China: Waiting for policy tailwind

A year after the restrictions imposed because of the COVID-19 pandemic were lifted, China's economic recovery still lacks enough momentum. One thing is clear: China's economy as of today is operating at below potential. We believe a sizable negative output gap emerged in 2022 that has persisted in 2023, judging from the low capacity utilization rates, labor market slack, weak credit demand and, most importantly, negative consumer and producer prices inflation. Therefore, China's potential for growth should be higher than the 4.1 percent average growth in 2022-23. In our view, it should be in the 4.5-5 percent range. Growth could be even higher for a short period, if the economy can enter a cyclical rebound to close the negative output gap.

That cyclical rebound hasn't happened yet, primarily because after a prolonged property sector downturn and a sharp drop in inflation, a vicious loop has emerged among consumer spending, business profits and forward expectations for income and prices. A positive shock is required to break the loop. Unfortunately, both external demand and public spending have contracted for most of 2023, thus reinforcing rather than breaking this vicious circle.

Only the government can jump-start the economy through forceful and coordinated policy responses. The most important policy variable is the government's 2024 growth target. Our base case is the government will likely commit to boost growth by setting a growth target at "above 4.5 percent" for 2024, moderately higher than the 4.1 percent average growth in 2022-23. This will be consistent with our 4.7 percent real GDP growth and 1 percent inflation forecasts in 2024.