Abstract: To achieve desirable economic growth in 2020, China must implement forceful expansionary fiscal and monetary policies and need not worry much about increase of the debt ratio. The amount of infrastructure investment needed should be significantly higher than the 4-trillion yuan stimulus in 2008. While implementing these policies, the government must be vigilant against waste of fiscal resources and avoid image projects.
With COVID-19 largely brought under control in China, the government must adopt expansionary fiscal and monetary policies to stimulate economic growth.
Before the COVID-19 outbreak, the consensus among government officials and economists was that China's potential economic growth rate was about 6%. As China's economy grew at -6.8% in the first quarter of 2020, from a supply-side perspective, if the economy can achieve a growth rate of 6% in the next three quarters, whole-year growth should reach 3.2%. However, if external demand continues to deteriorate and the rebound in consumer demand is unsatisfactory, whether the Chinese economy can achieve a growth rate of 3.2% or higher will depend on the growth of capital formation which in turn is determined by the growth of investment in sectors such as manufacturing, real estate and infrastructure. Among these sectors, only infrastructure investment is directly dependent on the government's fiscal expansion and project reserves. Given the growth rates of other investments, increasing the growth of infrastructure investment is the main means for government to make up for the shortage of effective demand and achieve GDP growth above 3%. A simple calculation shows that the growth of infrastructure investment must be much faster than the growth of GDP in the next three quarters and surpass that in 2009 and 2010.
For years, many people have called the $4 trillion stimulus package in 2009-10 a failure. In fact, a careful analysis can show that despite the shortcomings of the 4 trillion yuan stimulus plan, without it, China's economy would not have been the first to get out of the global financial crisis and recession, neither could its GDP have risen from 4.6 trillion dollars in 2008 to 14 trillion dollars in 2019. In fact, all major economies have embarked on massive stimulus measures since 2008, with varying degrees of success.
To implement the four-trillion-yuan stimulus plan, the central government increased government spending by 1.18 trillion yuan from 2009 to 2010, and local governments by 2.82 trillion yuan. The national deficit-to-GDP ratio rose from 0.3% in 2008 to 2.7% in 2009. It is not clear to me since when the deficit-to-GDP ratio not exceeding 3 percent has become the golden rule. Maybe it's from somewhere in the textbook.
But here's the reality: the US fiscal deficit was 9.8 percent in 2009. Forceful fiscal stimulus and ultra-loose monetary policy have enabled the U.S. not only to stabilize the financial system, but also achieve the longest economic recovery in history. Did any countries actually follow the 3% rule? No country did and now they are embarking on another round of fiscal stimulus.
With insufficient demand, the government must implement expansionary fiscal and monetary policies, and fiscal expenditure must grow faster than the economy. Expansionary fiscal policy is needed when economic growth is low and fiscal revenue growth declines. Thus, expansionary fiscal policy indicates an increase in the fiscal deficit- and outstanding government debt (cumulative fiscal deficit)- to- GDP ratios.
Given China's situation, to ensure an economic growth of more than 3 percent, the government must boldly implement expansionary fiscal policy, supplemented by expansionary monetary policy. According to a preliminary estimate by the Institute of World Economics and Politics of the Chinese Academy of Social Sciences, the amount of infrastructure investment needed to implement the expansionary fiscal policy this time should be significantly higher than the 4 trillion yuan back in 2008.
Moreover, after the outbreak is largely put under control and production fully restored, the government is likely to continue its pandemic relief spending in many areas. In particular, the government will provide assistance to those who have gotten unemployed or underemployed due to the epidemic but are not covered by the social security system. Due to changes in the world trade pattern, some export-oriented enterprises may face severe difficulties, with some orders lost permanently. These enterprises will have to transform from external demand-oriented to domestic demand-oriented. In this case, the government may need to set up a special spending program to help these enterprises get through the difficult transition.
While fiscal expenditure will substantially increase, China's fiscal revenue is bound to decline significantly due to the slowdown in economic growth and the implementation of tax cut and fee reduction, which will make the significant increase in deficit ratio inevitable. Many people do not support the adoption of policies similar to the 4 trillion yuan stimulus package in 2008, mainly because they worry that the government fiscal deficit will rise too fast, leading to a further increase in government leverage. Such fears are not entirely unfounded, but are not persuasive enough for China not to adopt a more expansionary fiscal policy in 2020 than it did in 2009-10.
First, the debt level of the Chinese government is quite good compared with the rest of the world, especially major developed countries. From 2008 to 2017, the average deficit-to-GDP ratio of EU, UK, Japan, the US and India were 3.5%, 6%, 6.8%, 6.7% and 7.8%, respectively. Over the same period, China's deficit-to-GDP ratio averaged less than 2%. Many scholars in western countries and international organizations believe that China's actual fiscal status is much worse than what China officially announces. For example, based on the percentage of broad government deficit in GDP, a measure put forward by the World Bank, the IMF included a number of budget items that are not included in China's general public budget deficit, thereby significantly increasing China's fiscal deficit ratio by about 10%. While this calculation is not entirely unreasonable, it has greatly exaggerated the fragility of China's fiscal system, and China needn't to be bound by the ratio when making budget decisions.
Another key measure of government fiscal condition is the public debt-to-GDP ratio. China's ratio is lower than that of most countries in the world - much lower than that of the US and Japan, and significantly lower than that of the European Union (including Germany). It is true that local governments debts are high in China, which we should be highly vigilant about. But even when these are taken into account, China's public debt-to-GDP ratio is still lower than 50%. According to the US Central Intelligence Agency, China is one of the 30 countries with the lowest public debt-to-GDP ratio in the world.
Second, the reason why high leverage is worrisome is that creditors worry that debtors will not be able to repay the debts hence will not continue to provide financing, which may lead to sovereign debt crises. But this basically does not apply to China. China has a high savings ratio. Its residents are willing to own more financial assets, and the government bond is the safest financial asset. So Chinese residents and financial institutions have a strong demand for government bonds, and it is not a big deal for the Chinese government to issue new debts at a lower cost. Moreover, the Chinese government has huge state-owned assets that far exceed the outstanding government debt. Who would doubt the solvency of the Chinese government? The situation may be different if the Chinese government borrows a large amount of foreign debts, but its debts are mostly domestic, and the likelihood of a sovereign debt crisis is basically zero for China. Finally, China has plenty of room to further loosen monetary policy, and the central bank is the lender of last resort.
Third, the leverage ratio is a dynamic measure, the change of which depends on the change of outstanding government debt and GDP. There are two ways to reduce leverage, one is to cut the numerator and the other is to increase the denominator. The numerator is China's debt outstanding, and the denominator is GDP. From a dynamic perspective, the major means to reduce leverage is to increase GDP growth, through which China reduced its leverage in the past 20 years or so. In particular, from the late 1990s to the early 2000s, the improvement of China's fiscal status was mainly due to the increase in economic growth through expansionary fiscal policies.
In the first quarter of 2020, China's fiscal condition deteriorated sharply, with the fiscal deficit-to-GDP ratio and the outstanding government debt-to-GDP ratio both increasing significantly. Is this caused by the rapid increase of fiscal expenditure? The answer is no. In the first quarter of 2020, public revenue decreased by 14.3% year on year. Meanwhile, public spending fell only 5.7% from a year earlier. As a result, the fiscal deficit rose to 4.5% in the first quarter from 2.8% a year earlier. It is clear that the deterioration of China's fiscal condition in 2020 is not caused by the increase in expenditure, but by a rapid decrease in fiscal revenue. The main reason for the decrease in fiscal revenue is the slowdown in economic growth. Therefore, to improve the fiscal position, economic growth needs to be increased. Without economic growth, fiscal condition can hardly get improved. Further tightening of fiscal spending will only lead to a further slowdown in economic growth, leading to a vicious cycle of lower growth - higher leverage - further lower growth - and much higher leverage.
Currently China's priority is to increase economic growth rather than reduce leverage. It can wait to deleverage. In fact, almost all countries are now recklessly increasing their leverage. China, with a very favorable condition, is the most qualified to increase government leverage. There is no need to worry about the increase of leverage at this moment.
Fourth, although the leverage ratio of the Chinese government is low, leverage of Chinese enterprises is among the highest in the world. A significant proportion of China's highly leveraged companies are state-owned. Should the Chinese government therefore avoid sharply increasing fiscal deficit and the debt ratio? That many Chinese enterprises have high leverage is the result of poor management and lack of market exit mechanisms for zombie companies. However, it should be noted that due to the different national conditions, the leverage of Chinese enterprises should not be treated the same as that of enterprises in other countries. First, the main reason for the high leverage ratio of Chinese enterprises is that China’s stock market is still underdeveloped so corporate financing is excessively dependent on the credit market and the bond market. Second, many of China's large state-owned enterprises (SOEs) were starved of capital from the beginning. In fact, capital requirements for SOEs should have been largely different from those for private enterprises. Third, the rise in China's corporate leverage is also a result of the 4 trillion yuan stimulus package. Back in 2008, the central government didn't want the fiscal deficit to increase too fast, so the financing for infrastructure investment had been mainly done through local government financing platforms. I think infrastructure investment should be financed primarily through issuance of government bonds by the central government while fiscal deficits and government debt should be made explicit.
Fifth, high leverage in an economy is not necessarily a bad thing itself, which should be analyzed on a case-by-case basis. China has both a high savings ratio and a high growth rate, which makes high leverage inevitable: enterprises may not have enough capital of their own, but the household sector has plenty of savings; producers need to borrow from the household sector through the credit and bond markets. If producers do not increase their leverage, or in other words, governments and companies do not borrow from the household sector, household savings will not be mobilized. While households save to postpone consumption, the borrowing needs of government and enterprises match well with households' savings. Generally speaking, as long as high leverage is matched with high savings, it will not increase financial risk, but is necessary for achieving rapid economic growth. When demand is insufficient, expansionary fiscal policy will have the "crowding in" effect rather than the "crowding out" effect. Government-financed infrastructure investment will generate orders for a large number of related businesses, particularly small- and medium-sized enterprises (SMEs), because of which the output at those firms will increase, and their leverage will naturally fall.
Of course, with a well-developed stock market, China's leverage ratio can also be reduced holding other factors constant. If the Chinese government and enterprises carry a large amount of foreign debt, the financial risks will be huge. Fortunately, risks from China's external debt are manageable.
The general public tends to be quite wary of increase in government spending, especially the general budget spending. This is entirely understandable. While advocating expansionary fiscal policies, we must be highly vigilant against waste of fiscal resources, and resolutely resist all kinds of image projects or white elephant projects. For instance, local governments who have held expensive and pointless international conferences have already caused public discontent. Therefore, while implementing expansionary policy and increasing support for infrastructure investment, the government must stick to financial discipline and hold those who waste public funds accountable even after they leave office.
Before the outbreak of COVID-19, scholars had different opinions on the potential economic growth rate of China, whether China should adopt expansionary fiscal and monetary policies to stimulate growth, and whether China's fiscal deficit should exceed the threshold of 3%. It is now an indisputable fact that the lack of effective demand is serious problem to Chinese economy. We believe in order to stimulate economic growth, create jobs and fight the epidemic, the Chinese government will certainly adopt forceful expansionary fiscal and monetary policies, especially the former. We are fully confident in the outlook of China's economic growth.
