Re-defining a Relationship

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Traditionally, times of economic crisis can rekindle the passion of the relationship between markets and governments, as the two tend to be forced into closer cooperation. In China, this relationship has always been much closer and stronger, if not sweeter, than elsewhere. The government’s response to the global financial turmoil in 2008 made China the world’s second largest economy in 2010, a position that was strengthened in 2011, as world markets continued to slide. However, changes afoot could lead to a less unbalanced relationship between Chinese authorities and the country’s commercial interests.

Though still outshining any other country in the world in terms of economic growth, by the first quarter of 2012, China’s economy had been in decline for five consecutive quarters, the longest continuous fall since 2003. Market data in April and May forecast even bleaker times ahead growth rate forecasts well below 8 percent in the second quarter have become commonplace. Since 2003, only three fiscal quarters have seen such lethargic growth.

Unsurprisingly, predictions of a policy shift have quickly come back into fashion. On May 23, the State Council declared that “stabilizing growth should be given higher priority,” a clear shift from the previous focus on price stability. An array of measures taken right before and after that announcement were immediately interpreted by the market and the media as the launch of a new multi-trillion yuan stimulus package, similar to the one China launched in 2008. Analysts leapt into action, identifying industries likely to benefit from the new policies, and attempting to calculate exactly how big the new package would be.

The government rushed to manage expectations. One week after the State Council’s announcement, both Xinhua and the People’s Daily, the top two State media outlets, made it clear that there would be no“stimulus 2.0.” However, both recognized that efforts were needed to boost the economy, and that some sort of action had indeed been taken.

The market was disappointed by the absence of a stimulus, and continued to call for more pro-growth measures. But this time, the calls were tinged with caution like the government, the market also recognized that a 2008-style stimulus was not what the economy needed.

This hesitance reflects concern that a stimulus could worsen the imbalance left behind by its 2008 predecessor. The economy has changed, and both sides seem to realize it.

Tough Times

Since 2010, China has been aiming to cool its economy. However, a downturn of this scale and duration is apparently a bridge too far for either decision makers or the market. Seven out of eight quarters since the second quarter of 2010 saw decrease, the longest sustained downward movement since 1992. “Quarter-on-quarter growth in the first quarter stood at only 6 to 7 percent,” said Rosealea Yao, principal analyst with GK Dragonomics, a research and advisory agency.

In April, industrial production, which normally moves in close step with GDP, recorded its lowest growth for 35 months. The April data “shocked the leadership,” according to a report by Standard Chartered in early June. Figures for May are more mixed, with foreign trade and inflation better than expected, but consumption and new orders markedly worse. The consensus on the market is that the danger of a further downturn is becoming increasingly palpable. Unexpected interest rate cuts by the central bank can be seen as an even clearer sign of the central government’s worries.

Yao believes that the current slowdown can largely be blamed on shrinking property development as a result of the government’s house price reduction policy. Real estate, she explained, absorbed about 25 percent of total investment, and at the same time, part of the investment in infrastructure and manufacturing was also related to the sector.

Professor Li Xuesong with the Chinese Academy of Social Sciences believes that external shocks are to blame. Both of China’s most drastic economic slumps, during the Asian and global financial crises in 1998 and 2009 respectively, were precipitated by a plunge in exports, he argued. “Export affects not only our trade surplus, but also a considerable part of investment in manufacturing,” he said.

There are two convergent points behind these ostensibly different arguments. Firstly, neither the real estate boom nor exports can be restored in the short term. The central government has repeatedly made it clear that it would be impossible to relax the current controls on property purchasing. Uncertainty over the fragile US recovery and the eurozone crisis has increased, and these problems will take time to resolve. China hopes to expand exports to other emerging markets, but those markets are also enduring slowdowns of their own.

Secondly, both arguments are based on the same focus: investment both the hero and the villain of China’s economic miracle. It is no coincidence that controversy over the new growth policy is nearly all related to investment, a lesson learned from the stimulus in 2008, and from China’s growth model in general.

Quick Remedy

In November 2008, to cope with the shock of the global financial crisis, the Chinese government launched a high-profile 4-trillion yuan (about US$586bn at the time) stimulus package, with a focus on infrastructure investment. This was equal to 12 percent of the total fiscal stimulus commitment made by all G20 members in April 2009. Spurred by this policy, new loans nearly tripled in 2009, and by 2010, they were still double the pre-crisis year of 2007.

In China, growth was restored just after two quarters of slump, while developed economies debated over bailouts to their ailing banks.

However, this short-term recovery soon began to show signs of undesirable side effects, and ultimately led to losses in the long term. Inflationary pressure became a concern in the second half of 2010, and was top of the agenda by 2011. Some stimulus cash was used for speculation, creating asset bubbles in numerous products, from garlic to gold.

More importantly, the stimulus aggravated a crucial problem in China’s economy. In 2007, the central government decided to rebalance the economic structure by promoting domestic consumption, which had lagged far behind investment and export, the other two engines of China’s economy. However, as most of the stimulus package went to infrastructure, the role of government-led investment was further reinforced.

It is natural that emerging economies should save more, investing their savings in industrialization before they become rich enough to rely on consumption. China’s problem, however, is that its consumption is dwarfed by investment. Over the past five to ten years, household consumption in China increased by 9 percent annually. Though a high figure, investment and export were increasing much faster, according to Yao.

“Consumption protects an economy from external shocks, and is a real guarantee for long-term growth,” said Professor Li. He added that household consumption also guides manufacturers on what to offer to the market. Otherwise, the economic structure becomes distorted, and resources are wasted on misplaced investment.

According to the CASS report issued in April, 54 percent of China’s growth in 2010 was from investment, compared with 44 percent in 2006. The proportion reached 91 percent in 2009 when the previous stimulus was implemented. Returns from those investments, however, have been poor. The CASS report shows that investment efficiency (GDP created by a given amount of investment) from 2008 to 2011 was at its lowest since 2000. The investment spree in 2008 and 2009 also led to heavy debts for local governments. Alongside a possible property market bubble, this has become the most significant threat to China’s financial stability.

In that context, the word “stimulus” has too many bad memories attached to it, both for the government and the market.

Keeping Distance

The difference between a “stimulus” and a “growth-stabilization policy,” according to Louis Kuijs, project director at Hong Kong-based think-tank Fung Global Institute, is “mostly about the size and intensity of the policy response.”

Media and analysts have been trying to piece together various data such as loan growth and budget spending to detect whether or not there has been a policy change, and how it may shape up. They agreed that the new package is not only much smaller, but involves only a resumption of suspended projects, or accelerating projects originally scheduled for a later date, rather than initiating new ones.

The current downturn is not as sharp as that of 2008, and no mass unemployment has been reported. But more important reasons underlie the caution. Labeling the new package as “mini-stimulus,” Standard Chartered stressed that “the senior leadership is clearly worried that people will interpret these policies as a doubling down of China’s boom-and-bust, investment-heavy growth model.” UBS, a Swiss bank, says in its report that “the government is keen to avoid another 2009.”

The worries are apparently justified. It seems that the market and local governments are much more eager than the central government for a stimulus. Even the State broadcaster CCTV asked whether market sentiment would force the govern- ment to be more forthcoming with the stimulus. Local governments are already trying to circumvent restrictions on the property market.

Yao at GK Dragonomics thinks this reflects that the market itself has become too reliant on government intervention, and on an investment-based growth model. Once there is suggestion of a downturn, the market’s knee-jerk response is to resort to government handouts.

Fortunately, the market has not lost all its independence. Criticism was aroused by recent reports that the National Development and Reform Commission (NDRC), China’s foremost macroeconomic planning agency, had been fast-tracking approval for infrastructure projects. Dr Zhang Monan at the State Information Center, for example, warned in the media that the risks of a new wave of government-led mega-investment should not be played down “when the negative effects of the 4-trillion yuan stimulus are yet to be dealt with.” Concern over the market was so serious that both the People’s Daily and Xinhua stressed that there would not be a repeat of the low-efficiency investment of the 2008 stimulus. “We need investment, but not an investment frenzy,”said a People’s Daily editorial on May 30.

“This caution over government intervention is necessary and positive,” said Professor Li at CASS.

In any relationship, personal space matters. This time around, the government and the market have become more prudent memories of the failings of the 2008 stimulus are still too fresh. Details of the new package need to be assessed to determine whether the new development will re-shape China’s growth model.