the second-highest in history, only overshadowed by the unprecedented fiscal stimulus during the Great Financial Crisis back in 2009. Yet, with the outstanding local government debt slated to rise by 15.5% as we outlined above, a dip in the government leverage entails that the nominal GDP would also grow by at least 15.5%. Combined with expected real GDP growth of 8.4% in 2021 as per the latest IMF forecast, it would lead to an impossible GDP deflator of 6.5%. Thus, the campaign to deleverage the government sector is most likely to target local governments’ implicit or off-balance debt, which is even larger than the on-balance debt in some regions according to a recent research. The local SOEs and local government financing vehicles (LGFV) are therefore not likely to receive generous support if they are prone to default as debt settlement could be used to decrease the leverage. Considering a slew of defaults by local SOEs rattling the bond market, the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC) issued guidance to rein in the debt risks of local SOEs in late February 2021. However, local SOEs may as well resort to other approaches such as debt-equity swaps to prevent defaults so that they are able to raise capital at reasonable rates from the market. Against the backdrop of a deleveraging government sector, infrastructure investment is doomed to slow down further.



The central government set the 2021 deficit target at 3.2%, which is lower than that in 2020 but still higher than that in 2019. By the end of 2020, the macro leverage of the central government was 20%. As with local governments, the surge in leverage was only overshadowed by that in 2008. The overall government sector by the end of 2020 had a leverage ratio of 45.8% according to the statistics by the Ministry of Finance (MOF), which is still below the internationally accepted alarm level of 60%. The problem is, however, that when considering the implicit debt of local governments, the combined leverage ratio would reach 59% as per the BIS data, which is almost the alarm level.

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