Under our base-case scenario in which the COVID-19
pandemic continues to subside (without a large-scale second wave), we foresee a
modest global recovery in 2H20, with China growth outpacing that of the US and
EU. We expect China GDP growth to rebound to about 6.0%
YoY in 4Q20 from -6.8% YoY in 1Q20, before rising further (on a low base) in
2021. We expect inflation to stay muted despite the notable pick-up in growth. Economic
forecasting under the current (extraordinary) conditions is subject to great
uncertainties. However, we are reasonably confident in our assessment that a
cyclical recovery this time around will not be accompanied by rising inflation in the near term.
We foresee an “atypical recovery,” since we expect supply to recover more rapidly than demand; a typical up-cycle tends to be led by demand. As the slowdown during containment was driven by temporary restrictions rather than a decline in potential output, relaxation of the restrictions should boost supply instantaneously, while demand may take time to normalize. Meanwhile, we believe higher post-pandemic government debt levels are more likely to boost to a resumption in production than they are to boost investment or consumption.
We expect a rising savings rate driven by this mismatch in the supply and demand recovery to cap upside for the natural interest rate. Faced with exogenous shocks, the government may opt for monetary easing and reduce interest rates, or conducting fiscal stimulus/boost demand directly, thereby raising interest rates. We expect a more sizable YoY fiscal expansion in 2H20, which may support market rates in the short term. But it remains unclear if fiscal expansion would be sufficient to offset the tendency of falling rates over the medium term.
With regards to policy response, the US has relied more on fiscal relief, while China has leveraged more heavily on monetary expansion. M2 growth accelerated in both China and the US. The main growth driver in the US was fiscal expansion (i.e. quantitative easing by the Fed), while the key contributor in China was credit growth. Although unlike the US, China has room to cut rates, we do not believe it is desirable to rely too heavily on monetary expansion, as the debt-servicing burden would dampen growth in 4–6 quarters’ time.
China should try to strike a balance between management of the short-term (economic) cycle and the medium-term (financial) cycle. A side-effect of a credit-fueled recovery is a potential spill-over to property demand. With housing prices well above affordable levels for average households, China should avoid leveraging property demand to boost GDP growth. Since credit binges tend to prolong the financial down-cycle, fiscal policy plays a larger role in cyclical management.
Policy responses to COVID-19 point to new possibilities for monetary and fiscal policy coordination. The Fed has effectively turned from the lender of last resort to the “lender of first resort” in bearing the credit risks of the private sector. It remains to be seen whether such quasi-fiscal operations will change from emergency measures into common practice, like QE. As history is unlikely to simply repeat itself, we believe attention should shift from debates over the monetization of fiscal deficits to the potential fiscal functions of the central bank’s digital currency.
For more details, please see our report An "atypical" economic recovery published in June 2020.