China: Government response to the slowdown Global Economic Outlook, Q2 2015
The Chinese economy continues to decelerate, and the government continues to take action to thwart the slowdown—mainly easing monetary policy. The result has been acceleration in credit expansion.
The Chinese economy continues to decelerate, and the government continues to take action to thwart the slowdown—mainly easing monetary policy. The result has been acceleration in credit expansion, but the underlying problems remain. Moreover, a boost to credit creation runs the risk of exacerbating some of the serious imbalances in China’s economy. More investment in heavy industry and property may fuel the excess capacity that is already driving down wholesale and property prices, thereby adding to the possibility of additional trouble down the road.
What exactly is happening, and what are the government’s plans?
Although most China watchers expected the data to indicate a slowdown, the news was worse than expected.
The decline in Chinese house prices accelerated in February, with prices of new homes falling in 66 of 70 cities analyzed and the average price down 5.7 percent from a year earlier. This compares with a decline of 5.1 percent in January; the February fall was the sharpest decline since the government started compiling these data in 2011.1 This was the sixth consecutive month of falling house prices. Concerned about falling property prices, the government has taken measures to ease credit market conditions, such as cutting interest rates and reducing the required reserve ratio of banks. In addition, Chinese banks have extended $16 billion in credit to one of China’s largest property developers.2 This has led to an increase in equity prices of property developers, suggesting that investors believe the government will not allow property developers to fail and that other bailouts are likely. Meanwhile, as the economy slows, there is a massive glut of vacant residential property, largely held by developers waiting for the market to rebound. As developers, many of which are laden with debt, face a cash problem, they may attempt to unload properties onto the market, thus causing prices to fall. Or, as the market might now expect, they will get cheap loans from state-run banks that will enable them to roll over existing debts.
As property prices fall, the government reports that the amount of housing floor space sold in the first two months of 2015 was down 16.3 percent from a year earlier. This will simply exacerbate the problem of excess supply in the property market, thus pushing prices down further. On the other hand, the government reports that new residential construction was down 17.7 percent in the first two months of the year compared with a year earlier.3
The government reported that the economy grew 7.4 percent in the fourth quarter of 2014, and that it expects even slower growth in 2015. Indeed, the early signs are not promising. The government reports that in January and February, industrial production was up only 6.8 percent from a year earlier.4 This was the slowest rate of expansion since the financial crisis in 2008; before that, such slow growth had not taken place since 1995. In addition, the government reports that fixed asset investment in the first two months of the year was up 13.9 percent from last year, the slowest rate in roughly two decades.5 Private sector investment grew faster than investment by state-run companies. Investment from non-Chinese companies declined, but investment from Hong Kong, Macau, and Taiwan grew rapidly. Given that investment has been the primary source of growth for the Chinese economy in recent years, the overall slowdown is important, and the decline in foreign investment is notable. Retail sales were up 10.7 percent from a year earlier, also a relatively slow rate of growth.
Overall, these data suggest that economic growth in the first quarter will be relatively poor and that, despite policy shifts by the central bank, the economy continues to decelerate. Moreover, although most China watchers expected the data to indicate a slowdown, the news was worse than expected. Consequently, many analysts now expect a further easing of monetary policy. One possibility is another cut in the required reserve ratio for banks. That ratio remains relatively high by international standards, so the central bank has plenty of wiggle room. Another possibility is that the central bank’s benchmark interest rate will be cut further—yet monetary policy might still not be effective. An easing of monetary policy, when effective, would stimulate more borrowing by businesses. Yet China already has excess capacity in industry and property, resulting in declining wholesale prices. Why would a business bother to borrow more? Thus something beyond monetary policy is needed.
Consumer price inflation in China accelerated in February, while producer prices continued to fall rapidly. Consumer prices were up 1.4 percent from a year earlier, far below the central bank’s target of 3.5 percent, but faster than the 0.8 percent inflation registered in January. The faster rise in consumer prices was largely due to higher food price inflation and is considered temporary. Meanwhile, producer prices fell 4.8 percent in February from a year earlier, faster than the 4.3 percent decline in January.6 The rapid pace of producer price deflation is related to excess capacity in industry, weak domestic demand, and declining energy prices. The current situation suggests a modest risk of consumer price deflation. The central bank has lately eased monetary policy by cutting interest rates in order to stimulate credit market activity. It is evidently not concerned about stoking inflation. Yet even with much lower capital costs, businesses are likely to be hurt by a rapid drop in producer prices. Moreover, with excess capacity, many businesses will not want to invest in greater capacity. Thus monetary policy might not have the desired effect.
China’s central bank has taken steps to ease monetary policy due to the economic slowdown and following news that the manufacturing sector continues to weaken. It is clear that the economy is afflicted with weak demand for manufactured goods, declining wholesale prices, decelerating consumer prices, and excess capacity in industry and property. The solution, according to the central bank, is to further ease monetary policy; it did so by cutting the benchmark interest rate by a total of 75 basis points in the last two months.7 The benchmark rate is now at a level not seen since 2010. The hope is that this will boost bank lending to the private sector and will help to reverse the movement toward deflation. The bank noted that disinflation has boosted real interest rates. It said that its goal is to create “real interest rate levels suitable for fundamental trends in economic growth, prices, and employment.”8 Still, given considerable excess capacity in the economy, it is not clear why China needs more credit-driven investment.
Meanwhile, the central bank reports that Chinese banks created new loans worth1.02 trillion yuan in February—more than investors had expected.9 This suggests that the central bank’s easier monetary policy is starting to bear fruit. On the other hand, total social financing, a broad measure of credit creation that includes the shadow banking system, was 1.35 trillion yuan in February, down from 2.05 trillion in January. Restrictions on shadow banking thus may be working. In addition, the government reported that money supply growth in February accelerated from January, again due to the easing of monetary policy.
What did Li say?
Premier Li Keqiang has been quite vocal recently in key government meetings on a wide range of economic issues. His comments can help to get a better understanding of the intended direction of policy.10
On the issue of the policy response to the slowdown in growth, Li said that the government has considerable tools available to maintain strong growth. He said, “In recent years, we have not taken any strong, short-term stimulus policies, so we can say our room for policy maneuver is relatively big, the tools in our toolbox comparatively many.” In other words, the government has a modest debt and deficit and can, therefore, afford to ease fiscal policy if needed. He also said, “If the slowdown in growth affects employment and incomes, and approaches the lower limit of a reasonable range, we will stabilize policies and the market’s long-term expectations for China.” On the other hand, he acknowledged that boosting growth might be challenging. He noted that getting a 10-trillion-dollar economy to grow 7 percent is not easy.
As for the slowdown itself, Li acknowledged what many already know: The Chinese economy is facing trouble. He said, “The downward pressure on China’s economy is intensifying. Deep-seated problems in the country’s economic development are becoming more obvious. The difficulties we are facing this year could be bigger than last year.” He said that the relatively slow 7.4 percent economic growth last year is the “new normal” and that the target for 2015 will be 7.0 percent growth. Li said that, in order to stabilize growth, the government would boost government spending by 10.6 percent in 2015 and run the largest budget deficit since the global financial crisis in 2009. The extra spending will go toward infrastructure investment.
However, Li offered this as a short-term measure and indicated that, in the longer term, economic reforms will be needed to rebalance the Chinese economy. He noted some of the challenges: “The difficulties we are to encounter in the year ahead may be even more formidable than those of last year. China’s economic growth model remains inefficient: Our capacity for innovation is insufficient, overcapacity is a pronounced problem, and the foundation of agriculture is weak.” Consequently, he wants to reform state-owned enterprises and liberalize the financial system. He pointed to manufacturing as key to China’s development and said, “We will implement the ‘Made in China 2025’ strategy, seek innovation-driven development, apply smart technology, strengthen foundations, pursue green development, and redouble our efforts to upgrade China from a manufacturer of quantity to one of quality.” He said that the number of industries in which foreign investment is prohibited will be cut by half. He also said that the government will encourage and support young people to start new businesses. It will “unswervingly” support the private sector.
As is often the case, the devil will be in the details.