Abstract: Export has been an important driver of China’s economic growth in the first half of 2021. However, external demand may decline and it’s critical that China expands domestic demand to maintain growth. In the second half of the year, China should adopt more proactive fiscal policy focusing on infrastructure investment, and create a sound financial market environment for government debt financing with proper monetary policy. Implementing these expansionary policies to achieve higher growth will set the stage for solving long-standing institutional problems.
According to data released by China’s National Bureau of Statistics (NBS) on July 15, in the first half of the year, China scored a yoy growth of 12.7%, with a two-year average of 5.3%. In Q1, GDP increased by 18.3%yoy, with a two-year average of 5.0%; and in Q2, growth stood at 7.9%, and the two-year average, 5.5%.
How should we assess the growth numbers? Are they desirable outcomes? What could potentially repress China’s external demand in the second half of the year? Will the Fed maintain the loose monetary policy, and what are the implications for China? Against this backdrop, how can China stabilize and expand its domestic demand? Which should be the priority, maintaining growth or stabilizing inflation? What roles should fiscal and monetary policies play, respectively?
I. Is the current GDP growth rate a desirable one for China?
We need to examine this issue against the backdrop of post-pandemic recovery, and also put it in a bigger context.
In a quarterly view, China’s GDP growth has been on a downward ride since Q1 2010 when the figure was 12.1% and descended to below 6% in Q3-Q4 2019. This long-lasting decline was unprecedented. However, there is no sign that the trend will reverse anytime soon.
To what level will China’s GDP growth fall before it stabilizes? We think it should not fall below 6%.
There are two considerations. On one hand, it’s important that China’s growth stabilizes at a relatively high level, which will not only protect the wellbeing of the Chinese people, but also sharpen China’s edges in geopolitical competition. On the other hand, since the global financial crisis, inflation in China has generally stayed low, and the PPI has stayed in the negative territory for a long time. In addition, many of the other indicators such as employment, capacity utilization, jobs for college graduates and trade balances have pointed to the possibility that there may not be sufficient demand if growth stays around 6%.
Therefore, we could assume that China’s potential growth stands somewhere around 6%. During times when economic growth keeps tumbling, if expansionary policies are not introduced, growth will only dip further. It’s with this consideration that we propose that China needs to keep GDP growth at or above 6%.
With this analysis, how should we assess China’s growth in the first half of the year? Since the strong base effect from last year has made comparison harder and two-year average two-year average could only provide an approximate analysis, we need find a proper reference first.
Assuming China’s potential growth rate is 6% and taking GDP in Q4 2019 as a base level (at 100), we have estimated the quarterly yoy growth for 2021 as 19.1%, 8.3%, 6.7% and 5.5% respectively, and 9.57% for the whole year.
Only when the actual growth reaches the projected rate in each of the four quarters, can we deem the Chinese economy to have returned to the pre-pandemic trajectory (at 6%).We could compare the actual growths to the projections to determine whether the economy achieved the desired 6% growth rate, and make policy proposals accordingly.
According to data by the NBS, China had actual growths of 18.3% and 7.9% in Q1 and Q2 this year, both lower than the projections, i.e. 19.1% and 8.3%. This means if China’s GDP could not grow faster than the projected 6.7% and 5.5% in Q3 and Q4, then the annual growth would be lower than the potential rate of 6%, or the pre-pandemic level. In other words, growth will continue the downward trend since 2010.
If we convert the quarter-by-quarter growth numbers into annual rates, then in Q1 and Q2 this year China had a growth rate of 1.6% and 5.3% respectively. Then it is almost certain that the annual growth in 2021 will fall below6%. To be honest, while China has basically contained the virus and had its economy back on track, it has yet to reverse the continuous downfall of growth that started in 2010. If the trend goes on, we worry that in 2022 the Chinese economy will further decline.
II. China’s export will be under strain in 2H21
Export has undoubtedly been one of the most powerful engines driving the Chinese economy in the first half of the year. NBS statistics reveal that in 1H21 China’s export grew by 28.1% year-on-year, much higher than GDP growth even after excluding the price effect. On the strength of such thriving export, in 1H21 value added created by industrial businesses above designated scale in China reached 15.9% (at constant prices), also much higher than the economic growth at large.
However, in 2H21 or 1H22, China’s export may be less of a substitute for products in major economies like the United States and European countries when their production capacities recover as most of the populations become vaccinated.
The strong recovery of the industrial sector in China over the past year was partly attributed to the large supply-demand gap in the United States and European economies. On one hand, the loose policy environment and strong support provided to people in these countries helped maintain the demand at a relatively stable level; on the other hand, the pandemic has disrupted production and weakened the supply capacity of these countries. This widened supply-demand gap was the reason for China’s export surge. But the gap could begin to close in the second half of the year.
First, with massive vaccine rollouts, in 2H21 European countries and the United States will gradually recover their production and supply capacities. Labor participation in these countries will remarkably pick up (which may not necessarily be accompanied by decline in the unemployment rate though), thus closing the demand-supply gap. For example, in the United States, the per-capita disposable income reached a year-on-year growth of 6.5% in 2020, which was the fastest since 1989—even faster than in 2000.
With the strong support given to individuals and families, the United States has seen increasing reluctance to go back to work among its unemployed people and ongoing decline in the labor participation rate. However, the policy support will expire in September, more people are expected to go back to work, which will elevate labor participation and significantly improve supply capacity.
Second, on the demand end, the United States and European economies are not expected to implement policies as expansionary as those of last year. On June 24, President Biden voiced endorsement for the Bipartisan Infrastructure Framework and called on the Congress to pass the proposal, which intends to invest 1 trillion USD over the coming 5 years, much less than the original proposal of 2.3 trillion USD. At the same time, with inflation pressure mounting up recently, many countries such as the United States are caught up in a dilemma in monetary policy. As these countries gradually bring the pandemic under control, they are expected to marginally adjust macro policies accordingly.
Third, the recovery of demand in Europe and the US in the second half of the year will mostly take place in the service sectors and not in industrial products. Still in the US, despite of the American Rescue Plan, the expenditure on services in 2020 dropped by 7.3% yoy (at constant prices), the biggest contraction since the Great Depression in the 1930s.
Social distancing measures have taken a toll on service spending, while durable and non-durable goods managed to dodge the shock and the consumption went up by 6.3% and 2.6% respectively (at constant prices) in 2020, far above the average GDP growth.
If vaccines rollout and slow the spread of COVID-19, the recovery of consumption will mostly happen in the service sector. But given that service is untradeable goods, the recovery of demand in Europe and the US will give very limited boost to China’s export.
Fourth, China's import-substituting production will be adversely affected when Europe and the US reopen their factories.
The automobile engine is a good example. The growth rates of its import and export were -30.2% and 39.2% in 2020. Import substitution was significant. Business revenue of the industry hit 233.7 billion yuan last year, an increase of 420 billion from 2019, up by 19.7%. The industry had been in zero and negative growth since 2018 when the data were first available. Profits of the industry were increased by 15.0% in 2020, also better than the pre-pandemic level. However, the import and export of the product are expected to be severely affected by the recovery of global production.
When the pandemic comes under control and production fully resumes, (1) the demand for non-tradable sectors like the service industry will lead the next round of demand recovery worldwide; (2) China’s exports will be affected by narrowed demand-supply gap overseas; (3) currently active import-substitution production will be affected.
It is inevitable that China’s share of global exports will fall in the second half of 2021 or in 2022 from the current historic high. By then it will be harder for China to play as an export-substitution provider, which will halt the expansion of the industrial sector. In addition, recovery of industries will be differentiated, and the changes to global environment will bring shocks to demand and supply. Full vaccination coverage in China will help its service sector return to normal.
Therefore, domestic demand, especially the demand for services, will become the major growth engine in the second half of 2021.
III. How to sustain domestic demand?
To stabilize the economy and buffer export decline, China needs to prioritize domestic demand.
China has learned from the past the problems with over- dependence on overseas markets and unveiled a “dual circulation” strategy. Growth of export or trade surplus will no longer be policy goals, even if export continues to grow. To sustain employment and growth, China should focus on expanding domestic demand.
In 1H21, manufacturing investment grew by 19.2%, higher than the 12.6% increase of fixed asset investment. The growth of manufacturing investment has also been higher than that of real estate investment and infrastructure investment since this April. Even when excluding factors such as the weak base period of 2020 and PPI surge, there was still a jump in manufacturing investment in Q2, which is consistent with export increase as evidenced by data. For example, the import of mechanical and electrical products from Japan, and investment of the private sector is stronger than that of SOE.
In contrast, infrastructure investment has been weaker, showing a gradual month-by-month decline. The cumulative growth of infrastructure investment was 7.2% yoy in the first half of this year, but in May and June, it might have fallen into the negative territory. If taking into account the high PPI inflation, infrastructure investment is even weaker. This could be attributed to fiscal pressure of local government and shift in fiscal policy.
In addition, consumption has also contracted. In the first half of the year, the two-year average growth of total retail sales of consumer goods was 4.4%, with a significant gap from the pre-pandemic yoy growth of 7%-8%. Several factors caused the slowed growth, and the major ones include:
(1) Consumer’s expectation for uncertainty has been aggravated by sporadic cases of Covid-19.
(2) The savings rate has not yet dropped to the normal level. Most residents have to rely on savings to sustain the living standard during the pandemic. Before replenishing the savings account, they are not likely to resume to the pre-COVID-19 level of consumption.
(3) Income gap has been widened due to the pandemic. On the one hand, the ratio of per capita disposable income of urban residents to that of rural residents shrank in the first half of the year, indicating better income distribution. On the other hand, the average of urban disposable income constantly grows faster than the median, suggesting the proportion of people with high-income and high preference for saving was on the rise. With income staying the same, consumer spending of urban residents is bound to drop.
(4) Consumption of services was directly inhibited by the pandemic. While demand for industrial products can be easily met, its rise cannot completely offset the decline of spending on services.
Recovery of demand requires: first, increasing economic growth and people’s income; second, improving the primary and secondary income distributions and elevating the income of low-income groups; third, reducing the COVID-induced income uncertainty and enhancing consumer confidence through investment in infrastructure, especially soft infrastructure; and finally, speeding up the vaccination process and seeking a balance between pandemic control and convenience of mobility.
In addition, when analyzing future consumption, population aging cannot be ignored. Based on the life cycle theory, population aging leads to greater propensity to consume and lower saving rates. In reality it is not necessarily the case; Japan, as an exception, goes the opposite of life cycle theory. China is more likely to follow this theory with more consumption and less saving.
COVID-19 has elevated the saving rate and lowered the propensity to consume in China. Before its outbreak, per capita expenditure of urban household was over 60% of total income (average propensity to consume, APC). The number was 66% in Q4 2019. Since the outbreak, the APC has been lower than 60% most of the time, sliding to 57% and 60% in Q1 and Q2 of 2021. There was a rebound from the lowest point in 2020, but the number is still far below the pre-COVID level.
Although the life cycle theory does not necessarily conform to the economic reality China, by introducing certain policies, the demand of the Chinese elderly may be significantly increased. China could increase investment in infrastructure for the elderly, such as nursing homes, medical facilities, universities for the elderly, and more medical staff. These investments will boost demand of the elderly. In addition, tax reform would change the consumption behavior of the elderly. Furthermore, although population aging may curb consumption of goods, it will increase spending on services.
IV. It’s highly possible that the Fed will exit from expansionary monetary policy gradually and China should reduce the exposure to US financial risks
Rise of inflation in the US since the beginning of this year has aroused global concern. In his recent speeches, Fed Chair Powell predicted that inflation would stay at a high level in the following months and then the rise will slow down.
Against this background, when the Fed will tighten its monetary policy has caught global attention. When quantitative easing (QE) was adopted in 2009, the Fed's balance sheet expanded from about US$1 trillion to more than US$2 trillion. After that, the United States began to consider exiting from QE in 2010. Then there were rounds of debates and attempts. The Fed did not want to withdraw from QE until early 2014. Moreover, the withdrawal was only to slow down the pace of asset purchases. In fact, the expansionary monetary policy lasted for a while, and the Fed did not raise the interest rate until the end of 2015. At that time, the Fed's assets had reached US$4.5 trillion. It can be seen that the exit process can be rather tangled and complicated.
The Fed’s total assets dropped to US$4.2 trillion before the COVID outbreak after several years’ contraction, and then expanded rapidly to US$7.8 trillion in early 2021. With the rise in commodity prices and inflation expectations since the beginning of the year, the United States has again begun to discuss the exit strategy. But such discussions never brought any practical action. Instead of exiting the loose monetary policy, the Fed has rolled out more expansionary policy measures.
Now the Fed still maintains asset purchase of $120 billion every month. As of July 14, its assets reached US$8.25 trillion. Many expect the Fed to start to withdraw from QE at the end of 2021 or early 2022. But COVID has posed much uncertainty. We can only wait and see what the actual progress would be. In short, the Fed’s policy is very realistic and not bound by any dogma.
The US CPI was 2.6% in March 2021 and has risen month by month since then, reaching 5.4% in June, the highest record since August 2008. With the fear of an early withdrawal from QE, the yield on the 10-year US Treasury bond rose to 1.73% on April 5. However, considering the uncertainty brought about by the pandemic, employment, labor participation rate among other factors, the market believed that an early withdrawal would not happen. Although the US CPI has kept rising, the yield on the 10-year US Treasury bond fell back to 1.31% on July 15. Currently market expectation is that US inflation has peaked, but it may not fall soon. In addition, the Fed has adopted average inflation targeting. Therefore market worry over withdrawal from QE has dropped off.
US monetary policy will probably not change much in the near future unless something big happens. Even if there are policy changes, the change will be moderate and gradual. The focus of the world economy will still be controlling the pandemic and promoting global recovery.
In this context, the Fed’s exit from quantitative easing is likely to be gradual and will not bring a shock on global finance and economy for the time being. However, the Fed has implemented ultra-loose monetary policy for more than ten years, so the withdrawal is only a matter of time.
The exit will start from reducing the purchase of Treasury bonds and mortgage-backed securities (MBS); then the Fed will stop buying the bonds and securities; and in the end, it will sell the bonds and MBS and hold the securities till maturity. Other measures to normalize monetary policy may include increasing the reserve ratio, raising interest rates on excess reserves, and strengthening repo operations. All policy measures related to the withdrawal from QE will cause interest rates to rise.
But the US government debt is huge. Since the outbreak of COVID-19, the US government has launched an extremely expansionary stimulus plan. In 2020, the US federal fiscal deficit was US$3.1 trillion and the deficit ratio was 14.9%. The deficit ratio of 2021 is expected to exceed 10%. According to a prediction by the US Congressional Budget Office (CBO), the ratio of US federal debt to GDP in 2023 will exceed the historical peak of 106%.
Under this circumstance, how can the United States withstand the substantial increase in interest rates? If the Fed does not exit from QE, inflation may get out of control; however, US Treasury bond financing will be difficult when exiting happens. How will the US government respond to the dilemma? Will it damage the interests of other countries?
China, as the United States' second largest foreign creditor and largest source of trade deficit, must take precautions and be fully prepared for any possible situation.
In the short term, China should reduce trade surplus with the US by stimulating domestic demand. Efforts are needed to ensure a free floating exchange rate, strengthen and improve the management of cross-border capital flows, and diversify overseas assets.
In the long term, China needs to accelerate its economic reform, strengthen the protection of property rights, improve laws and regulations, optimize the allocation of overseas assets, and actively participate in the formulation of rules of important financial institutions. In short, China should minimize the exposure to US financial risks.
V. China is not faced with excessive inflation
The rising inflation in the United States has triggered concerns about imported inflation in China. Chinese economists have been very sensitive to inflation. Every time CPI rises, they would worry. But this tendency is open to question.
For example, before the end of 2010, China started the withdrawal from the 4 trillion yuan stimulus program. One of the important reasons why we hurriedly "exited" is the rise in inflation. In May 2010, the year-on-year growth of PPI reached 7.1% and CPI 3.1%. The increase in the inflation rate at that time was the result of the base effect to some extent, and we were too afraid of a CPI exceeding 3%. With the increase in CPI growth, the People’s Bank of China made a statement in early 2011 that the primary task of macro-control is to maintain stability of the overall price level. In March 2012, China’s PPI witnessed negative growth, and it lasted for 54 months. For a considerable period of time, China’s economy was actually in a state of deflation.
In fact, China should tolerate inflation levels higher than 3%. However, in a rapidly developing country like China, due to wage rigidities, the downward price rigidity is relatively strong. While the prices of some products have risen, the prices of other products may not fall consequently or fall insufficiently. Therefore, changes in relative prices often lead to upward changes in the overall price level. If the monetary authorities of Japan and the United States set the inflation target at 2%, China should set the target higher.
From the changes of CPI and PPI, we can see that in the past ten years, PPI has been in a state of negative growth for most of the time. CPI growth is below 3% most of the time. In the last ten years, China’s main problem is not the risk of high inflation, but the curbed economic growth under the fear of inflation.
Recently, a notable feature of the Chinese economy is while PPI has risen sharply, CPI has remained at a fairly low level. Except for the excessive hoarding of bulk commodities, increases in PPI in China are generally a positive sign. Under the current situation, what China should worry about is not the increase in PPI, but the fact that the increase in PPI cannot be converted into an increase in CPI. The profitability of downstream companies of many different sectors is under pressure, which has a negative impact on consumption and investment, and economic growth as well.
China should take further measures to expand employment, boost income confidence and stimulate effective demand so that downstream companies can further transfer the increased costs. The weak domestic demand at present has hindered the transmission of PPI of production materials to PPI of means of subsistence, which in turn hindered the transmission of PPI growth to CPI growth.
Inflation itself is of course a crucial issue. However, to China, maintaining growth is more important than curbing inflation, especially in the context of China-US competition where ensuring stable growth has its special significance. Of course, this is not to say that we must encourage growth regardless of approaches, but we should not deliberately limit the space for growth.
We agree with the mainstream view that inflation is not yet a threat to the Chinese economy. At present, inflation, which is mainly manifested as an increase in PPI, is caused by supply-side shocks. It is more of a structural problem. PPI may have reached a periodic high, and it is expected to drop at some point in the future. If the increase in PPI is transmitted to the final consumer, CPI will also rise. However, at the moment, China is not facing the threat of excessive inflation and an annual CPI inflation below 3% won’t see any risk.
VI. More active fiscal policy should be adopted in the second half of the year; monetary policy should create a more desirable financial environment
The Chinese economy needs to cultivate new growth drivers. In the long run, reform measures should be adopted to improve income distribution and promote the development of emerging industries. In the short term, macroeconomic policies, especially fiscal policies, can play a greater role.
In the years before the COVID outbreak, China’s efforts to cut taxes and fees were faced with intensive pressure, and in 2020, China’s public finance was under pressure again due to reduced revenue. Since the beginning of the year, public finance has generally shifted to stabilizing the tax burden. Fiscal expenditure of the first five months accounted for only 37.4% of annual budgeted expenditure, while fiscal revenue reached 48.8% of the budgeted amount. Fiscal expenditure growth is significantly lower than growth of revenue. The difference between the growth rates of the two is also the highest in many years.
In the second half of the year, fiscal policy should be more active to unlock the potential of fiscal space. Fiscal funds should not be squandered, and flexible policies tailored to specific situations should be adopted. One solution may be to delegate powers to lower levels, and improve the incentive mechanism. While local governments are facing high fiscal pressure, the central government can play a greater role. Compared with other major economies, China has sufficient fiscal policy space.
From Jan to May, China completed 37.4% of budgeted expenditure for the year. In the second half of the year, China should speed up spending, especially to stabilize the growth of infrastructure investment, so it won’t become a drag on economic growth.
Fiscal authorities should design government bonds from the perspective of building financial infrastructure and big finance. At present, the central government can use government bonds as a major instrument to resolve fiscal difficulties. It is essential to strengthen the incentive mechanism of local governments and enterprises, and improve the government bond market so that government bonds can play their due role. In other words, the adoption of an expansionary fiscal policy requires necessary support measures.
At the same time, monetary policy should curb the yield of government bonds, providing a more desirable environment for government bond financing, and alleviate the crowding out effect caused by fiscal policy. In fact, the crowing out effect will remain relatively weak as the uncertainty brought by the pandemic still persists.
Many economists believe that there are deeper reasons for China's economic slowdown as China has adopted loose fiscal and monetary policies for many years, but economic growth has kept declining. If institutional and income distribution problems are not resolved, expansionary fiscal and monetary policies will not take effect, or even backfire. There are indeed institutional and structural reasons behind the sluggish demand. Without solving these problems, it will be difficult for the economy to maintain growth. It is true that without the reforms carried out after the Third Plenary Session of the 18th Central Committee of the CPC, the rapid economic growth in China would not have taken place. However, China’s rapid growth would not be possible without the subsequent timely macro-control policies.
Economists' concern about the relatively lagging performance of supply-side structural reforms is completely understandable. We believe that implementing expansionary macroeconomic policies and promoting faster economic growth will create favorable conditions and buy more time for solving those long-term institutional problems.
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