• Government-directed infrastructure investment will not be enough to compensate for an anticipated slowdown in real estate investment growth in 2017.
  • Infrastructure’s already-large share of fixed-asset investment implies that the central government would need to engineer a large and difficult increase in financing if it wanted to counter a housing market slowdown.
  • Local government investment plans mostly point to a flat or even reduced pace of spending this year.

Infrastructure investment will not grow enough this year to offset an anticipated slowdown in real estate investment growth. That will leave demand for steel, which has helped drive a price rally in recent months, looking vulnerable (see chart).

Recovering real estate investment was the main driver of steel demand in 2016, while prices were also buoyed by government-mandated capacity cuts and another round of stimulus that increased inflows into commodities futures markets. But the housing market will slow this year and financial constraints suggest central and local governments will be unable to fill that breach with a meaningful infrastructure investment boost.

Real estate as driver of steel demand

Investment activity was a highlight of January-February data from the National Bureau of Statistics. Investment in real estate grew 8.9 per cent year-on-year, its fastest pace in two years, while infrastructure investment rose 21.3 per cent.

We do not expect the recovery in real estate investment to last. Under its new maxim that “a home is for living in, not for speculation”, the government has signalled its intent to continue clamping down on the real estate sector this year.

Investment activity may remain supported for now by robust housing sales but local governments are continuing to restrict developers and buyers in accordance with the centre’s policy goals. The People’s Bank of China said its most recent increase in the cost of funding to institutions in the interbank market was in part aimed at the rapid increase in house prices. We expect the cumulative impact of central and local government policy moves to drag real estate investment growth to 3-4 per cent.

The new swing factor

Real estate and infrastructure together account for about 61 per cent of Chinese steel demand (see chart). But infrastructure investment this year will not be enough to take up the slack of a housing market slowdown given how quickly housing is already growing.

Real estate investment grew 6.9 per cent last year from just 1 per cent in 2015 while infrastructure investment growth ticked down to 15.7 per cent from 17.3 per cent (see chart).

Real estate investment has been falling as a proportion of overall fixed-asset investment, to 17.2 per cent last year from 19.7 per cent in 2013, while the share of infrastructure investment has risen to 25.5 per cent from 21.5 per cent (see chart).

These shifts indicate that a longstanding relationship between infrastructure investment activity and steel output has broken down. Previously, they were highly correlated — rising infrastructure investment was a driver of steel output — but even as output rebounded last year, infrastructure investment growth remained relatively stable (see chart).

Instead, real estate investment growth has become the swing factor for steel output. The scale of overall investment is less important to steel output than changes in growth rates. In absolute terms, infrastructure investment has been a key and consistent driver of steel demand, but the upturn in steel prices last year was in direct response to a turnaround in the housing market (see chart).

No repeat of last year’s funding frenzy

Given infrastructure’s already large share of overall investment activity in China, the government would need to provide massive funding support to increase growth significantly from current levels. It has neither the appetite nor the ability to do so. In its work report to the National People’s Congress, the government said it is targeting total fixed-asset investment growth of 9 per cent this year, less than last year’s 10.5 per cent target but more than the 8.1 per cent increase recorded.

The central government’s policy banks have been the main vehicles for financing infrastructure construction. The amount of money lent by the People’s Bank of China to such banks doubled last year to an outstanding Rmb2.05tn ($297bn) while their bond issuance rose 30 per cent to Rmb3.35tn.

Local governments issued Rmb8.5tn in bonds last year, either directly or via companies under their control, up 51 per cent on the total in 2015. We do not think the scale of these funding activities can be replicated in 2017, particularly with the bond market no longer a source of ultra-cheap credit.

The public-private partnership (PPP) model that is currently favoured by officials is a more viable channel for financing but progress here is too slow to make a meaningful contribution to overall infrastructure investment. Just Rmb2.2tn of the Rmb13.5tn in PPP projects registered so far has actually been invested.

The crimped ambitions of local governments

Local governments have demonstrated little appetite for a big ramp-up in investment growth this year. Of the 22 local authorities that have announced investment growth targets for 2017, only five are looking to increase investment growth (see chart). These include the government of the Xinjiang Uighur Autonomous Region, which has raised its investment target by 50 per cent this year to Rmb1.5tn because investment fell in the western region in 2016. Of the remainder, seven are aiming for lower investment growth this year and the remaining ten have kept their growth targets unchanged.

Furthermore, our analysis shows local governments constantly fail to hit their targets. Last year, 14 of 24 local governments missed their investment targets while 14 of 26 missed in 2015 and 18 fell short in 2014.

Don’t rule out an upside surprise

Investment activity has underpinned economic growth at the start of 2017. A continuation of this would provide support for steel demand, helping to justify the steel and iron ore price action of recent months.

The official GDP growth target for this year has been lowered to “around 6.5 per cent” from 6.5-7 per cent. However, the government added a qualifier that growth greater than 6.5 per cent should be sought “if possible in practice”. If the investment activity seen in the first two months carries through the year then above-target growth is achievable.

However, this would presume that, in defiance of the central government’s stated policy goals, speculation will be allowed to continue running rampant in housing markets and that massive volumes of debt will continue to flow to the state sector in pursuit of greater infrastructure investment.

We do not think this is likely, but would never rule out the possibility that long-term reform goals are again sacrificed at the altar of short-term growth.