Abstract: In this paper, the author points out that China’s economic recovery is not only uneven and unstable, but also faces shocks from two “grey rhinos”, i.e. change in the external environment, and domestic economic disparities compounded by regional financial risks. He cautions against over-optimism, and suggests speeding up fiscal expenditure and expanding social financing and credit in Q3 and Q4.
I want to talk about some concerns over China’s economy in the second half of 2021.
Acceleration of global economic recovery has infused the world with optimism. A strong bullish sentiment on the Chinese economy is also found among domestic researchers.
While I welcome this optimism, I must caution that we do need to prepare for worst-case scenarios. As President Xi Jinping repeatedly stressed, the world is in the midst of changes that have not been seen in a century, and the next round of structural transformation could be right around the corner. We must understand how we arrived to where we are today and chart a clear path ahead. If we only focus on economic numbers without a big picture in mind, we would fall into the trap of short-term thinking.
There are three main pillars that support China’s economic recovery:
The first pillar is “a basket of extraordinary stimulus”, which not only include “special government bonds” and “direct fiscal transfers to local governments”, but also measures to ensure 6 priorities (job security, basic livelihood, businesses sustainability, food and energy security, stable supply chains, and smooth operation of government) and stability in 6 key areas (employment, finance, foreign trade, foreign investment, domestic investment, and market expectation). Market operations tend to bring certain negative impacts, that’s why governments typically refrain from adopting such extraordinary measures during regular economic downturns and instead rely on administrative means to ramp up the intensity and effects of stimulus. But in special times, however, these measures can have special stimulating effects.
The second pillar is a stronger-than-expected upturn in trade. Since the second half of 2020, the biggest contributor to GDP growth has been external demand.
During this global pandemic, China has provided the most stable and fast supplies for the world. This has dramatically boosted China’s export and drawn back foreign investments that were thought to be pulling out of China.
Against this backdrop, many export-oriented sectors and those involved in coping with the pandemic have not been hit hard by the pandemic, but instead achieved a great upturn in profits. Many export companies, especially those mainly export medical supplies, as well as businesses that serve the stay-at-home economy, generated enormous profits in the last year which were higher than the profits from the previous 5 or 6 years combined.
The third pillar is the sustained growth of the housing market. Since the second half of last year, the real estate sector has maintained a sound operation with a 7.0% increase of fixed asset investment and an 8.7% rise of revenue. The sector has not been affected by the pandemic, but seen a 2.2 percentage-point increase of sales growth. During the global pandemic, real estate has been the best-performing sector. Housing prices are surging and property investment is rising, not only in China, but also around the world.
How these three pillars will change in the second half of 2021 is a question worth study.
Currently, China has withdrawn from the extraordinary stimulus policies. This does not simply mean reining in the massive amount of stimulus but also withdrawing some extraordinary measures, such as canceling special anti-pandemic government bonds, financing guarantee fund for SMEs and discount loans. Last year, in our China Macroeconomic Analysis and Forecast Report (2020-2021), we pointed out that the first step should be to phase out some of the extraordinary measures and replace them by conventional expansionary policies, and the next step is to shift from an expansionary macroeconomic policy to one that is more prudent.
Seen from current fiscal expenditure and the growth rate of money supply, China has already taken both steps.
It is crucial to take the first step because extraordinary measures that last too long will have a huge impact on the market order. Every medicine has its side effect, and any large-scale stimulus will leave after-effects, so these extraordinary policies must be withdrawn. But does this mean completely withdrawing the expansionary monetary and fiscal policies? This is a key question that we need to think about.
To answer this question, we need to look at two factors: 1) whether China’s economic growth has returned to normal with output gap close to zero; 2) whether the drivers of economic growth have normalized and could maintain stable in the short-to-medium term?
Data on the current level of employment rate and core CPI show that China’s actual output has not returned to the trend line and a negative output gap still exists; more importantly, from the perspectives of the three main pillars, the economy still faces the challenges of unstable and imbalanced development, and in particular, the shocks from two “grey rhinos” that could cause systemic changes.
The first “grey rhino” is systemic changes of China’s external environment at the end of this year or the beginning of next year.
First, recent developments may cause the US to change its monetary and fiscal policies, possibly in September, which will significantly affect global liquidity and financial environment.
Second, despite uncertainties in how the pandemic will evolve, the world economy is recovering faster than expected. The global supply chain will also recover faster than expectation, which will help ease the mismatch between global demand and supply.
Third, the US’ containment strategy towards China is advancing faster than we expected, which is likely to put more pressure on China’s economy.
Fourth, in the second half of 2021 and the beginning of 2022, China-US Phase 1 trade agreement will expire and the negotiation over a Phase 2 deal will start. Early on many people were optimistic about reducing the tariffs. However, if China doesn’t have the bargaining chips to ease the hardline political stance of the US, there will be tough battles to fight.
Fifth, after the pandemic, countries around the world will step up the adjustment of supply chains, industrial chains and innovation chains, which will significantly change global division of labor and the trade landscape.
The current boom of foreign trade has painted us a rosy picture of China’s economic recovery, but the situation can be easily reversed. If China doesn’t work to expand domestic demand in advance, once the external environment changes, the country’s output gap and overcapacity problem might be even worse than in 2019.
The second “grey rhino” is rising regional financial risks amid widening regional economic disparities. We have been watching closely local financial risks for years. In 2014, we paid great attention to the surge of local government debt and implicit debt, but in fact not much progress has been made in solving the problem.
Why will this problem become the second “grey rhino” in the latter half of the year?
One important reason is that the Chinese economy faces huge regional disparities. In addition, local debts also show a strong regional feature and are expected to reach a new high.
How to solve the local debt problem? I think now is the best time for action. We must push forward the reform of local state-owned enterprises, financial systems as well as fiscal and taxation systems in the coming years. This reform might help us rid of the potential risks. This is what we need to pay attention to in the second half of this year and next year.
In summary, the first “grey rhino” will reverse the expansion of external demand, and the second will erode the capacity of many local governments to drive economic recovery under the shock of financial risks. Therefore, the outlook of China’s economic recovery is not completely positive as optimists expect.
Equally important, we should attach equal importance to this year’s implementation of new strategy and new development pattern. Future recovery and growth call for a new economic circulation system, new growth drivers and transformation of strategic models.
To achieve these transformations, an incentive mechanism that aligns with the new development pattern should be established.
Current fiscal expenditure data show that local governments and relevant departments are not highly motivated to implement the transformations. Many regions have failed to identify or are unwilling to take on high-quality projects. There still lack effective mechanisms for enhancing sci-tech self-reliance, new infrastructure and new technology development, and industrial and supply chain self-sufficiency, which may hinder domestic demand expansion.
Therefore, we might face the following issue: withdrawing extraordinary policies is important, but it does not mean phasing out all expansionary policies.
If we tighten policies too much, we might face the following challenges:
1. It will be difficult to cope with unexpected external shocks. We will be unprepared if domestic demand is overly subdued and there is sudden change in external demand.
2. It will be difficult to create a favorable environment for deepening reform.
3. It will be difficult to provide fiscal support for the implementation of the new development strategy and create the conditions needed for the upgrade of domestic circulation.
4. Some of macroeconomic data are illusionary and not sufficient to support policy tightening.
5. We should not worry too much about inflation. It is, to a large extent, a structural problem and related to people’s livelihood, and has not become a medium-term macro issue.
Therefore, in my opinion, fiscal expenditure should speed up in Q3 and Q4 of 2021, especially in Q3; as for monetary policy, social financing and credit should also be expanded.
The reasons are simple. China’s economic recovery is not only uneven and unstable, but also faces shocks from the two “grey rhinos” mentioned above, i.e., changes of the external environment, and economic disparities among regions and local financial risks. Besides, China has to compete with the US and push forward the new development pattern. Therefore, policies in the near-term should be loose rather than tight.
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