• China’s economic recovery has been led by state companies in upstream sectors that have benefited from surging commodities prices. This has not spread sufficiently to downstream industries.
  • The outlook for producer prices suggests this recovery may prove unsustainable as the housing market weakens and commodity prices soften.
  • In the event of slower growth, the government might step up its fiscal response, particularly in the run-up to a Communist party meeting this autumn. This is a more likely outcome than a demand-driven reflation.

China’s economic rally has been the result of a price-driven recovery in traditional engines of growth. We do not think this will prove sustainable without clearer evidence that the pick-up is spreading downstream, or without more government intervention.

GDP growth hit 6.9 per cent in the first half of the year, well above the government’s full-year target of about 6.5 per cent. This represents a strong turnround from the start of last year, when fear about a Chinese hard economic landing sent shockwaves through global markets.

The government’s response to that turmoil was to stimulate the economy’s traditional drivers of growth, as it had done many times previously, helping lift the domestic housing market and domestic and global commodities markets.

Eighteen months later, the economy is still benefiting from that stimulus, providing stability in the run-up to the 19th Communist party congress, due to be held this autumn.

It’s all happening upstream

This has been a top-heavy economic recovery, however, driven by a liquidity-backed surge in commodities prices which has thrown a lifeline to large state-owned enterprises operating in upstream industries such as mining. The vaunted recovery in the semi-official purchasing managers' index published by the China Federation of Logistics and Purchasing has been led by large companies. PMIs for small and medium-sized companies fell below the 50 mark in July, suggesting deterioration in operating conditions.

The impact of recovering commodities prices on Chinese industry is seen in adjusted industrial output growth. While key measures of economic activity have recovered, headline industrial output growth has remained relatively flat. Output growth rose 7.6 per cent in June, faster than April and May’s 6.5 per cent, but it has not increased at the same rate as other key activity measures (see chart).

Although the National Bureau of Statistics is understood to adjust industrial output growth for inflation using the monthly producer price index, its adjustments have understated the impact of changes in prices. Directly readjusting this series using the PPI shows a clearer correlation with the NBS’s industrial profit growth series, which shows that movements in producer prices have had an outsized impact on the profitability of SOEs (see chart).

Mining companies reported profits of Rmb243.6bn in the first six months of this year versus just Rmb22.1bn in the same period of 2016. In contrast, manufacturing sector profits were up 18.5 per cent in the first half of the year while those of utilities fell 28.2 per cent. SOE profits rose 45.8 per cent in the first half while those of private companies were up just 14.8 per cent.

While sales of construction machinery have recovered sharply this year, according to China Construction Machinery Association data (see chart), a closer read finds that heavy machines of 30 tonnes or more, which are used in upstream industries, are accounting for a larger proportion of sales (see chart).

PPI drivers are softening

China’s PPI turned positive in September last year after 54 straight months of negative readings. PPI grew 7.8 per cent in February but has since fallen to 5.5 per cent growth in May, June and July. We expect it to weaken through the remainder of this year, even if it remains in positive territory.

This is partly because the index has tracked key property market indicators closely since 2015, with house prices and sales rising several months ahead of the move in producer prices. Housing sales have been slowing in recent months and these will drag on producer prices (see chart). The PPI will also be negatively affected by global crude prices, which it tends to track closely (see chart).

The government’s supply-side reform programme supports the recovery of upstream industry because mandated closures of idle or inefficient capacity should strengthen the position of SOEs in key sectors. However, we think this supply side-driven recovery will prove sustainable only when downstream sectors benefit as well, and there is insufficient evidence to suggest this will happen.

Retail sales growth of furniture and decoration materials — the two sectors supposed to directly benefit from a housing market boom — have not risen with property prices, as they did before 2010 (see chart). This is because speculation has become a key driver of the housing market. Property is being bought for investment purposes so stands undecorated and empty. Furthermore, the prices of major home appliances, which should be indirect beneficiaries of a buoyant housing market, have lagged behind PPI and the consumer price index.

Stuck at the top

The government may counter slowing growth with yet more stimulus — fiscal expenditure rose 19.3 per cent in June, versus just 4 per cent and 9.4 per cent in April and May respectively. There is strong political impetus to maintain growth momentum ahead of the party meeting. This could sustain this unbalanced recovery for a while but would probably still leave midstream and downstream industries languishing.

There is also the possibility that improvements spread through the economy, triggering demand-driven inflation supported by the government’s supply side reform programme of capacity closures. Rising inflation would help erode corporate debt but the threat of rising market interest rates would pose a key challenge to policymakers. The trajectory of China’s PPI, and the health of state industry, suggest they will not have to grapple with this.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.