As China’s economic weakness spreads into labor markets and consumption, growth is heading below the government’s 7% target. So policymakers have once again swung into action, last week announcing measures aimed at juicing auto sales and housing. But will more stimulus be enough to arrest the slide in growth and turn around negative sentiment about China? In this piece, we explore four different scenarios for how China might stimulate growth.
More of the same. So far the government’s approach has been to steadily roll out many different supportive measures: interest-rate cuts, reserve-requirement cuts, central government funding for infrastructure, corporate tax breaks, targeted support for consumer spending, very modest currency depreciation, and so on. The strategy is an accumulation of incremental measures to support both investment and consumption. Last week’s announcement of a cut in taxes on automobile sales, and a reduction in the required downpayment for mortgages, is straight out of this playbook. The consensus view of Chinese policy over the next several months is that this approach will continue and produce a steady stream of easing measures—and the consensus view is indeed most likely the right one.
The problem of course is that this strategy has not led to a fundamental improvement in the business cycle or sentiment. Rate cuts have been substantial, and the interest-rate-sensitive part of the economy has responded, with housing sales and prices bouncing nicely. But housing investment remains in the doldrums because of the overhang of unsold housing from previous years, and without a pickup in construction the domestic business cycle is not going to turn around. So policy easing is basically softening the downturn rather than generating an upturn. “More of the same” thus looks unlikely to change the trend of an unpleasant grind downward in growth. With housing investment set for another decline in 2016, headline GDP growth will take another step down toward 6%—but that figure will disguise a much more severe downturn in heavy industry and the regions that depend on it (see The Diverging Fortunes Of The Two Chinas). So it’s not surprising that some investors feel that more of the same is not enough, and that China should do something very different to avoid a downward spiral in growth. A big currency devaluation has already been ruled out by the top leaders, but what else might they do?
Shock and awe, or 2008 all over again. Rather than dribbling out incremental support measures over time, China could attempt to get ahead of expectations by doing much more than expected, much sooner. Just as it did during the onset of the global financial crisis, China could slash interest rates, tell its state-owned banks to start lending as fast as they can, and ramp up public works projects. Since they’ve done it before, they can do it again, the thinking goes.
We don’t think such a repeat of the mega-stimulus is very likely at all, or indeed would be very effective if it was attempted. First, consensus opinion within China now views the 2008 stimulus as excessive, and the current leadership has repeatedly pledged “no big stimulus” to show they are better economic managers. They have instead started to rebuild a proper legal framework for local government spending—which was essentially destroyed by the massive infrastructure binge—and a rerun of 2008 would require a public and embarrassing reversal. Second, it would actually be very difficult to simply repeat the 2008 stimulus. The real problem was not that the response in 2008 was excessive—it was that the stimulus never went away afterward. Once all the off-budget borrowing by local governments is accounted for, China has run a budget deficit of 8-10% of GDP every year since 2009. Fixed-asset investment in infrastructure is currently more than RMB1trn a month, and has been growing by around 20% for all of 2013, 2014 and 2015. In reality, a debt-funded infrastructure stimulus is and has been in full swing, and it will be quite difficult for the government to deliver significantly more stimulus through this channel (see The Infrastructure Conundrum).
If the choice is between more incremental stimulus, and 2008 all over again, then the government is indeed better off choosing more of the same. But this is a false choice, as there are other options. While they are not very likely, they are still worth exploring.
A real consumer stimulus. There are indeed some observers who advocate that China go all out to cut interest rates and boost borrowing now, and aren’t fussed about the details. But most recognize that it does matter what the money is spent on, and that yet more debt-funded infrastructure spending is unlikely to bring much benefit and could even make things worse. So the typical outside recommendation is for a stimulus that would support consumer spending rather than investment. The problem is that it is difficult to say just what such an idealized consumer-focused stimulus would look like in practice. (Tax breaks and subsidies for consumer durables have already been used extensively, and so fall in the “more of the same” scenario.) This is because the institutions that China has for delivering counter-cyclical stimulus rely mainly on public works spending, and to deliver a different type of stimulus would require a different set of institutions.
Yet there are ways out of the impasse. One option, recently proposed by Bert Hofman of the World Bank, would be for the central government to issue sufficient debt to finance the expansion of social welfare benefits to rural migrants. This makes sense because it is precisely the huge fiscal cost of such an expansion that has kept the government from breaking down the systematic discrimination embedded in its household registration (hukou) system (see Urbanization 2.0). Such an expansion would deliver a large and very direct support to consumer spending in the short term, and also pay long-term dividends by encouraging greater urbanization and its associated agglomeration effects. And some research suggests the cost of such an expansion of social programs would cost not the trillions of dollars some feared but only US$100bn or so a year—which would require only a 3-4% increase in total government spending. The trick of course would be to find a sustainable way to finance this increased level of benefits after the initial stimulus period. The political and institutional challenges of implementing such a marriage of hukou reform and stimulus are serious, and make the odds of this unconventional option low. But the benefits would be real: a stimulus that helps resolve structural problems rather than worsen them would restore confidence, and consumer spending would be much more resilient.
Reset the business cycle by clearing out excess capacity. An alternative approach would be to focus not on finding new ways to support demand, but on dealing with supply-side problems. Such an approach could actually move forward the time when the investment cycle turns up again—since it is excess supply that is the biggest current drag on the construction-driven business cycle. For instance, Liu Shijin of the Development Research Center, a government think tank, has proposed a plan that to use central government debt to finance the closure of excess capacity in the most problematic heavy-industry sectors. Closing this capacity would push up the prices of industrial materials, improve profit margins, and allow the remaining companies to make reasonable plans for future investment. Liu estimated that his plan would require only RMB300bn, which is not a very large sum for a country with RMB15trn in tax revenues.
An even more aggressive supply-side solution would be for the central government to finance a large private-sector debt restructuring, clearing up bank balance sheets enough for them to restart the credit cycle. Beijing is already underwriting a debt restructuring for local governments with its RMB3trn program to refinance their off-budget borrowing, and the principle is the same. The politics of course are not, and this would represent a big change of course from the current strategy of avoiding corporate defaults and making it easier for indebted companies to continue operating (see The Emerging Strategy For Debt). It would also require officials to accept that China suffers not from a temporary shortfall in aggregate demand, but a different problem requiring different solutions. We think either of these supply-side approaches would be quite positive for both the economy and markets. But there is so far little sign that the economic debate in Beijing is moving in this direction.
In the box, or outside it?
The most likely trajectory for China is for the government to keep announcing growth-supporting policies, and for growth to keep slowing, if not collapsing. This may not be the disaster scenario that some fear, but neither is it a hugely positive one. Heavy industry is already essentially in recession, and as business conditions stay weak, financial stress on a significant swathe of corporate China will intensify. Though the labor market is overall in good shape, conditions will still worsen and there are already layoffs in some regions and industries.
China does have some options that could help it avoid this central scenario—but it could also make things worse. A repeat of the 2008 mega-stimulus would most likely mean that global investors would stop panicking about an impending collapse in China’s growth and start panicking about the impending collapse of its financial system instead. The better options are not impossible to deliver, but they are difficult, and not without risk. A more aggressive restructuring of excess capacity could cause panic about unemployment and social unrest, while a debt-financed boom in consumer spending could cause panic about a debt blowout and the collapse of government finances. The rest of the world can always find something to worry about in China regardless of what it does.