Introduction: China’s exchange and the stock markets have experienced large fluctuations recently. The People's Bank of China announced a 1 percentage point cut in the reserve requirement ratio for foreign exchange deposits in financial institutions on the evening of 25 April and called for stabilizing capital market expectations before the bell on 26 April. Meanwhile, major deployments to stabilize growth, such as infrastructure layout by the Central Finance and Economics Commission and the pro-consumption documents issued by the State Office, have released positive signals. On the 27th, USD/CNY, USD/CNH, and the three major stock indexes rebounded, with Shanghai Composite Index closed up more than 2%.
However, the market is more concerned about what triggered the sharp fluctuations in the currency and stock markets. How will the economic growth be in Q2 and the year 2022? What should the next macro policy be in regard to the zero-covid policy?
To answer these questions, Li Xunlei, Academic Committee Member of Shanghai New Finance Institute (SFI) and Chief Economist of Zhongtai Securities Co Ltd, gave an in-depth analysis in an interview with CF40.
Q1: What caused the volatility in China’s currency and stock markets?
Li Xunlei: Several unexpected factors this year have made the market weaker. For the current decline in forex and stock markets, there could be two explanations.
First are external factors, namely the Russia-Ukraine conflict and the tightening of the Fed's monetary policy. The conflict was a black swan event that led to rising prices of commodities such as crude oil, natural gas, and food, pulling up global inflation. It was believed that commodity prices should peak and fall back this year against the backdrop of Fed’s hikes, but the geopolitical conflict caused an even higher surge, which in turn forced the Fed to further tighten its policy, so the hikes also exceeded expectations.
For example, Powell explicitly proposed "front-end loading" hikes on the IMF annual meeting last Thursday. The Fed's monetary policy had always been largely behind the market curve. This sudden policy shift, along with Powell’s praise for former Fed Chairman Volcker (1979-1987) for his contribution to the fight against inflation – Volcker's severe austerity against the great inflation in the 1970s and 1980s – has raised market concerns about the next phase of the Fed's policy, that it will not only raise rates and taper, but may also further increase the intensity of hikes.
The market now expects a 0.5 percentage point rate hike in May, a possible 0.75 percentage point hike in June, and a possible increase in the federal funds rate to 2.5% during this year. If interest rates are raised at such a pace, I think it will inevitably cause a sharp drop in asset prices, because markets are sensitive to rates; especially when the US capital markets have long been in a low-rate environment, a sudden sharp hike is more likely to trigger panic. At the same time, the US dollar index rose, and currencies fell accordingly, also leading to a slide in USD/CNY. The devaluation of RMB dragged Chinese asset prices down through the expectations of capital outflows.
From a domestic perspective, the fluctuations were mainly caused by the spread of the COVID-19 in many places. Because the transmission coefficient of Omicron is extremely high, with some mutant strains having an R0 (basic reproduction number) close to 10, there is concern about whether the virus can be contained, and if must be controlled, there will be more and more areas under blockade for a longer time, which will be detrimental to the industrial chain and supply chain, the operations and production of enterprises, and more significantly in the service sector.
The capital markets have receded out of concern over a number of factors.
As for the weakening of expectations, I don’t think it is a short-term phenomenon, nor is it just starting now, as there are many factors for the weakening. In 2018, the central government called for stable performance in six key areas, one of which is "market expectations", mainly because the US-China trade frictions at that time led to weaker expectations. The slowdown in economic growth will also lead to weaker expectations. After more than four decades of high growth, a dwindle is almost inevitable, and that is why we need to shift from high-growth to high-quality development. The third reason lies in the structural problems in the Chinese economy, or "fragmentation". In fact, not only China but also the world has entered a K-shaped economy, that is, the growth of the digital economy, new energy, new materials, high-tech, and other areas enjoy faster growth compared with the traditional industries, which will also lead to a certain degree of weakening expectations.
Q2: How long do you think this round of market decline will last? In the past, RMB exchange rate tended to have one-way movement due to impact of market sentiment. Will we see a continued one-way devaluation this time?
Li Xunlei: The USD/RMB exchange rate had been fluctuating around 7 for quite some time. Over the past 2 years, China’s exports have grown rapidly and economic growth has remained at a high level; meanwhile, factors like the Fed’s rate cut have weakened the US dollar. All these have led to the continued strengthening of RMB. The volatility of the exchange rate sometimes does not simply reflect a short-term causality but a long-term one. Since RMB appreciated sharply in the previous period, it also depreciated more significantly this time, which is a more symmetrical rise-and-fall relationship.
As for the duration of this round of depreciation, it is hard to tell because global uncertainty has increased this year. But one thing is certain—RMB is more stable than any other currencies in emerging markets.
In the evening of April 25, China’s central bank announced it would cut the reserve requirement ratio on foreign exchange deposits. The move is to strengthen the friction factor of RMB by supplying more foreign exchange to maintain the relative stability of RMB. Therefore, I think we do not need to worry too much about the stability of the currency. The exchange rate will reach an equilibrium point and float around that level.
Currently, RMB’s role as a global settlement and reserve currency is still weak. As China’s economy continues to account for a larger global share and the internationalization of RMB moves forward, RMB’s status as an international currency will further improve. So I don’t think the depreciation of RMB will be a long-term trend. In the long run, the real effective exchange rate of RMB might still keep rising.
Q3: There is a belief that getting the GDP growth in the second quarter back to over 5% is critical to achieving the 5.5% growth target for the year. What is your estimation of China’s GDP growth in the second quarter? Can we hit the annual growth target?
Li Xunlei: I think unless the Covid-19 outbreak can be controlled within a short time, it will be difficult to realize a GDP growth of over 5% in the second quarter. Take Shanghai as an example, when can Shanghai get back on track? If it gets back to normal in mid-May, half of the second quarter will have gone by then. There are other places like Shanghai where normal production and social activities are disrupted. Given Shanghai’s leading status in the Yangtze River Delta and its role as a global financial and trade center, the lockdown of such a central city will have impact on its surrounding regions and relevant industries. In this case, how can we ensure that economic growth in the second quarter will reach over 5%?
The data in Q1 2022 shows that the real estate market and consumption were relatively weak in the first quarter. In terms of export, with the gradual recovery of the world from the pandemic, China’s manufacturing PMI and new export orders are declining, which might turn China’s relative advantage in export over the past two years into a relative disadvantage this year. Previously, China’s relative advantage was a “misalignment”—while other countries had Covid-19 outbreaks, China had put the pandemic under control. Such a misalignment offers China an opportunity. The same logic applies to the present situation. However, the current misalignment will be detrimental to China’s export.
To summarize, of the three main drivers of economy, investment fares rather well— the aggregate amount is large enough while the structure needs to be optimized; consumption is obviously weak; and export is also worrisome. Given these factors, the IMF recently also lowered its estimate for global economic growth and meanwhile cut China’s economic growth forecast.
As for the annual GDP target, it is an anticipatory target based on the situation at the beginning of the year. The National People’s Congress sets two types of targets to evaluate government performance: one is anticipatory target and the other is restrictive target. Restrictive targets must be accomplished, whereas anticipatory targets are constantly changing since it is an expectation. For example, a 5% growth is also within the range of the “around 5.5% target” (the 2022 government work report proposed that “GDP growth would reach around 5.5%). So I think it is unnecessary to be too fixated on the number of 5.5%. Maintaining high-quality growth and improving effectiveness should be the premise. Otherwise, we will not realize high-quality growth if we simply meet the 5.5% target at any cost.
Q4: At present, what do you think is the top priority for stabilizing growth?
Li Xunlei: Prioritizing stability requires efforts to help the young groups such as college students and the low-income groups get a job, rather than merely making calculations around the 5.5% growth target. This is the core issue that calls for special attention during the course of stabilizing growth.
Most of the occupations in China are created by the private sector and the service industry. The employees of private enterprises account for more than 80% of the total working population in the country. It is essential to promote the growth of the service industry, which should start from stimulating consumption.
As I mentioned before, the living state of the Chinese economy is more important than the rate of economic growth. The former requires the government to pay attention to consumption, employment as well as the survival of private businesses. If the mentioned three elements remain good, then even if the growth rate slows down a bit, China can still enjoy smooth internal and external circulation.
Q5: In the context of the zero-Covid policy, what is your suggestion for macro policy in the next step?
Li Xunlei: I have three suggestions.
The first is to issue coupons. The negative growth in consumption in March was mainly caused by the slowdown in the growth of residents' income. To study China's economic problems, one should not only look at the total size of the economy as it sometimes covers up structural problems. One must look into the structure because the differentiation is becoming increasingly obvious now. For example, in domestic consumption, the proportion of consumption by the middle and low-income classes has declined, while that by the wealthy class increased. To boost consumption, the country should encourage consumption of the low- and middle-income groups, and improve their quality of life.
Infrastructure construction is usually a ten-year plan or hundred-year plan, which of course requires investment. It includes water conservancy construction in farm fields for the benefit of future generations, as well as urban pipeline renewal and transportation improvement, and so on. However, it should also be noted that subsidizing the middle and low-income classes by issuing consumer coupons can drive consumption directly, which can boost enterprises to increase production. This way to stimulate the economy has a relatively high multiplier effect. In the past two or three years, some places occasionally issued consumer coupons, but all on too small a scale.
Second, employment, especially the employment of youth groups is of great concern. This year, against the background of the resurgence of the pandemic, the number of college graduates has reached a record high. A very important question is what we can do for the college graduates who fail to get a job. My suggestion is to allow these students to delay graduation and undertake some vocational training.
The third is to ensure soft landing of the real estate sector. At present, the real estate sector suffers a sharp decline. The upward trend of the sector has reached an inflection point. In order to realize a soft landing of the real estate market, strengthened control measures should be avoided. At present, measures such as relaxing borrowing requirements for developers and lowering mortgage interest rates have been implemented, but the strength may not be enough. I think it is still necessary to increase the willingness of developers to invest by having governments surrender some profits, such as reducing land prices. Falling land prices can reduce the costs of real estate companies and selling prices, which is conducive to the stability of the real estate market.
In general, my policy recommendations revolve around reducing the pressure on residents and businesses by encouraging the government to take on more leverage. Fiscal policy must be supportive, forceful and problem-oriented. Many things in the economic operation are changing. While developing high technology and creating new growth momentum are all good, promoting common prosperity is also one of the most important goals. I think at this stage, China should focus on people's livelihood and particularly, the issue of having enough to eat.
In the past, economic growth was mainly driven by the leverage of enterprises and the household sector. However, when the economic growth rate drops and the return on investment declines, the government should assume the responsibility of stabilizing growth, realizing transfer payments and supporting the corporate sector (especially private enterprises) and the household sector (especially income subsidies for the middle and low-income groups) so as to achieve the goal of stable growth.
From this point of view, I am afraid that now we have come to a very critical juncture. If investment continues to be insufficient, the magnitude of the economic downturn may be even greater. For this year, even though it is extremely difficult to achieve the 5.5% target, it is essential that we strive for a growth of above 5%.
Q6: To whom and how are the coupons given? How much are they worth? And where does the money come from?
Li Xunlei: There are two types of coupons.
The first type is targeted coupons that are mainly issued to low-income groups. Assuming that low-income groups account for 20% of the Chinese population, then around 280 million people would be covered. Part of the money comes from the government, and part from donations.
Specifically, the total disposable income of high-income groups in China is expected to exceed 25 trillion yuan in 2022. If the rich donate 0.5% of their income, it would be 125 billion yuan, and if the central government provides the same amount of money, then coupons worth a total of 250 billion yuan would be distributed to the 280 million low-income people in China, pushing up their annual disposable income by over 10%.
If provided on an annual basis, coupons, while narrowing the income gap and rooting out massive re-poverty, can boost consumer spending. With an assumed multiplier effect of 1:3, coupon issuance could stimulate additional consumption of around 750 billion yuan.
Generally speaking, targeted coupons could provide a basis for promoting the third distribution, but it could be difficult in practice.
The second type is inclusive coupons that are issued to a much larger group of recipients, such as the entire Chinese population. If everyone is given coupons worth 1,000 yuan, then it would amount to over 1.4 trillion yuan in aggregate. This isn’t a targeted measure, and it increases fiscal spending pressure; but it’s fair and easy, and wouldn’t arouse too many complaints.
Coupons should be issued and financed by the central government. The reach of local governments is limited. The sooner they are issued the better, as it takes time for the effect in stabilizing economic growth to show.
Hong Kong has done pretty well in this regard. It issued coupons of around 60 billion HKD with satisfactory outcome: 80% of the money has been spent. The key to its success is to set constraint conditions and define the coupons’ scope of use properly.
The money needed for coupon issuance could be raised by issuing special government bonds. The Chinese government isn’t highly leveraged; different from the U.S. government, it holds many assets, and so this move wouldn’t negatively affect its credit.
Q7: Some call for intensified efforts to stabilize growth, hinting at further cuts of the interest rate and the required reserve ratio (RRR). How much policy room do you think the PBC has? China has frontloaded many policy measures, with many fiscal and monetary moves delivered. But aren’t the policies enough? Or is it because the effect has yet to fully demonstrate itself?
Li Xunlei: I don’t see much room for rate cuts. With big rate hikes by the Fed likely ahead, the interest rate spread between China and the U.S. has fast narrowed and inversion has appeared. Take the 10-year government bond yield for example. According to PBC Governor Yi Gang, a spread with the U.S. at 80-100 base points (bp) would be “comfortable” for China. Then it’s not so comfortable now. What should be done about it? The market-based interest rate should not be pared down artificially, and if it is reduced further, it could trigger more capital outflows.
An invariable character of monetary policy is that it doesn’t play much of a role amid economic downturns, but have pretty good effects during economic booms when it tightens up. Monetary policy is like a rope that is hard to stretch to boost the economy, but easy to tighten with immediate effects.
That’s why we shouldn’t overestimate the potential effects of monetary policy. Financial data for Q1 shows that the main problem facing China is not a lack of credit supply, but a lack of demand for financing. This is not something that could be solved by interest rate or RRR cuts. What businesses most urgently need is short-term loans, and there is a lack of demand for medium- and long-term ones. After money is put in circulation and arrives in the hands of businesses, a big proportion is put in fixed deposits rather than production, and so fails to translate into tangible economic output. At the same time, households’ demand for loans in the short, medium and long term is falling.
In comparison, when the economy faces mounting downward pressure, fiscal policy tends to have bigger effects.
This article is compiled from an interview with the author, and was published on CF40 WeChat blog on April 27, 2022. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
