News & analysis

The National People’s Congress (NPC) delivered major headlines in Friday’s session. The most notable of these were the scrapping of the 2020 growth target, a widened fiscal deficit projection, and the introduction of a national security law for Hong Kong. While the scrapping of the growth target was commendably prudent given the current state of the domestic and global economy, the further political interference from Beijing in Hong Kong grabbed the headlines.

With tensions rising again between the US and China after the Senate passed a bill to restrict semiconductor trade with Huawei, the latest measures taken by Beijing could see another collapse in US-Sino relations. The PNC is due to continue until the 28th, where members will attend many press conferences and interviews, while the security law is expected to be rubber-stamped in that time.

Developments from the NPC, the Hong Kong security law and US-Sino tensions will be the main themes for next week’s trading session as markets begin to seek shelter from increased risk yet again.

ECONOMIC GROWTH TARGET SCRAPPED IN FAVOUR OF MORE ACHIEVABLE AND POLITICALLY APPEALING TARGETS

Despite being embattled with the trade war in 2019, the Chinese economy managed to maintain a relatively stable economic growth path of 6.1% YoY, while unemployment remained below 5.3%. With COVID-19 making its first known appearance in December 2019 and further spreading in Q1 2020, the country was forced to implement strict lockdown measures. GDP dropped 6.8% in the first quarter, marking the worst GDP reading since 1992. Given that lockdown measures were extended into Q2, many believed the NPC would avoid setting a formal GDP target for the year, or alternatively a low growth target. With the latter potentially being politically damaging, the NPC opted to set no growth target at all. This was confirmed on Friday, when Premier Li said that the extreme amount of uncertainty presented by the virus shock, and containment measures, make any growth development predictions difficult.

Instead, the state council opted to focus on targets for other economic indicators this year. They are aiming for the urban surveyed unemployment rate to stand at 6.0% and the Consumer Price Index to increase by 3.5% year-on-year. Li also pledged to create 9 million new urban jobs, 2 million less than last year. Additionally, they are aiming to have more stable, and higher-quality, imports and exports, as well as growth in personal income in line with economic growth, while also eliminating poverty among all rural residents living below the current poverty line.

The now scrapped GDP target was assumed to sit at around 6% for the year, prior to the outbreak of Covid-19, such that authorities could achieve their goal of doubling the size of the economy by the end of 2020.

Considering that the Chinese government views employment as a key factor in maintaining social stability, it appears that the urban unemployment rate target will be the main substitute for the growth target this year. The increase in the unemployment target from 5.5% in 2019 to 6.0% in 2020 outlines the leniency taken to adjust for the economic toll of the virus. The government’s official urban unemployment rate for March was 5.9%, which translated to over 27 million people looking for a job. The true rate may be even higher as the urban surveyed unemployment rate may not depict the full unemployment situation.

China’s labour force consists of a large group of migrant workers that are not included in the urban surveyed unemployment rate. Additionally, the survey only considers urban areas, leaving large parts of the population unaccounted for. China’s unemployment already underwent a change in methodology in 2018, but this may not have sufficed to make the jobless rate more accurate and the use of other indicators such as household surveys may be necessary to provide a more complete narrative. Upcoming unemployment data, along with timely economic activity indicators, will drive monetary and fiscal policy expectations now in lieu of an official growth target to aim for.

 

China’s GDP and urban unemployment rate since the global financial crisis

 

FISCAL DEFICIT TARGET RISES FROM 2.8% TO 3.6% “OR ABOVE”

In response to the current economic contraction, the government boosted its fiscal support measures significantly compared to 2019. The Special Purpose Local Bond quota was also raised to 3.75trn yuan (3.6% of GDP) – higher than the 3% level seen in the response to the financial crisis. This can be used to fund local infrastructure projects. The government will also issue 1trn yuan (1% of GDP) of anti-virus bonds, labelled the Special National Bond quota, which together with funds from the wider budget will be transferred to local governments to support firms and regions hit by the outbreak. This will total 2trn yuan.

Overall, the broad measure of the budget deficit has increased to 8.2% of projected 2020 GDP, up from 5% in 2019. Additionally, the inclusion of the phrase “or above” highlights the uncertainty around the economic damage both domestically and externally caused by the coronavirus, doubling down on the state council’s unwillingness to set firm targets in this environment. Any increased fiscal stimulus is likely to be loaded towards the back-end of the year, when the state of the domestic economy becomes clearer and the previous fiscal and monetary stimuli filters through.

 

China’s fiscal deficit explodes as authorities aim to shelter economy

 

BEIJING’S EXTENSION INTO HONG KONG COULD PROMPT A BACKLASH FROM THE US AND A NEW BEGINNING FOR THE TRADE WAR

The announcement of a draft decision on establishing and improving the legal system and enforcement measures to safeguard national security in Hong Kong roiled markets on Friday. Many saw the bill as inconceivable prior to its announcement given the current economic climate and US-Sino tensions, leading to a widespread risk-off move at the back-end of the week. The main risk is the revocation of the territory’s special trading status with the US. This is a low hanging fruit for the Trump administration should Beijing rubber-stamp the draft law before the annual session ends on May 28th.

Under the “one country, two systems” principle, the US recognises Hong Kong as a separate entity from mainland China, which is enshrined within the Hong Kong Policy Act of 1992. The act sees a separate customs arrangement between the US and Hong Kong, allowing a favourable trading relationship which also pertains to the trade of “sensitive technologies”. Such technologies have been in the public eye recently after the US senate passed legislation that would impose restrictions on global semiconductor trade with Chinese firm Huawei should it involve US property. However, within the act itself it is outlined that if Hong Kong was to become less autonomous, the US President may change the way the laws are applied.

Many see the security law as a threat to the one country, two systems principle despite acclamation from Premier Li that this wouldn’t be the case. Should it pose a threat, it would likely lead to the US ramping up its punitive measures on China by imposing its trade war tariffs on the territory.

Markets traded on Friday in a manner suggesting this was a likely scenario with the Hong Kong dollar selling off and the Hang Seng falling over 5%.

Speculation is rife that this is to be the case, especially after US Secretary of State Mike Pompeo delayed the annual report on whether Hong Kong still enjoys a “high degree of autonomy”, only one year after its formation.

The bill itself specifies that when needed, relevant national security organs of the Central People’s Government will set up agencies in Hong Kong to fulfill relevant duties to safeguard national security in accordance with the law. With Donald Trump already taking to Twitter to throw his hat into the ring, and US senators Van Hollen and Toomey proposing a bi-partisan bill sanctioning Chinese officials and entities who enforce the new bill, markets are likely to trade in a manner that hasn’t been seen since the last escalation phase of the trade war in September. This extra dynamic comes at a time when traders are already having to battle the fluid coronavirus situation, which suggests that defensive flows into haven assets are only likely to continue.

 

Hang Seng returns worst since Chinese 2015 stock crash while one-year HKD forward points rise to highest level since 1999

A GAME CHANGER FOR THE EURO?

The European Commission is expected to present a new proposal for the Eurozone recovery fund next Wednesday 27th May. EC President Ursula von der Leyen, has previously called for an “ambitious” plan to overcome the current unprecedented crisis, after several failed attempts to come up with a joint fiscal effort in the area.

The latest proposal from France and Germany for a mutualised debt issuance may mark a turning point in the history of the European integration project.

The core of the €500 billion German-French proposal is the idea of raising mutual debt via the EU budget to be distributed among countries worst hit by the pandemic in the form of grants. The plan has strong economic and symbolic significance. On one hand, it could serve as an effective mechanism to channel funds to fiscally challenged countries like Italy and Spain, in order to ease the economic pain left by the pandemic. Crucially, it will also complement ECB’s efforts to stimulate the recovery via asset purchases, by narrowing peripheral bond yield spreads. On the other hand, a step towards the direction of a mutual debt mechanism in the Eurozone also removes the political risk of further fragmentation in the area. If the proposal becomes reality, a debt instrument backed-up by European institutions could share in the dominance of US and Japanese safe assets worldwide and provide the EU some extra political capital.

As the proposal currently stands, von der Leyen has reportedly found a “landing zone” for the size of the recovery fund, although the €1.5tn firepower demanded by Southern European governments has faced opposition from Northern states and some Eastern European countries. The ECB puts the fiscal cost of the pandemic at between 1 trillion and 1.5 trillion euros, while the worst-case scenario could rise as high as 2.5 trillion euros according to Bloomberg estimates.

Beyond of the package size, however, the strategy faces additional challenges and questions:

  • Loans vs Grants: For the package to work most effectively, a large part of the stimulus must be given as grants to damaged economies, as opposed to loans on capital markets conditions. The advantage of grants over loans stems from the neutral effect on national risk premiums, and therefore their ability to promote a sustainable recovery. Germany and France are proposing that 500 billion euros are granted to countries in financial distress and this is the benchmark markets will likely be assessing the final plan against. If the grant portion was cut to, for example, €200bn, the measures may have a limited impact in boosting market confidence.
  • Distribution criteria: The economic impact of the bailout will depend on how the funding is distributed among member states. If it is spread evenly across the bloc, the significance will be diminished. The German-French proposal allows a disproportionate share of the funding according to idiosyncratic financing needs.
  • Duration and maturity: The temporary nature of the recovery fund may be a problem in creating enough confidence to raise low-cost funds in capital markets, therefore curtailing the instrument´s potential to overcome the dominance of the German bund as the safest government-backed asset in Europe. The duration of the debt may be constrained by the seven-year period in which the EU budget operates. This would prevent the bloc from building out a full yield curve, which is critical for this instrument to succeed as an alternative European safe asset.
  • Strings attached: Member states will also have to discuss how the debt will be repaid out of future EU budgets in a sustainable manner. The commission stands ready to ask member states to grant it fresh revenue streams or “own resources” in the form of already existing custom duties. Other likely ideas –aligned with EU policies- are plastics or digital taxes, which are, in turn, politically contentious among some state members.
  • Timing: Even if agreed, the recovery money would only arrive next year after a full round of negotiations in the European Council and Parliament.

If the European Commission can get the EU-27 members on board with a project resembling the German-French initiative, markets could move significantly. Peripheral spreads can narrow notably from currently high levels and European stocks could deliver some rare outperformance. The euro could certainly recover from its depressed levels against the US dollar and other safe heaven currencies as the Swiss franc and the Japanese yen.

 

EURUSD remains near bottom of three-year range

 

 

Authors: 
Simon Harvey, FX Market Analyst
Olivia Alvarez Mendez, FX Market Analyst

 

 

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