China’s economy continued its downward trend in the third quarter with growth of just 4.8% after 5.2% in the second quarter and 5.4% in the first. The weakness was broad-based, with retail sales, fixed asset investment and industrial output data all tepid. Combined with increasing headwinds from the Sino-US trade war, the latest data argues that Beijing needs to shake off any complacency and continue its easing policy to protect growth.
Although the official 5.0% growth target remains within reach even if GDP were to grow by 4.6% in the final quarter of this year, deflationary forces remain entrenched. Third-quarter nominal GDP rose by only 3.7%, down from 3.9% and 4.6% in the two preceding quarters. That puts China in its longest period of deflation (10 quarters in a row) since the 1990s (see Exhibit 1) and implies that policy easing so far has not been enough to stabilise prices.
It is not just policy easing
To turn things around requires more than just further policy easing. Beijing must keep up with its two-prong policy approach of:
- Structural reforms to improve systemic efficiency and
- More fiscal and monetary easing to keep domestic demand from faltering under the deflationary pressures of structural reforms.
Beijing seems to have come to terms with the need for more assertive easing and has stepped up its efforts in that direction. On 17 October, the Ministry of Finance announced a new RMB 500 billion local government bond quota to reliquefy local government balance sheets. It also pre-approved some of the 2026 government bond quota to support more fiscal spending and infrastructure investment.
Since late 2024, Beijing has announced some large-scale easing measures, including targeted cash transfer to families with young children, tuition subsidies for pre-school education, and significant infrastructure projects, notably a mega ($1.2 trillion) hydro project in Tibet and a new 2,000-kilometre railway linking Xinjiang and Tibet.
Confidence is key
Chinese consumers are not budget constrained because household savings have risen sharply (see Exhibit 2). What they lack is confidence, which is pegging consumption down.
Household savings can be seen as pent-up demand that could be released when confidence returns. From a policy perspective, Beijing must keep up with more aggressive easing to stabilise the economy (including the property sector) and restore consumer confidence and, hence, private consumption and investment.
Has Beijing delivered?
There are signs that China’s economy may have start responding to Beijing’s additional easing since late last year. Firstly, the narrowing of the negative M1-M2 growth gap to its smallest since May 2021 (see Exhibit 3) is a sign that households are directing their idle savings towards spending and the asset market.
The smaller negative gap indicates a shift of funds from M2 (fixed deposits) to M1 (current accounts) and from there on to the stock market. The latter step is vindicated by the rising number of retail brokerage accounts (see Exhibit 4), perhaps an initial sign of public confidence recovering.
Secondly, Beijing’s monetary easing and debt-swap programmes have helped reliquefy local government balance sheets and recapitalise banks to clear the logjam of hidden government debt. As a result, the credit impulse has finally recovered (see Exhibit 5).
Drivers for market recovery
Increasing growth headwinds amid weak growth momentum are forcing policymakers to ease policy further. Meanwhile, the collapse of the housing market leaves equities as the other, if not only,S viable investment outlet for households’ excess savings.
Sustaining the economic recovery and stock market rally requires more structural reform and policies to boost demand.
Granted, the A-shares market no longer looks exceptionally cheap. However, as more signs of economic stabilisation and policy easing emerge, portfolio flows should start returning to Chinese stocks. Already, net Stock Connect northbound flows (an indication of foreign buying of A-shares) are returning (see Exhibit 6).
Barring any macroeconomic or policy hiccups, momentum could also fuel further upside for China’s retail-dominated stock market. Sitting on massive savings and fuelled by FOMO – the ‘fear of missing out’ – Chinese retail investors could continue to pile in, pushing Chinese stocks to overshoot their mean reversion levels.
