Robin Xing：China’s fiscal policy has begun to shift

Robin Xing 

Chief Economist, Morgan Stanley China

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1、 The Difference between Chinese and American Fiscal Policies

My fellow speakers have focused on monetary policy. In the next five to ten minutes, I want to share a few more thoughts on the significance of fiscal policy, with a focus on China. I want to start with a story. Consider two economies: Economy A has a very strong labor market and CPI inflation is above 5%; economy B has a very weak labor market and a headline inflation below 1%. Which of the two economies require support from fiscal policy? It must be economy B, isn’t it? It was just the opposite. You guessed right: economy A is the US, and economy B is China. In the last 12 months, fiscal deficit in the US stayed elevated even as US reopened and labor market remained tight. On the other hand, the augmented fiscal deficit in China have narrowed by 4 percentage point of GDP over the last 12 months. As you would expect, fiscal easing in the US helped support growth while the fiscal consolidation or tightening in China was a significant drag to growth. But fiscal outlooks in the two economies are now shifting again in opposite directions. China is easing its fiscal policy, and we would argue this is the beginning of a reflation campaign.

2、The Shift of China's Fiscal Policy

In the past Chinese policy makers have adopted a counter cyclical growth model, stimulating domestic demand via infrastructure construction and housing sector when exports were weak. But in this cycle, fiscal policy has been surprisingly procyclical. The root cause is deleveraging in the property sector, which started about three years ago. This has had a knock-on effect on local government financing because a big part of the local government revenue came from land sales. Local government and housing sector together have taken up debt worth 100% of GDP. They have been in rapid deleveraging over the last two years and that's why we see the downward pressure on the Chinese economy with aggregate demand deficiency and the emergence of deflationary pressure.

While this is somewhat expected, what surprised us was that even the central government was still tightening in the first seven months of this year.

But finally, the fiscal policy stance started to turn from August after the pivot from the Politburo meeting. Moreover, just in the past week, Beijing formally widened the on-budget deficit target for this year. That's the first time since 1998-2000.

Revising the budget deficit in the middle of the year was very rare in China. They only did that during Asian financial crisis in 1998. It's a very critical step. It showed finally, policy makers are probably embracing the idea when you have both local government and housing deleveraging, you need the central government to leverage up to facilitate a smooth deleveraging to fend off deflationary risk.

3、 The “5R” Plan: Breaking the Debt-Deflation Cycle

But this is only the beginning, right? How does China exit deflation? As you may know, we have been working on something called China's reflation path since beginning of this year. We think a “5R” plan to break this debt-definition loop is needed. Because without that, China will be facing a prolonged battle against this “3D” battle that demographics, debt and deflation. To prevent China from falling into a debt-deflation loop like Japan did in 1990s, policy makers will need to maintain an adequate gap between real interest rates and real GDP growth. So, in turn, we have advanced this to a 5R framework comprising of the reflation, rebalance, reforms, restructure and rekindle. According to this framework, policy has been moving in the right direction as more coordinated monetary and fiscal easing is the first step to address deflation risk.

But there is no quick fix. In our base case, policy makers are reflating the economy with just modest support. This one trillion RMB budget revision is a start, but not enough. To be sure, policymakers are still erring on the cautious side as they do not want to reignite misallocations seen in past cycles. It is precisely the recognition of past excesses that led to policy tightening, or as some people call it, crackdown since 2021. But we would argue there has been over tightening in the housing sector. Consider housing investment: housing construction as percent of China's economy has fallen from 11% of GDP a couple of years ago to today's 6.5% of GDP. It took Japan 20 years to achieve similar magnitude of adjustment. Meanwhile, in the infrastructure space, local governments are constrained from a slump in land revenue and tightened financing discipline. The central government must do the heavy lifting to reflate the economy. To limit renewed misallocations, Beijing is focusing on green capex, smart grid, charging station, the battery system for storage, which is not oversupplied yet. But these are relatively small. Housing plus local old infrastructure used to take up 50% of China total fixed asset investment; the green capex and the high-tech sectors like data center together accounts only 15% or 1/5. China has been in this transition period over the last three years. You had “fast and furious” correction because of policy tightening or over tightening.

Against this backdrop, policymakers came to the realization that they must provide a floor to facilitate the economic transition. They have been reducing mortgage rate and down payments and lifting the second home purchase restrictions. And on the infrastructure front, policymaker have pushed local governments to complete their issuance of special bond, which will drive some of the infrastructure spending in the coming months. But these are not reflating the economy in a significant manner. In the past cycles like 2008 or even 2015, China provided all-out stimulus. But given the concerns over misallocations and the buildup of unproductive capital, this time they don't want to do a bazooka.

So, we expect China's inflation to remain very low. If you think about GDP deflator, it could gradually move back into positive territory from a minus 0.8% this year, but it's far below a desirable level of 2 to 3%. In the past, when China was growing at 6%, GDP deflator was around 3%, so nominal GDP growth was a robust 8 to 9%. That's quite attractive to multinational firms.

But now we think given China's approach amid housing and LGFV deleveraging, it will take China multiple years to complete this reflation journey. GDP deflate is going to improve modestly in 2024, but still below 1%. And if China's real GDP growth is also below pre-pandemic level, say 4%, this would give us 5% normal growth. For global multinational firms, this is a regime change, as 5% would be in line with normal growth in the US or even Japan. So that's why there is a big reset of expectations in China. But I do think if China keeps delivering this gradual reflation, eventually they could be out of woods, and they can reach 2-3% optimal GDP deflator. It just takes some time. And as a major first step, we expect policymakers to widen augmented fiscal deficit by 1.5 percentage point next year. They are saying goodbye to that old mindset that on-budget deficit must be within 3% of GDP.

That's just one part of this reflection. Policymakers also need to ensure the right level of real interest rates relative to real GDP growth, and to revive animal spirits and private investment. Policymakers must also rebalance the economy towards consumption. What does that mean? Can they do more fiscal transfer to household? I know it has been quite controversial in China. Can the western-style paychecks and direct fiscal transfer be adopted by China? That's very controversial. But at least, they can increase social welfare spending on household: for example, migrant workers and their family can enjoy access to schools, hospitals, and pensions system. This could reduce the precautionary savings and probably increase the consumption going forward.

And finally on restructuring. One and a half trillion RMB has been allocated this year to for the central local debt swap. If you look at the Chinese government debt (including hidden debt of local financing vehicles), it's roughly 100% of GDP, which is similar to US federal debt. But China's mix is quite unique, with nearly half denominated in hidden debt by local government. The central government always have the option to underwrite this these hidden debts, and PBoC can provide liquidity for banks to purchase the bonds. So, I don't think China will have any financial crisis moment. But of course, they will also need to install fiscal discipline for the local government to prevent future model hazards. So, it’s gradual deleveraging process for the local government. They will play a less important role in supporting capex growth. It's up to the central government to use its fiscal budget to sponsor green capex, urban redevelopment and social housing.

Recently we launched the so-called China Reflation Tracker, which tracks policy progress in relation to the “5R” policy framework. We try to quantify the progress every month and as of now we think they have fulfilled about 25% of the strategy needed to fend off debt-deflation risk. Some of the Rs have seen more progress, some still lagging. If policymakers can deliver 50% by end of next year, we will be much more optimistic. The mid-year budget expansion is a good step, and we expect fiscal impulse to strengthen next year. I think that's very important and that's the right gap towards eventual reflation.

In the final part of my talk, I want to show if China successfully reflates in about 2 to 3 years, even if the potential growth is lower, they will still be able to cross the so-called high-income threshold by 2027. After all, there is a still a lot of potential for further productivity again. You can see it from EV supply chain and green transition. You can see it from China’s own semiconductor and AI firms. With that, I will stop here and hand over to the host.

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