Abstract: Insufficient demand would be the key challenge facing the Chinese economy for some time to come. In this paper, the authors put forward eight policy suggestions on how to effectively boost domestic demand.
Since Q4 2021, the negative impact of supply shocks on the economy has subsided, and insufficient domestic demand has become the most serious challenge to China’s economic growth at present and for some time to come.
Analysis of multiple scenarios shows that economic growth is still at risk of stalling in 2022.First, measures to prevent and control the pandemic can hinder economic recovery in 2022, as it is difficult for consumption of services to return to normal. Second, the real estate industry faces the dual challenges of long-term adjustment and short-term liquidity pressures, and it is inevitable to see a sharp slowdown in real estate sales and investment, the impact of which will be felt by not only the upstream and downstream industries, but also the credit expansion of the whole society. Third, the contribution of exports to economic growth has declined. Since the peak time of global economic recovery was gone, and considering the high base effect, it is inevitable that the export growth will decline sharply this year.
Aggregate demand management policies require a new mix of policy tools to expand domestic demand while avoiding the side effect of previous stimulus policies. The main problem of the 4 trillion stimulus program is not the adoption of stimulus packages in the face of insufficient demand, but the lack of appropriate monetary and fiscal policy tools and the excessive investment expansion by local governments, state-owned enterprises and financial systems. The wrong way of providing stimulus led to the sequelae of hidden debt risks of local governments, systemic financial risks, and the rapid rise in leverage ratios.
China can achieve economic growth goals and reduce those side effects by relying on standard monetary and fiscal policy and policy-based financial instruments and reducing over-reliance on local government financing platforms. Specific suggestions are as follows.
First, lower interest rates by 25 bps each time until the employment target and desired economic growth rate are achieved. A clear trajectory of interest rate adjustment can show to the market the authorities’ determination to stabilize growth and the path to achieve it.
There are three advantages of using interest rate adjustment to promote demand growth. First, interest rate adjustment can realize credit expansion through channels such as reducing the cost of borrowing, improving asset valuation, and strengthening the balance sheet, which is essentially tapping market potential to increase investment and consumption. Second, it can guide market expectations and help create synergy between market and policymakers for achieving steady growth. Third, it is fairly flexible, open to timely adjustment, and sees little side effects.
As of the first half of 2021, the debt of government, businesses (including platform companies) and the household sector in the country was73 trillion yuan, 171 trillion yuan and 67 trillion yuan respectively. Only from the perspective of debt cost, a 100bp drop in the interest rate can save about 3 trillion yuan of interest expenses for the three sectors, which can strongly support investment and consumption.
Judging from developed countries, the United States and the euro zone have gradually achieved their employment and economic growth goals after sharply reducing interest rates. In Japan, although the loose monetary policy adopted by the Abe administration did not help achieve the 2% inflation target, it still enabled the country to enjoy the longest cycle of economic prosperity since the late 1980s.
There are concerns that interest rate adjustment can causes increases in asset prices. However, this is not necessarily detrimental to the real economy. Asset price increases can support consumption through the wealth effect and investment through the valuation effect, both of which could contribute to the expansion of aggregate demand.
What needs to be worried about is that excessive leverage may be created in the process of asset price rises and will bring about asset price bubbles. Macro-prudential policy measures can be implemented to address the issue, instead of abandoning interest rate policy tools.
Second, support unprofitable public and quasi-public infrastructure investments with new-type of bonds and policy loans with fiscal subsidy.
Achieving an economic growth rate of 5.5% and higher requires growth of fixed capital formation at no less than 4.5%. In the context of a significant downward adjustment in real estate investment, the growth rate of infrastructure investment cannot be lower than 10%.
Infrastructure projects with better returns can be financed through special bonds. The issuance of special bonds has rapidly expanded in recent years and can well support such projects.
Projects of water conservancy, environmental protection and public facilities account for half of the total infrastructure investment, and the proportion of such investments is expected to rise further along with urban development. These projects generally have low cash flows, making them difficult to access financing from the commercial financial system. Discount bonds and policy loans supported by fiscal subsidies at a level of 2-3 trillion yuan can be used to support such infrastructure construction, an approach that can greatly reduce financing costs, enable rational project planning, and reduce the reliance on local financing platforms which borrow from commercial financial institutions at high costs.
Third, introduce market-based interest rates for housing mortgage loans, reduce the debt burden of the household, adopt city-specific policies and levy a temporary transaction tax to curb the sharp rise of housing prices in some cities.
Currently residential mortgage loans exceed 50 trillion yuan, and every 1 percentage point drop in the interest rate reduces the debt service expenditure of the household sector by about 370 billion yuan each year.
Compared with developed countries, the interest rate of personal housing loans in China is at a fairly high level. From 2008 to 2021, the average interest rate of personal housing loans in China fell in a range of 4.34% to 7.62%; in the same period, it was 1.09% to 4.84% in Germany and 2.28% to 4.83% in the United States. This is a result of the lack of market competition in interest rates. According to what happened in the developed countries, by launching market-oriented interest rate reforms, the interest rate of personal housing loans is expected to reduce by 1.2-1.5 percentage points, and the household sector can save 450 billion-570 billion yuan in debt service each year.
The decline in policy interest rates and market-oriented reform of home loan interest rates may drive housing prices to rise in some large cities. To curb the possible increases in home prices, the medium and long-term strategy is to effectively increase the supply of homes, especially the supply of affordable housing and homes in metropolitan areas; the short-term strategy can be the temporary introduction of a sufficiently high transaction tax.
Revenue from the transaction tax can be used to support the construction of affordable housing. This temporary tax can be adopted in certain areas, so it is a targeted measure and can avoid giving a blow to areas where there is no upward pressure on housing prices.
Fourth, turn some inventory of real estate companies into affordable housing, so as to resolve the risk of excessive debts.
The real estate market is one of the key factors determining whether the economy can stabilize in 2022. The real estate sector is linked to mortgage loans, revenue of local governments from land sales and the loans of local government platform companies. It is the core sector supporting China’s credit expansion, so stabilizing the real estate sector is crucial to China’s macroeconomic stability.
In the early years, the housing sector went through rapid growth, but significant changes have since taken place in the economic and policy environment. Now the sector sees a need for adjustment, and should strive to achieve a smooth transition.
Currently, it faces the risk of excessive downward adjustment. A large number of real estate companies are over-indebted and find it difficult to get out of the predicament. Even if the regulatory authorities take measures to help alleviate the liquidity difficulties of real estate companies, it is far from being enough to help the sector return to its normal operating trajectory.
The reason why real estate companies are generally over-indebted is that, in addition to their own excessive expansion, they are required by local governments to hold a large number of supporting facilities such as commercial buildings, office buildings, hotels, and industrial parks. These assets are large in scale and generally lack of one-time cash returns. One way to revitalize this part of the asset is allowing suitable projects to be transformed into affordable housing.
Fifth, set up a special fund to compensate market entities that have suffered losses from measures to prevent and control the pandemic, and offer them support to resume operations.
The government can set up a special fund to cover expenses for vaccination, COVID-19 testing, quarantine, medicine R&D and production. The government should formulate compensation measures for market players who have suffered from the measures to prevent and control the pandemic and inform the market players about it in advance so as to improve confidence for investment and operation. It is also suggested to develop a financial support plan for start-ups to help small and micro enterprises resume operations.
Sixth, offer a one-year temporary income subsidy for disadvantaged families.
During an economic downturn, vulnerable families are the first to suffer. Temporary subsidies for low-income groups, such as the elderly and infants can protect people's livelihood and help boost consumption.
A common concern is that subsidies will become people’s savings rather than consumption. If this is the case, the subsidies won’t bring pressure on inflation, so the policy cost will be rather low.
Seventh, avoid the practice that local government financing platforms secure financing from commercial financial institutions for infrastructure investment.
The main lesson of the 4 trillion yuan stimulus package is not a the adoption of stimulus packages in the face of insufficient demand, but the excessive use of investment expansion by local governments, state-owned enterprises and the commercial financial system while standard monetary and fiscal policy tools were neglected.
Although this way of stimulating the economy achieved results rapidly, its shortcomings are also very prominent, including the high financing cost from the commercial financial system, and the mismatch between the term structure of loans and investment projects. With soft budget constraints, local governments often excessively use such policy tools, and the regional distribution of investment projects is inconsistent with the flow of population and industries.
These deficiencies will inevitably lead to excessive borrowing and bad design of projects, and form a large amount of hidden debts of local governments and nonperforming loans. While excessively increasing the leverage ratio, it can threaten the stability of the financial system.
Eighth, let the exchange rate fully play its role as a stabilizer.
With upcoming interest rate hikes by the Fed and the downward pressure on China's economy, the country may face pressure from capital outflow and RMB depreciation this year. In this case, monetary authorities are suggested not to intervene in the foreign exchange market and have the yuan to depreciate freely, which can help boost demand and economic growth. Different from other emerging market economies, China is highly competitive in export, which determines that the RMB exchange rate will not fall relentlessly. Past experience shows that the less intervention in the market, the less expectation for unilateral movement of the currency there will be, and the more conducive it is to stabilizing capital flows.
This article was first published on CF40’s WeChat blog on February 10, 2022.
