1 China’s economy and fiscal situation worsens further while the PBoC plans bond market intervention
Li Qiang admits that China is struggling with recovery
June 25
Hong Kong media reported that PRC premier Li Qiang said in a speech at the World Economic Forum that the Chinese economy is like a patient recovering from severe illness and “cannot withstand strong medicine” (不能下猛藥). Instead, the Chinese economy needs to “consolidate its foundation and restore its vitality” (固本培元).
Li also reportedly said that a combination of policies, including fiscal and financial measures, are required to address major economic issues in China. During the implementation of major policies for macroeconomic regulation, greater emphasis will be placed on combining short-term and long-term solutions, as well as addressing both the symptoms and root causes of problems.
In reporting Li’s speech, PRC state media Xinhua only quoted Li as saying that the Chinese economy needs to “consolidate its foundation and restore its vitality” and left out the more crucial point about how the economy “cannot withstand strong medicine.” Gelonghui, a leading Chinese global investment research platform, initially published a piece titled, “Li Qiang: China’s Economy Cannot Withstand Strong Medicine” (李強：中國經濟目前不能下猛藥), but it was quickly deleted.
China’s PMI contracts again
June 30
The National Bureau of Statistics announced that China’s purchasing managers’ index (PMI) for June was 49.5, or unchanged from May and below the 50-point mark separating contraction from growth. The June PMI figure indicates that China’s factory activity has been in contraction for two consecutive months and in contraction for four months in total in the first half of 2024.
Of the sub-indices that make up the manufacturing PMI, only the production index was above 50 (50.6, down 0.2 percentage points from the previous month) while indices of new orders, raw material stocks, employment, and supplier delivery times were in contraction territory.
Also, with the exception of main raw material purchase prices (51.7 percent, down 2.5 percent from the previous month), other related indices of China’s manufacturing PMI including new export orders, imports, purchasing volume, ex-factory prices, and backlog orders were in the contraction zone.
Jan-May 2024 local debt data
June 27
The PRC Ministry of Finance released data for the issuance and debt balance of local government bonds for the first five months of 2024:
- 2.82 trillion yuan of local government bonds were issued nationwide, including 881 billion yuan of general government bonds and 1.94 trillion yuan of special government bonds.
- 1.17 trillion yuan of local government bond principal was repaid, including 1 trillion yuan repaid through the issuance of refinancing bonds and 170.7 billion yuan repaid using fiscal funds and other means.
- 522.7 billion yuan of interest on local government bonds was paid.
- At the end of May, there was 42.38 trillion yuan of outstanding balance of local government debt nationwide. This includes 16.27 trillion yuan of general government debt and 26.11 trillion yuan of special government debt. Government debt is in turn composed of 42.22 trillion yuan in government bonds and 166.2 billion yuan in non-government bonds.
- At the end of May, the average remaining term of local government bonds was 9.2 years, with general bonds averaging 6.2 years and special bonds averaging 11.1 years. The average interest rate was 3.21 percent, with general bonds averaging 3.21 percent and special bonds averaging 3.22 percent.
PBoC plans to intervene directly in bond markets
July 1
The People’s Bank of China announced that it would “borrow sovereign bonds from primary traders in the open market in the near future.” The decision was made on “prudent observation and evaluations of current market situations” in order to “maintain the stable operation of the bond market.”
Following the announcement, government bond futures plummeted significantly on the same day. Previously on June 28, 2024, the yields on 10-year, 30-year, and 50-year government bonds were 2.2058 percent, 2.4282 percent, and 2.475 percent respectively. The yield levels were below the central bank’s desired range of between 2.5 percent to 3 percent.
Indonesia to impose import tariffs on Chinese goods
June 29
Indonesian media Antara reported that Indonesia would impose import tariffs of up to 200 percent on Chinese goods to mitigate the impact of the Sino-U.S. trade war. Zulkifli Hasan, Indonesia’s trade minister, said that the policy will go into effect once the related regulation is issued.
Hasan said that the Sino-U.S. trade war is causing oversupply in China as Western countries reject Chinese products, forcing China to redirect exports to markets like Indonesia. “The United States can impose a 200-percent tariff on imported ceramics or clothes; we can do it as well to ensure our MSMEs and industries will survive and thrive,” he said. Tariffs would range from 100 to 200 percent, Hasan said.
Chinese firms seek to relocate to Malaysia
June 25
Financial Times reported that Chinese executives have been meeting top government officials in Malaysia to get assurances that they can sidestep U.S. tariffs if they relocate there, citing three people familiar with the matter.
The companies, including those making batteries, medical devices, and semiconductors, have also asked Malaysian ministers and senior officials to lobby Washington against imposing tariffs on products made or assembled in Malaysia by Chinese groups. The requests follow the Biden administration’s sharp raising of tariffs on Chinese imports in May 2024.
Backdrop
1. In the first half of 2024, the central parity rate of the renminbi against the U.S. dollar fell by 441 basis points, a drop of 0.6 percent. The central parity rate of the onshore RMB against the dollar fell by about 1,739 basis points, a fall of about 2.7 percent.
Meanwhile, the central parity rate of the offshore RMB against the dollar fell by about 1,738 basis points, a decline of about 2.4 percent. The offshore RMB was below the 7.3 yuan to 1 U.S. dollar mark from June 26 to June 27, and reached its lowest level in nearly eight months.
2. China’s A-shares were sluggish from June 21 to July 2, with the Shanghai Composite Index remaining below the psychologically important level of 3,000 points for eight consecutive days.
Our take
1. There are increasing signs that China’s economy is in a recession, with recovery nowhere in sight.
i) Li Qiang’s speech at the World Economic Forum suggests that the Chinese economy sustained a significant shock in recent years and is in serious trouble. In particular, Li used traditional Chinese medicine parlance (“cannot withstand strong medicine,” “consolidate its foundation and restore its vitality,” etc.) to signal that the economy is akin to a critically ill patient whose condition would worsen if the CCP regime resorts to the aggressive stimulus measures of the past, but instead has to be carefully “nursed” through modest policies that will not aggravate the economy’s poor “health.”
Li’s WEF remarks affirm our earlier observation that the CCP is at a loss at what to do to rescue the economy, and is relying on propaganda and doctored data to keep up appearances and avoid a panic. A closer look at the CCP’s manipulated data shows that residents and businesses are increasingly unwilling to spend and invest, and the real economy is shrinking instead of expanding.
ii) China’s contracting factory activity reflects the increased intensity of U.S. and Western tariffs and sanctions against the PRC, which has impacted domestic manufacturing and is driving the relocation of Chinese production abroad.
The Sino-U.S. trade war will likely continue and escalate regardless of the outcome of the 2024 U.S. presidential election given the general consensus in Washington about the CCP threat and the need to address China’s export of excess capacity. Other countries could also turn to protectionism to mitigate the impact of the Sino-U.S. trade war (like Indonesia) and the problems associated with China’s overcapacity.
Sustained and increasing trade tensions with the U.S. in particular will push Chinese companies to shift production out of the mainland to countries in Southeast Asia like Vietnam and Malaysia to avoid tariffs. To close the tariff loophole, future U.S. administrations are likely to end waivers on tariffs imposed on goods made by Chinese companies based abroad, such as what the Biden administration did in May 2024 with regard to solar panels made by Chinese firms in Malaysia, Cambodia, Thailand, and Vietnam. America’s strengthening tariff regime will hinder Chinese companies from recovering their overseas investments even as they leave infrastructure, equipment, and technology in host countries.
The impact of tariffs and sanctions would erode China’s competitive advantage in manufacturing while aiding the growth of manufacturing in neighboring countries. Early signs of this can be glimpsed from the PMI of several Asian countries being in expansion territory in June:
- Vietnam: PMI of 54.7 in June (compared to 50.3 in May), the highest since May 2022 and with new orders growing at the fastest pace since 2018.
- Taiwan: PMI of 53.2 in June (compared to 50.9 in May), the highest since March 2022 and with production and new orders both rising.
- South Korea: PMI of 52.0 in June (compared to 51.6 in May), the highest since April 2022 and with steady expansion in new orders and exports.
- The Philippines: PMI of 51.3 in June (compared to 51.9 in May), the lowest in the past three months and with significant decreases in new orders, backlogs, and employment.
- Indonesia: PMI of 50.7 in June (compared to 52.1 in May), with business confidence at its lowest in four years.
- Japan: PMI of 50.0 (compared to 50.1 in May), with new orders declining for 13 consecutive months.
- Malaysia: PMI of 49.9 (compared to 50.2 in May), with rising prices and the fastest increase in business costs since September 2022.
With fewer places to export excess capacity, fierce price wars could break out in China amid prolonged trade tensions. Several vicious cycles could also emerge, including companies facing increasingly slimmer profits and the prospect of closure, Chinese workers seeing reduced income or unemployment (which in turn affects consumption in China), and the CCP authorities taking in less and less tax revenue.
We believe China’s PMI will keep trending towards contraction going forward, and the CCP authorities will find it even more difficult to guide the Chinese economy towards recovery.
2. The official local government debt data for the January to May period suggests that the CCP authorities’ fiscal difficulties and debt crisis are being exacerbated by China’s economic contraction.
We previously spotlighted China’s worsening tax and fiscal deficit situation this year. In the first five months of 2024, China’s fiscal deficit increased by 119.2 percent year-on-year to 1.14 trillion yuan. Meanwhile, major sources of tax revenue like the domestic value-added tax, corporate income tax, domestic consumption tax, and individual income tax all saw sizable contractions during the same period. The drop in fiscal revenue means that local governments have reduced capacity to repay debts.
Official data also shows that local governments have less than two-fifths of the funds that they raised through bond sales available for non-debt uses because the bulk of the funds go towards debt repayment. Of the 2.82 trillion yuan of local government bonds issued in the first five months of the year, 1.17 trillion yuan (41.5 percent) went towards the repayment of principal and 522.7 billion yuan was used to pay interest, leaving just 1.12 trillion yuan (39.7 percent) of the funds raised available for other purposes.
Data from Chinese business information provider Qichacha’s enterprise early warning portal shows that during the January to May 2024 period, about 36 percent of the funds raised from the issuance of special government bonds were allocated to municipal and industrial park infrastructure projects, about 21 percent of the funds went to railway, rail transit, government toll roads, and other transportation infrastructure projects, while projects involving shantytown renovations, healthcare, agriculture, forestry, and water conservancy also received relatively significant funding. Put another way, more than half of the funds raised by local governments were invested in non-revenue or low-revenue projects, while local governments have to pay interest on debt in excess of 42 trillion yuan annually. Meanwhile, the interest paid (522.7 billion yuan) on local bonds nationwide accounted for 5.39 percent of local government fiscal revenue, while principal repayment (1.17 trillion yuan) accounted for 12.1 percent of fiscal revenue.
3. China’s economic downturn has led to an asset shortage, with financial institutions rushing to buy long-term government bonds. This has increased pressure on the RMB to depreciate and made it more conducive for capital outflows, as well as the continuous accumulation of financial risks. The PBoC’s plan to intervene directly in bond markets appears to be an attempt at controlling risks.
i) The PBoC’s plan to borrow sovereign bonds from primary traders in the open market implies that it intends to short government bonds in an attempt to lower their prices and raise their yields. Medium- and long-term government bond yields have declined significantly recently, deviating from the central bank’s “reasonable range” of between 2.5 percent to 3 percent.
Falling government bond yields is the result of two broad developments. First, economic contraction in China has contributed to an asset shortage, with financial institutions unwilling to put money in traditional sectors given widespread manufacturing losses, a worsening of the real estate market, a rising risk of local government bond (including local government financing vehicle bonds) defaults, and a sluggish stock market. Second, excessive liquidity in the market (China’s M2 has exceeded 300 trillion yuan) is pushing financial institutions to put their funds somewhere. As a result, financial institutions are increasingly buying up “risk-free” long-term government bonds, and in doing so, driving down yields.
ii) In shorting government bonds, two of the central aims of the PBoC are preventing the one-sided, self-reinforcing expectation of RMB depreciation and curbing the trend of capital outflow.
The rising yield differential between China’s benchmark 10-year government bonds and U.S Treasuries is raising capital outflow risks for the PRC. As of July 2, the yield spread between China’s 10-year government bonds (2.248 percent) and U.S. Treasuries (4.428 percent) was 2.18 percent.
Meanwhile, multiple factors are putting pressure on the RMB to depreciate, including weak global economic growth momentum and persistently high inflation in the U.S. causing the Federal Reserve to postpone rate cuts. This has led the RMB exchange rate to slide continuously after December 2023. On Dec. 29, 2023, the onshore RMB exchange rate was 7.0865, up from a low of 7.3498 on Sept. 8, 2023. By July 3, 2024, the onshore RMB exchange rate had fallen to a low of 7.2716 to the dollar.
iii) The PBoC is also likely looking to curb the idling of capital in the financial system and avert systemic risks by shorting government bonds. Financial institutions, which are expecting China’s economy to contract further and interest rates to fall, are likely to hold a large amount of long-term government bonds for arbitrage instead of using funds obtained from various channels to support the real economy. Therefore, the central bank is looking to shift these expectations by acting in advance by signaling that it will borrow sovereign bonds from primary traders in the open market, and in doing so, reduce the circulation of idle funds in the financial system.
If interest rates rise in the future, however, the government bonds held by financial institutions will depreciate. This could see financial institutions run into similar trouble like Silicon Valley Bank and Norinchukin Bank in Japan, and trigger financial risks in the Chinese financial system.
iv) Should China’s economy continue to deteriorate without significant improvement, the PBoC’s plan to borrow sovereign bonds from primary traders in the open market will not only fail to stop financial institutions from buying government bonds, but will also put the central bank at risk of a short squeeze.
Financial institutions will likely continue to increase their holdings of government bonds to engage in arbitrage as long as the Chinese economy does not recover, there remains an asset shortage, and funds in the market far exceed the scale of government bonds. According to PBoC data, the custodial balance of government bonds at the end of May was 30.4 trillion yuan while the M2 money supply was 301.9 trillion yuan (with fixed and other deposits of domestic residents and enterprises totaling 160.5 trillion yuan). Meanwhile, the continued depreciation of the RMB exchange rate after the PBoC’s July 1 announcement that it would intervene in the bond markets indicates that financial institutions are not optimistic about the long-term impact of the central bank’s move.
The PBoC potentially faces a short squeeze as it seeks to depress bond prices. This is because primary dealers and large state-owned banks could pursue their own interests instead of heeding the central bank (even though the aforementioned entities are state-owned enterprises) and continue to engage in arbitrage. Such a development would force the PBoC to step in and short government bonds itself. This in turn puts the central bank at risk of a short squeeze if financial institutions continue to increase their holdings of medium- and long-term government bonds while the PBoC is limited in the scale of government bonds it can sell to lower prices.
v) If the PBoC borrows government bonds from primary dealers in selling short, it will need to purchase government bonds from the secondary market in the future to maintain its short position. This paves the way for the central bank to work around a stipulation in the “People’s Bank of China Law” (the central bank cannot purchase government bonds in the primary market) and indirectly monetize the fiscal debt of the CCP authorities.
With Chinese financial institutions and the central bank working in tandem, the CCP authorities can technically have the PBoC purchase large amounts of government bonds from the secondary market to provide funds for the Ministry of Finance to help manage the continued deterioration of the Chinese economy and the fiscal revenue problems of local governments. This operation, however, would have the central bank run its money printing press in high gear and could lead to hyperinflation.
4. We believe that rather than see a recovery, the Chinese economy will only worsen further so long as Xi Jinping insists on having the CCP strengthen its grip over the economy and financial sector while dominating everything else, and as the international community increasingly takes action to guard against the PRC.
2 Military rumors, ‘anti-Xi’ bookstore displays signal growing political instability in China
Various rumors and information circulating on Chinese social media or carried by overseas Chinese media hint at growing political instability in the PRC.
Xi purging the defense industry?
June 29
Zhao Lanjian, a former Chinese citizen journalist who is currently based in the United States, told Kanzhongguo that he learned from a PRC defense industry insider that Xi Jinping is conducting a “continuous and in-depth purge” of military enterprises, group companies, and listed companies under the purview of the Central Military Commission.
The insider said that the entities that have been targeted include China Aerospace Science and Industry Corporation, China Aerospace Science and Technology Corporation, China North Industries Group Corporation (Norinco), and China South Industries Group Corporation. The insider added that the extensive purge and rectification of defense industry entities, involving intertwined corruption cases and factional interpersonal relationships in the military, is “unprecedented” since the “reform and opening up” era.
The insider said that investigation teams from the CMC move into the aforementioned key military enterprises on Feb. 25, 2024 (after the Chinese New Year) and are expected to conclude their operations before Oct. 1, 2024. Several key personnel have already been arrested, some have been forced to commit suicide, and others have been covertly silenced, according to the insider.
The insider alleged that Wan Yanhui, a supervisor responsible for the approval of technologies at the China Aerospace Science and Technology Corporation, was silenced by a CMC investigation team, but his death was reported as a suicide with Wan’s family not daring to question the matter further. The insider also alleged that some individuals at the China Academy of Space Technology (a subordinate agency and Fifth Academy of the China Aerospace Science and Technology Corporation) were either forced to commit suicide or were covertly silenced.
The insider claimed that the CCP authorities sent a 30-member investigation team to the Eighth Academy of China Aerospace Science and Technology Corporation “due to the complexity of the cases.” The insider alleged that Zhang Hongjun, the former head of the Eighth Academy and current deputy general manager of China Aerospace Science and Technology Corporation, is under investigation. Wang Bolan, the current Party secretary and deputy dean of the Eighth Academy, has allegedly also been arrested. The Eighth Academy, or the Shanghai Academy of Spaceflight Technology, is one of three major general research institutes of the China Aerospace Science and Technology Corporation and is a key base for China’s aerospace industry.
June 30
In a post on X, Zhao Lanjian alleged that Zhang Chunming, the deputy dean of the Eighth Academy, Lu Tongshan, the former head of the Eighth Academy’s Third Research Department, and Zhuang Guopoing, the former head of the Eighth Academy’s Research Department, are all under investigation.
Alleged suicide of retired general
June 29
Information circulating on Chinese-language social media alleged that Geng Liaoyuan (70 years old), the former director of the former PLA General Staff Department’s (now Joint Staff Department) Political Department, committed suicide on June 27. Geng spent a good portion of his career in the General Staff Department and was promoted to Political Department director in December 2010.
Displays of displeasure towards Xi
Recently, a surge of “anti-Xi” sentiment can be glimpsed in bookstores across China. In those stores, books in the Xi Jinping collection appeared to have been deliberately placed and photographed alongside titles such as “The Collapse of a Great Power,” Ernest Hemingway’s “For Whom the Bell Tolls,” and Karl Popper’s “The Open Society and Its Enemies.” Photos of such displays were spread online and garnered widespread attention.
Later, rumors circulated online that the PRC police were instructed to monitor certain bookstores “24/7) and personnel were assigned to maintain book sections dedicated to the Xi Jinping collection. Some police officers even advised bookstores not to set up Xi Jinping book sections so as to avoid trouble.
Backdrop
The above developments come amid the lead up to the Third Plenum of the 20th Central Committee, the purge of two former defense ministers, and a CMC political work conference held in Yan’an.
Our take
1. The claims of Zhao Lanjian’s PRC defense industry source and other political rumors circulating in Chinese language circles are hard to independently verify. In particular, the CCP authorities have virtually ceased disclosing information about military personnel adjustments save those involving top positions since the 19th Party Congress. Meanwhile, the purge of several former military officers and defense industry executives who were members of the National Committee of the Chinese People’s Political Consultative Conference and the National People’s Congress (see here, here, and here) starting from the latter half of 2023 were only known because the removal of personnel from the NPC or CPPCC had to be publicized.
However, the military and defense industry-related rumors and information above do match with official developments and the current direction of elite CCP politics. Notably, the Xi leadership acknowledged in officially charging Li Shangfu and Wei Fenghe of corruption that they had “severely polluted the political and professional environment” in the military (Wei Fenghe) and its equipment sector (Li Shangfu). There were also Western media reports earlier in the year that corruption in the PLA was so severe that missiles were discovered to be filled with water instead of fuel and Xi Jinping was less likely to consider military action in the coming years. If so, then the Xi leadership would almost certainly undertake a serious investigation into the PRC defense industry and sanction large-scale purges and “rectifications.”
2. If the rumor about Geng Liaoyuan’s suicide is true, then it is possible that the Xi leadership is revisiting old issues within the PLA involving the Jiang Zemin faction. Geng rose up the ranks during the Jiang-Hu era when the Jiang faction was in firm control over the military and the PRC regime.
3. The proliferation of bookstore displays that are cryptically “anti-Xi” is a sign that Xi Jinping is currently not well-liked in China. As the Xi leadership continues to produce failures of governance on crucial issues and hurt the interests of those across the social strata, the CCP authorities will find it increasingly difficult to maintain stability both during normal times and when crisis erupts.
