Abstract: Currently, market entities in China are facing triple challenges, i.e., repeated outbreaks of the pandemic, insufficient demand, and policy uncertainty. It is hard for market entities to fight the triple challenges on their own. Policy adjustment is needed urgently, with the aim to improve the cash flows and balance sheets of market entities, boost market expectations, and expand endogenous market demand. If these measures are not enough, infrastructure investment needs to play a more active role to ensure that aggregate demand remains at a reasonable level.
Multiple factors such as repeated outbreaks of the pandemic, insufficient demand, and policy uncertainty have posed severe challenges to the 150 million market entities in China, especially for SMEs and self-employed individuals.
Economic policies need to adapt to the changing situation and make timely adjustments to ensure the stable operation of market entities, which will help stabilize not only the economy and employment but also preserve the foundation of future economic development.
I. THREE MAJOR CHALLENGES FACING MARKET ENTITIES
Currently, market entities in China are facing three major challenges.
The first is the repeated outbreaks of Covid-19 pandemic. Since mid-March, multiple outbreaks have occurred, adding to the pressure on many cities to rein in the pandemic by adopting stringent control and social distancing measures. As China’s most economically active regions, the Yangtze River Delta and the Pearl River Delta face more severe situation in this round of outbreaks. Service sectors including catering, entertainment, tourism, and airlines have been hit particularly hard. Data from the service app Meituan show that since mid-March, 2022, the number of operating stores in the catering sector has fallen by 50 percent and their revenue down by over 70 percent. Since mid-March, China’s box office revenue has dropped by 60 percent compared with the same period in 2021. In addition to the service sector, the industrial and agricultural sectors have also felt the impact. Some companies related to energy and chemical, steel, and export are facing the challenges of declining efficiency in cross-provincial logistics and increased difficulty in production scheduling, while some livestock farming companies find it hard to solve the problem of slow transport of feed.
The second challenge is insufficient demand and its impact on sales revenue and operating profit of firms. The weak demand has two causes. On the one hand, the market’s endogenous demand is not strong enough. On the other hand, policies that support demand expansion are not robust enough. The main forces that boost demand come from the balance sheet expansion of households and businesses, mainly in the forms of growth of mortgage loans and credit, respectively. In February, China’s new household loans reached -337 billion yuan and witnessed the largest fall since data became available, which is a very rare phenomenon. It means that households have started to deleverage and reduce their balance sheet. As for the business sector, companies’ willingness to borrow is generally low. This is especially the case for private enterprises due to the high costs of debt service, meagre profits from investing in traditional industries, and policy uncertainty associated with investing in new industries. Excluding platform companies, credit expansion in the corporate sector has declined dramatically over the past decade.
Given the weak demand, government needs to adopt policies to expand demand. In the past, policies boosted demand mainly through increasing local debt and loosening regulations on the real estate sector, while budgetary fiscal spending and interest rate cuts were only secondary choices. Currently the demand curve of the real estate market has passed the inflection point, balance sheets of real estate companies will shrink in the long run. Therefore, even if regulations on the real estate sector are loosened, the sector will still play a less important role in supporting aggregate demand. As local financing platforms need to rein in hidden debt, their support for demand is also declining. In this case, on-budget fiscal expansion and interest rate cuts need to play a bigger role in stimulating demand. So far, the growth rate of on-budget fiscal spending has remained roughly at the average level during the three years before the pandemic. The 10-basis-point cut to the interest rates and less than 10-basis-point cut to the depository-institutions repo rate (DR) demonstrate that the monetary authority is not willing to reduce rates significantly.
The third challenge is the market’s concern over policy uncertainty. As the Chinese economy is shifting from manufacturing-driven to service-driven, scientific research, education, medical care, sports and entertainment, professional services, high-end manufacturing, etc. can serve the need of industrial and consumption upgrading, have great growth potential, and will be the main sources of job creation in the future. Some segments of these industries have attracted great attention from the capital market and a considerable amount of venture capital, which has helped create many star private firms. Along with their growing scale and influence comes the regulatory challenges of addressing illegal and non-compliant behavior. One reason for the dive of Chinese stocks listed overseas in recent years is investors’ concerns about the uncertainty of future regulatory policies.
II. MACRO POLICIES SHOULD FOCUS ON ADDRESSING THE CONCERNS OF MARKET ENTITIES
It is hard for market entities to fight the triple challenges on their own. Policy adjustment is needed urgently, with the aim to improve the cash flows and balance sheets of market entities, boost market expectations, and expand endogenous demand of the market. If these measures are not enough, infrastructure investment needs to play a more active role to ensure that aggregate demand remains at a reasonable level. China has ample policy leeway to address these challenges.
Multiple policy instruments are needed to expand the endogenous market demand.
First, offering compensation to market entities who suffered losses due to pandemic control to help them resume operation. We should improve and step up measures to compensate market entities for their losses during pandemic control through advance notification so as to bolster their confidence in investment and operation. Financial support plan should be set up to help SMEs resume their businesses.
Second, lowering interest rates. The market should be clearly informed that policy interest rates will continue to be lowered by 25 basis points each time until economic operation maintains highly active for over two quarters in a roll. The role of rate cuts is to reduce firms’ interest burden and increase their asset valuation. Given that the debt of China’s market entities in various forms is around 200 trillion yuan, reducing rates will help improve the enterprises’ cash flow significantly.
Third, anchoring market expectations with regard to regulatory policies. Unlike the manufacturing sector, the service sector poses more regulatory challenges given more information asymmetry between the supply and demand sides. Regulations should leave the market more space for trial and error and ensure that problems are addressed along with the growth of the industry instead of completely wiping the industry out when problems arise. Before the introduction of regulatory policies, opinions of all stakeholders should be solicited to take into account all the possible policy outcomes. Accountability mechanisms should also be set up for regulatory authorities and policies.
Fourth, preventing the real estate market from excessive decline. The stability of the real estate market is critical not only to the upstream and downstream players in the market, but also to the expansion of credit and purchasing power as well as the cash flows in the whole society. To stabilize the real estate market, we should adopt multiple measures such as lowering the interest rate on mortgage loans, making better use of the sunk assets of real estate companies, and supporting the construction of subsidized housing, on the basis of “one city, one strategy” principle, so as to improve the balance sheets of real estate companies.
In the short term, the measures above may not be adequate to turn the situation around. Therefore, infrastructure investment by the government is still a powerful tool to boost aggregate demand and enhance the cash flow of the society.
However, we should avoid the traditional way in which local government financing vehicles (LGFVs) raise funds from commercial financial institutions. The main lesson from the 4 trillion yuan stimulus package in 2008 is not the adoption of such packages in the face of insufficient demand, but the excessive investment expansion by local governments, state-owned enterprises and the commercial financial system. The approach has obvious shortcomings, including the high financing cost from the commercial financial institutions, the mismatch between the term structure of loans and investment projects, the tendency of local governments to abuse this policy tool under soft budget constraints, and the inconsistency between the regional distribution of investment projects and the flow of population and industries. These deficiencies will inevitably lead to excessive borrowing and bad design of projects, create a large amount of local government hidden debts and nonperforming loans, excessively increase the leverage ratio, and threaten the stability of the financial system.
Instead, we should rely on government discount bonds and policy-based loans to support infrastructure investment. Infrastructure projects with high returns can be financed through special bonds issuance. In recent years, the scale of special bonds has been growing rapidly, which can satisfy the financing demand of these projects. Construction projects of water conservancy, environment and public facilities now account for half of the total infrastructure investment. With the development of China’s cities, investment in these projects is expected to gain a larger share. However, such investment projects usually have low cash flows, making it hard to get funds from the commercial financial system. The support of 2- to 3-trillion-yuan government discount bonds and policy-based loans can sharply reduce the financing cost of these infrastructure projects, improve the layout of the projects, and diminish the after-effects of over-reliance on local government financing platforms to raise costly funds from commercial financial institutions.
This article was first published on CF40's WeChat blog on March 31, 2022. It is translated by CF40 and has not been reviewed by the authors. The views expressed herein are the author's own and do not represent those of CF40 or other organizations.
