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A policy trilema weighs on China’s growth

China’s largely successful containment strategy from the first two years of the COVID-19 pandemic has run into a staunch foe: the highly transmissible Omicron variant. A zero-COVID strategy of lockdowns that allowed life to continue somewhat normally in the pandemic’s pre-vaccination days is hitting China’s economy hard in 2022.

A forthcoming Vanguard Global Macro Matters research paper quantifies the drag on China’s economy from months of lockdowns affecting hundreds of millions of people. According to Vanguard’s analysis, even the most optimistic scenario will leave China’s 2022 economic growth far below policymakers’ official growth target “around 5.5%.” In our baseline case, we foresee full-year 2022 GDP growth in China just above 3%, much lower than our expectation at the start of the year for growth around 5%.

Our economic and market outlook for 2022 discussed the delicate balance that policymakers globally would face this year. The manifestation of that in China is a “policy trilemma,” said Qian Wang, Vanguard Asia-Pacific chief economist. “China’s policymakers have three goals, but they can’t achieve all of them. We believe that, for considerations that go beyond the economy, they will likely maintain a zero-COVID policy as needed. To achieve 5.5% growth, they will need to loosen their financial stability goal and aggressively stimulate the economy.”  

China faces a “policy trilemma”

Source: Vanguard.


Stimulative measures to date—including modest cuts in policy and mortgage rates and the amount of cash that banks must hold in reserve; increased credit support to small businesses; and tax cuts, rebates, and infrastructure spending—fall short of levels needed to produce policymakers’ growth target, according to Vanguard’s analysis. We believe that concerns about financial stability will continue to limit stimulus, leaving the growth target vulnerable.

A significant easing of what had been strict COVID restrictions in Shanghai, China’s largest city, on June 1 is a positive sign, but the recovery is likely to be weaker than that which followed lockdowns in 2020.

“Although May is likely to be the trough in economic activity in China, we have tempered our expectations for a strong growth rebound in the second half of the year,” said Maximilian Wieland, a Melbourne-based economist and lead researcher on the forthcoming paper. “Structural factors, including a weak labor market and business confidence, the specter of renewed restrictions amid new COVID cases, and slowing global growth will limit the pace of recovery.”

Commodities exporters may feel China’s slowdown most

China’s Omicron lockdowns pose both supply and demand shocks to the global economy. Reduced Chinese demand will likely be felt most acutely by commodities exporters in both developed markets such as Australia and emerging markets such as Brazil. Supply shortfalls may be mitigated, however, by slowing global demand for goods and expanding supply from the rest of emerging Asia. Only in our downside scenario of a slow easing of current restrictions do China supply constraints cause U.S. goods inflation to break a recent downward trend.

In our base case, we expect lockdowns to be eased gradually through the second quarter, then for new, lighter restrictions to be put in place later in the year, driven by China’s desire for social stability ahead of the fourth quarter’s National Party Congress. Policymakers will want to avoid a large COVID outbreak ahead of such a strategic and psychologically important event, because China’s health-care infrastructure would be ill-equipped to deal with it, even as vaccinations have reduced mortality.


Our base case: Lockdowns, insufficient stimulus limit growth

Source: Vanguard.


China likely will act to prevent further currency depreciation

China’s currency, meanwhile, weakened significantly recently given the nation’s economic challenges and rising U.S. interest rates. The Chinese yuan depreciated by 6.6% compared with the U.S. dollar in little more than three weeks from mid-April to mid-May and since has regained about 1.9%. It traded around 6.66 to the dollar on June 3.1 Vanguard doesn’t foresee runaway yuan depreciation, however. Over the next three to six months, we expect the yuan to trade in a range of 6.6–7.0 to the dollar. (A higher number indicates weakening.)

We foresee a floor for the yuan because currency markets have priced in the rest of the year’s anticipated Federal Reserve rate hikes and China’s policymakers have always tried to avoid prolonged one-way moves that could lead to excessive speculation and volatility in financial markets, said Alexis Gray, a Melbourne-based Vanguard senior economist who covers the Asia-Pacific region.

“Both domestic and external forces that have weakened the yuan are likely to improve in the near term,” Gray said. “The end of lockdowns will be supportive, and we expect markets to stop pricing in more hawkish central bank policy rate paths as global growth slows and inflation moderates.”


1 Source: U.S. Federal Reserve, as of June 6, 2022.



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