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China ENG G20 / Global Sovereign Bonds

Macro Focus: Economic policy in China between the hammer and the anvil

the main focus for observers of the Chinese economy n the coming months and quarters should not be on the overall size of the stimulus package but on the nitty gritty details pertaining to the allocation of government-backed funds across sectors and geographic areas. In the context of an intensifying trade and technological war, a significant part of the effort could be geared toward insuring that productivity gains will be preserved in the post-Covid era by investing in Industry 4.0 and high tech ventures. Another area of focus is the need to reduce social inequalities – a subject that has been taboo for years if not decades in the wake of China’s transition to a market based economy – and supporting the build-up of an ambitious and comprehensive social safety net – targeting the rural population and migrant workers – that could increase social cohesion and preserve political stability in the years to come.

Key takeaways

  • So far, the response of the Chinese authorities to the economic crisis caused by the coronavirus outbreak has been tepid. The initial support package announced by the Chinese authorities in the wake of the sanitary crisis is estimated by the IMF at around 2.5% of GDP
  • China’s economic policy options are constrained by an uneasy equation: the Y4 trillion mega-stimulus deployed in 2009 led to an overwhelming accumulation of private and local debt, forcing the authorities to implement a multi-year strategy to crack down on excesses
  • Therefore, it comes as no surprise that the central government has decided to channel its new stimulus through market-based funding, focusing on targeted programmes and initiatives to ensure that the coronavirus pandemic does not impair the rebalancing of the economy toward consumption and services.
  • For the first time in decades, the Chinese government is set to abandon this year its GDP growth target.

Detailed analysis

After a delay of two months forced by the coronavirus pandemic, China’s main legislature, the National People’s Congress (NPC) will convene in Beijing starting from Friday, April 22. In the PRC’s unique institutional system, the Communist Party withholds a de facto – if not de jure – monopoly on political power and casts the shots on all the major decisions that could impact the lives of 1.4 billion Chinese citizen, and increasingly the rest of the world. Decisions have been prepared in advance by the State Council, but they will be publicly announced during this carefully scripted political gathering.

New economic stimulus measures are expected to be announced at the NPC’s yearly session even though the Chinese economy gradually started to recover from the self-imposed lock-down, travel restrictions and strict social distancing rules that led the quarterly GDP to fall by almost -10% in Q1 2020 against Q4 2019. China Caixin manufacturing PMI rebounded in March above the expansionary 50 threshold, after reaching an all-time low of 40.1 in February. The April reading for this indicator is slightly below 50. Official PMI compiled by the National Bureau of Statistics followed the same pattern, hovering over 50 after plunging down to 35 in February. In April, electricity production returned to the level it reached during the same month last year. This is matched by pollution levels similar to their pre-crisis levels in the major Chinese cities as of the end of April.

So far, the response of the Chinese authorities to the economic crisis caused by the coronavirus outbreak has been tepid. It consisted mainly of targeted liquidity support lines and credit guarantees, corporate tax cuts and rescheduling of loans owed by individuals and corporates. The initial support package announced by the Chinese authorities in the wake of the sanitary crisis is estimated by the IMF at around 2.5% of GDP.

This contrasts with much higher fiscal and quasi-fiscal packages announced and gradually ramped up in other G20 economies. On average, the IMF estimates that total revenue and spending measures for G20 countries account for 4.5% of GDP (cf. chart below). Across Europe, the support has mostly taken the shape of quasi-fiscal measures (loans, equity and guarantees), whereas the United States and Japan announced unprecedented levels of traditional fiscal support consisting of spending and revenue measures.

China’s economic policy options are constrained by an uneasy equation. Indeed, the country’s political leaders do not want to repeat the errors associated with government-backed and credit fuelled mega-stimulus deployed in 2009, in the aftermath of the Global Financial Crisis, which represented 4 trillion yuan or 10% of China’s GDP at that time. This led to an overwhelming accumulation of private and local debt that migrated in just a few years from the banking system to the so-called “shadow banking” entities, such as Trusts and LGFV (Local Government Finance Vehicles), forcing the authorities to implement a multi-year strategy to crack down on excesses and to rein-in the genius that escaped from the bottle.

Since 2010, the key indicator that the authorities have been following is the so-called Total Social Financing (TSF) which includes all the financing provided to domestic non-financial corporations and to households, including equity raising. According to preliminary statistics for Q1 2020:

The cumulative increase in the scale of social financing in the first quarter of 2020 was 11.08 trillion yuan, 2.47 trillion yuan more than the same period last year.  (..)

In terms of structure, the RMB loans issued to the real economy in the first quarter accounted for 65.5% of the social financing scale over the same period, which was 7.6 percentage points lower than the same period last year. (..)

Government bonds accounted for 14.2%, 3.2 percentage points higher than the same period last year.

http://www.gov.cn/xinwen/2020-04/10/content_5501148.htm

This encompasses LGFVs and Trusts as well as Government Directed Funds and special purpose bonds. The later two options are favoured by the central Government in order to gradually reduce the macro-prudential risks posed by local off-balance sheet financing vehicles. Therefore, it comes as no surprise that in the wake of the coronavirus crisis, in addition to limited some monetary easing measures by the PBC, the central government has decided to channel its stimulus through market-based debt funding instead of relying on government-backed credit or shadow banking structures that are connected to the provincial and local governments. This is a clear departure from the credit-based stimulus experienced by the Chinese economy after 2010, which led to a credit overhang, as confirmed in an IMF research paper by Sophia Chan et. al. published in 2017, whose main findings were summed-up in this blog post. According to this research:

In 2001-2008, GDP increased by 2 percent in response to a 10-percentage point change in the ratio of credit to initial GDP. However, by 2010-2015, the effect of credit on output growth fell to almost zero. This might be the consequence of the economy becoming saturated with credit

In contrast, the paper finds that:

fiscal stimulus may be powerful, assuming it is done correctly. The fiscal multiplier for on-budget expenditure was 1.4 in 2010-2015. In other words, GDP increased by 1.4 percent in response to a 1-percentage point change in the ratio of on-budget expenditure to initial GDP. This multiplier is high in international comparison, and is also higher than the historic 0.7 multiplier in China in 2001-2008. Therefore, fiscal policy can effectively support growth in the face of possible shocks

How much stimulus does China need and how much can the government effectively provide ?

For the first time in decades, the Chinese government is set to abandon this year its GDP growth target. In part, this is a consequence of the extreme uncertainty surrounding any forecasts amid an unfolding pandemic which still carries many unknowns. But more fundamentally, we might argue that the coronavirus crisis only served as a catalyst for an underlying shift of focus as a result of years of economic rebalancing aimed toward boosting private consumption and supporting the development of the service economy, as opposed to the “roaring 2Ks” growth model, based on public investment in infrastructure and private investment in export-oriented industries. Indeed, the idea of “engineered growth has been at the core of economic doctrine in China since the Mao era. It remained a pervasive feature of economic policy design and implementation in the Reform and Opening era that followed Mao’s death. It is now quietly losing its centrality as both Chinese policy makers and citizens alike are becoming more concerned about the quality of growth – in terms of quality of life and general well-being – than about the quantity of growth.

The reliance on government bonds wether they are generic or purpose-based will increase the government”s fiscal deficit and debt. Strictly speaking, China’s central government debt appears manageable as it stands sharply lower than in the United States or in the Eurozone – taken as a whole -, not to mention Japan. Officially, China’s public debt represented only 40% of GDP. and the public deficit stood below -5% of GDP in 2018 which is more than manageable for a country with low nominal interest rates and high nominal growth rates in which the government borrows mostly on its domestic market and in its own currency. But accounting for the Central government’s special off-budget funds and for off-budget spending by local governments, the picture is less rosy. According to an alternative measure of “augmented net lending and borrowing” devised by the IMF, China’s general government deficit has been above -10% of GDP since 2016. It is clear that the post-covid era will see a sharp and persistent increase of government debt to GDP all over the world and China will constitute no exception to this general trend.

Source: IMF, 2019 Article IV Report for the PRC.

In this context, the Chinese government will be focused on insuring that the pandemic does not impair previous efforts made to rebalance the economy. As per former World Bank chief economist, Justin Yifu Lin, whose advice is well-sought in Beijing:

As long as it maintains 3 to 4 per cent growth next year, the goals of doubling its 2010 GDP and per capita GDP will be achieved by 2021. In this once-in-a-century global pandemic and economic recession, it is entirely understandable and reasonable to postpone a target set 10 years ago by one year.

https://www.eastasiaforum.org/2020/05/17/growth-interrupted-covid-19-and-chinas-2020-economic-outlook/

Riders in the storm: avoiding a financial crisis and hedging social risks

The risk of a financial crisis unfolding in China has been for many years a key focus of analysts and policymakers. Macroprudential policies implemented from 2015 have sought to counter this risk by reducing macro-leverage in the economy which remains high as total social financing represents more than 200% of GDP. The idea that the government must replace some of the private and off-budget financial leverage by public debt has been floating around for years. The situation is now ripe for such a transition which will see the central government play a more prominent role in the social sphere. Inevitably, there will be some questions raised about the macro sustainability of this shift from mercantilism to keynesianism. A growing public deficit could translate into a current account deficit, as per the theory of twin deficits, which will eventually have to be financed by enhancing the international status of the renminbi and by accelerating the transition to price-based macroeconomic policies, as opposed to the quantity-based policies of the past. But these are questions that warrant further analysis.

For the time being, the main focus for observers of the Chinese economy should not be on the overall size of the stimulus package but on the nitty gritty details pertaining to the allocation of government-backed funds across sectors and geographies. In the context of an intensifying trade and technological global war, a significant part of the effort could be geared toward insuring that productivity gains will be preserved in the post-Covid era by investing in Industry 4.0 and other high tech ventures. Another pressing issue is the need to reduce social inequalities – a subject that has been taboo for years if not decades in the wake of China’s long transition to a market based economy – by supporting the build-up of an ambitious and comprehensive social safety net, targeting the rural population and migrant workers. This is a critical requirement in order to increase social cohesion and to preserve political stability in the years to come.

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