China’s Economy Needs More Stimulus. Beijing’s Room for Maneuver Is Limited.

People’s Liberation Army soldiers stand in front of the People’s Bank of China in Beijing.

Andrea Verdelli/Bloomberg

About the author: Alicia Garcia-Herrero is a senior fellow at European think-tank Bruegel and the chief economist for Asia Pacific at Natixis. She is a non-resident senior fellow at the East Asian Institute of the National University Singapore and adjunct professor at the Hong Kong University of Science and Technology. She is also a member of the Council of Advisors on Economic Affairs to the Spanish Government.

China’s decade-long economic slowdown is accelerating. The pace has picked up since former President Donald Trump launched his trade war against China and even more so since the Covid pandemic started. This year has been particularly difficult as stubborn zero-Covid policies have ground the economy to a halt, further pushed by the bursting of the real estate bubble that had been China’s most important engine of growth for decades. 

Against that backdrop, Chinese policy makers have been announcing fiscal and monetary stimulus for months, as a way to achieve the official 5.5% growth target. They’re fighting several other headwinds, including an energy-power crunch that occurred as a consequence of excessive leverage and lack of investment opportunities.

Looking into the economic impact of zero Covid policies, one should not miss that mobility both between and within cities started to recover in June after the government partially eased anti-Covid restrictions. But the momentum for further improvement clearly slowed later as outbreaks continued. Households have been reluctant to participate in social gatherings, weakening investment sentiment. Moreover, mobility indices have started to trend downward again since the second half of August.

It seems clear that Chinese policy makers need to react with more stimulus. Both fiscal and monetary policies are already laxer than last year, but they are clearly not enough to bring the growth rate back to the desirable path. How the situation will change depends on two types of macroeconomic policy. 

Starting with fiscal policy, the government has announced the use of infrastructure investment as a stimulus tool. We estimate infrastructure investment needs to grow at around 18% to reach the official growth target, but  it only grew by 7.4% year-over-year from January to July. The stagnant growth so far has weighed on China’s tax revenues, making it harder for local governments to engage in infrastructure spending, especially as their Covid-related expenditures remain high. As of July, the year-to-date narrowly defined general government deficit already accounted for 65% of the annual budget deficit, which is significantly higher than that of previous years. The fiscal situation is even more concerning after taking into consideration another critical component of the government deficit, namely the government fund, which is supported by government land auctions. Because of the slump in property sales, the year-to-date government fund deficit has already reached 94% of the annual budget deficit.Therefore, while the government needs to continue its expansionary fiscal policy to keep the current growth momentum, the room left within the budget is narrower. As such, we expect the government to take measures to gain more fiscal space. This is likely to include reducing the administrative costs of government operations, such as restricting wage growth in the public sector; frontloading local government bond issuance once again; or even issuing another round of special treasury bonds. However, even with these measures, the overall negative sentiment makes it difficult for local governments to embark on the kind of massive infrastructure projects that characterized the past decade, which would also be a bit late to achieve this year’s growth target. If anything, they could make a difference for 2023 growth. On the monetary policy side, the People’s Bank of China has taken an accommodative stance since the beginning of the year. In fact, the central bank cut the one-year and five-year loan prime rate twice and three times, respectively, to lower funding costs for the corporate sector and for mortgages. It also reduced the required reserve ratio in April to unleash more liquidity. Given that inflation is still rather muted in China, there could be some room for the PBOC to further cut rates. 

But pushing rates too low may have a number of counter effects. The first has to do with Chinese banks’ financial health. Banks may find their net interest margin reduced at a time when their asset quality, and therefore profitability, is worsening. In addition, given the hawkish stance of the Federal Reserve and the increasingly less appealing yield differential between China and the U.S., capital outflows may increase and further weigh down the renminbi. In other words, the PBOC is in a bind. It needs to cut rates to support the economy but faces too many constraints in doing so. Thus, we expect the rate cut in the remainder of 2022 to be only moderate.All in all, there is strong incentive for the Chinese government to keep expansionary fiscal and monetary policies in the second half of the year. However, the room for maneuver is much more limited than in the past. The fall in fiscal revenue is constraining the government’s ability to invest in infrastructure, even as the return on assets of such projects has declined. The PBOC will also find it hard to push interest rates too low given the concerns about financial health and the rising yield differential between China and the U.S. Because of these policy constraints, China’s growth should remain stubbornly low in 2022 and possibly beyond. China’s policy makers would need to shift suddenly to change that course. Such rapid change would need to start with reopening the border, followed by the liberalization of key sectors, especially services.

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