China’s vigorous recovery is under way, but is it sustainable?

After successfully containing its domestic COVID-19 outbreak by the end of February, China was able to jump-start its economy in the second quarter and now leads the global economic recovery.

With China's factories fully up and running, the question turns to who will buy the output from these factories. Right now, China is relying on investment to prop up its economy, which we think is ultimately unsustainable.

Key takeaways

China posted official real GDP growth of 3.2 per cent (year over year) in the second quarter, up from negative 6.8 per cent in the first quarter. While we have some doubts as to whether growth was quite this strong, clearly an aggressive recovery has occurred.

We're concerned about the sustainability of China's current economic recovery. Exports and (especially) domestic consumption remain somewhat weak, meaning that fixed-asset investment plus inventory builds are powering the recovery. These last two factors can only power a recovery for so long.

We expect China's growth recovery to flatten somewhat in the second half of 2020 and thereafter, given the abovementioned weaknesses. Additionally, we're not seeing a boom in stimulatory credit on par with the 2009 surge in the aftermath of the global financial crisis.

We still expect a long-term slowdown in China's GDP growth (an average 3.25 per cent over 2019-29), as a result of factors that were in place before COVID-19. China's prior investment and debt-fuelled growth path is unsustainable, as it has led to an overhang of excess capital stock and a mounting pile of debt, which is set to reach about 300 per cent of GDP as of year-end 2020.

Source: Morningstar Direct

China's economy roared back to life in the second quarter, posting official real GDP growth of 3.2 per cent year over year, up from negative 6.8 per cent in the first quarter. Our broad proxy growth was lower at 0.4 per cent, suggesting that the official figures may be inflated somewhat.

Our consumer durables index looked particularly weak, although the other proxy components were also around 100 basis points lower than the official growth figure of 3.2 per cent. In any case, our proxy, like the official figures, shows a tremendous recovery from the abysmal first quarter. The extent of the recovery is somewhat surprising, given that credit growth has ticked up only modestly, in contrast to the 2009 boom in the aftermath of the global financial crisis.

Investment is leading the recovery. According to the official data, real investment expenditure grew 10.2 per cent year over year, the fastest since 2013. We're sceptical that actual fixed-asset investment grew at that rate in the second quarter.

However, it could be that investment expenditure could be buoyed by massive inventory builds; this would be logical, given that industrial production is outpacing consumer spending in China's recovery so far. Of course, massive inventory builds can't be sustained for long.

The officially reported growth rate looks dubious in some service industries, such as retail, transport, and other services. Within the industrial sector, the data may be credible, but it points to unsustainable rates of production in some areas. Electronics, transportation, and capital equipment are leading the way in the manufacturing recovery, but it's unclear where this output will go, considering that global business investment is depressed.

China's exports have fared far better than in the 2008-09 downturn, a reflection of the unique nature of this global recession: Consumer goods spending in developed markets has quickly rebounded, while services spending remains depressed due to social distancing.

Also, we estimate that increased sales of personal protective equipment lifted China's overall export growth by around 500 basis points in the second quarter. Still, we shouldn't expect trade to be a tailwind in the second half. As such (combined with tepid consumer sentiment), China's economic recovery isn't on perfectly stable footing. We expect growth to flatten somewhat in the second half of 2020. We still don't expect an investment boom on par with the one seen in 2009.

 See also Morningstar Guide to International Investing