China faces pressing challenges. Handicapped by imbalances in real estate and finance, the economy has been decelerating for some time. A new surge of covid infections could aggravate that slowdown. Moreover, the West’s retaliation against Russia for the war in Ukraine starkly reminded China of its great vulnerability to American pressure if a crisis breaks out. Reducing that dependency requires some awkward policy decisions that China’s leaders had preferred to delay. Given China’s large footprint in the world economy, its responses to all these challenges will have a substantial impact on all of us.
Near-term economic challenges
In Premier Li Keqiang’s Government Work Report presented to the National People’s Congress last weekend, the government set an economic growth target of 5.5% for this year. This is quite an ambitious target as the economy has been losing momentum since the middle of last year, even before the recent shock to global investor confidence and spike in commodity prices.
But Li was right to signal ambition to China’s consumers and businesses — by demonstrating the government’s strong intent to act aggressively on the economy, he has sought to bolster their confidence which has taken a hit over the past year because of the many challenges that have proliferated in the broad economy.
The headwinds are well-known and related to policy choices: the leadership’s almost obsessively strict Covid-19 restrictions have taken a severe toll on consumer-facing services such as accommodation & restaurants while causing dislocations in the transportation & storage sector.
In addition, policymakers have been determined to reduce high debt levels in the economy and cool the real estate sector. This may have been necessary from a long term perspective but the resulting credit tightening has produced unintended effects in many parts of the economy, triggering a sharp fall in home sales, with considerable knock-on effects on associated activities.
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As a result, tough measures targeting the property sector have triggered a rash of defaults, which has shaken confidence. Financial institutions are wary of lending to riskier segments which include many of the private companies that are at the heart of the manufacturing sector. The real estate sector accounts for 11% of local intermediate goods purchases, so a crunch in that sector squeezed overall demand in the economy very quickly.
To add to the misery, the state-owned enterprises that dominate upstream industrial production have largely been able to pass on their cost increases to downstream producers who are mostly private companies. With their margins squeezed, these private companies have suffered cash flow difficulties.
Given these formidable headwinds, the government will have to aggressively expand its stimulus if the 5.5% growth target is to be achieved. It is indeed pulling out all the stops. It is amassing massive fiscal firepower. In addition to special-purpose bonds that it normally resorts to, the government will tap “surplus profits of state-owned financial institutions and state monopoly business operations” and “funds transferred from the Central Budget Stabilisation Fund”. The central bank, for example, has just announced that it will send more than RMB1 trillion ($215.5 billion) in accumulated profits to the Finance Ministry.
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Furthermore, the central government is increasing its transfer payments to local governments by 18%, the largest increase in recent years. Tax and fee cuts will be extended to provide a total of RMB2.5 trillion in financial support to micro, small and medium-sized enterprises and self-employed individuals. Finally, banks will be “encouraged to lower real loan interest rates and cut fees” so as to “achieve a considerable drop in overall financing costs” for firms. The stimulus will probably be front-loaded in order to generate a robust pick-up in activity in the first half of 2022.
The signal is now clear — the government is prepared to do what is necessary to boost the economy. Given that the current measures probably will not achieve the growth objective, the authorities will probably have to move far more aggressively soon:
• The effectiveness of government spending has to be strengthened: To do this, policymakers need to tackle the incentive structure facing local government officials. Currently, cash levels are reported to be accumulating in local governments’ accounts with the central bank because local officials are underspending or choosing to pay down debt instead of ramping up spending as they are supposed to.
There are many reasons for this. The downturn in land sales from the broader real estate slowdown has crimped a crucial source of local government revenues, with deep implications for financial management. Moreover, local officials are required to demonstrate that infrastructure spending is going to high-quality projects, which they are struggling to find. Aggressive efforts by the Central Commission for Discipline Inspection to crack down on corruption have rattled these officials as well, making them hesitate to issue contracts. In his speech, Premier Li showed that he appreciated these problems and indicated that he was committed to addressing them.
• The other area where further policy shifts are needed is the covid-zero approach to pandemic management that the authorities have pursued with extreme zeal. This has certainly disrupted the recovery in the services sector. Here, too, Premier Li appeared to grasp the issue, appealing to local officials to adopt a “scientific and targeted manner” so as to minimise disruption to work and normal life.
Overall then, we think that policymakers will act sufficiently quickly to turn the economy around. Given the opaqueness of the budgetary numbers in China, it is not easy to work out the net fiscal injection into the economy — but our rough estimate is that the government will inject an additional 3% of GDP of extra demand into the economy. This is a pretty big number and should allow the economy to grow by at least 5% this year, despite the marked turn for the worse in the global economy.
How will China respond to heightened geopolitical risks?
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The Russian invasion of Ukraine is one of those defining moments in history. This event is akin to the December 1979 Russian invasion of Afghanistan which ended the period of détente between the US and Russia and ushered in a decade of confrontation. China now faces a more adverse global environment than it had expected and will have to rethink many of its strategic calculations.
In particular, China’s leaders were probably surprised by the breadth and vehemence of American and European retaliatory measures against Russia. Ever since the global financial crisis and further reinforced by President Trump’s election victory and Brexit in 2016, China’s basic assumption about the West has been that it is in permanent and irreversible decline. It is now clear that despite all the many flaws in Western politics and economies, America and Europe retain considerable powers to inflict substantial pain on their enemies.
The decision to ban large Russian banks from SWIFT, the currency settlement system used by most banks was a shock. The further move to effectively prevent the Russian central bank from accessing the bulk of its foreign exchange reserves was even more of a shock. The wave of follow-up sanctions by both allied governments across the world and by private companies was also probably never expected.
Given the stark deterioration in China’s relations with the US, China’s leaders must assume that there could be a time in future when China might also be at the receiving end of such swingeing sanctions.
Thus, it is probably a matter of great urgency for China to vigorously address points of vulnerability to American pressure.
There are three broad areas which China would need to think about: (a) its overall dependence on external demand as well as specific dependence on imports for strategic components such as semiconductors; (b) its great financial vulnerability; and (c) Its dependence on critical sea lanes of communications which could be blocked by hostile American action in a crisis.
Thus, it would not surprise us to see China making some important policy changes to address these areas.
• Reduced reliance on foreign trade: In recent years, China’s economic strategy was based on the notion of “dual circulation” which places emphasis on both domestic as well as external demand. In the new era of greater big power contestation, China would want to substantially emphasise domestic demand and actively reduce its reliance on exports as an engine of growth so as to minimise the risk that its economy would be held hostage by US efforts to block its exports during a crisis. But to do so, it would need to tackle the deeper roots of why local consumer demand is so weak. It would need to move faster on areas such as reforming the hukou system which disadvantages the several hundred million migrant workers in urban areas and so depresses their spending power. China is also likely to double up on its import substitution efforts in areas like semiconductors.
• Protect China against financial sanctions: China already has its homegrown rival to Swift, called the CIPS system. It will now pull out all the stops to broaden the appeal of CIPS to a much larger set of countries. Swift is reported to have 11,000 financial institutions on board while CIPS has only about 1,200. A more difficult challenge will be what to do with its hoard of foreign exchange reserves, now totalling about US$3.2 trillion ($4.4 trillion). Despite efforts to diversify these reserves out of US dollars, the bulk of its reserves are still denominated in that currency, which gives the US the ability to freeze these valuable savings, virtually at the stroke of a pen. At the very least, the pace of diversification out of US dollars into other currencies and gold will now be significantly accelerated. But at a more fundamental level, China may have to ask itself whether it even makes sense to have such a large hoard of foreign exchange reserves if it can be frozen so easily by a hostile US. More drastic measures such as running balance of payments deficits through massive investments in hard assets in friendly countries could be one way to go.
• Maintaining access to critical sea lanes of communications: China’s large dependence on imports of food, energy and critical components means that it has to guard its access to shipping lanes carefully. The two most important such lanes are the Straits of Malacca and the South China Sea – both straddled in large part by Southeast Asian countries. China may now have to work out agreements with Southeast Asian nations on how its interests in this area can be protected. China’s aggressive occupation of territories in the South China Sea claimed by other countries has not given it sufficient protection since the US Navy continues to operate in strength around those waters. China may thus have to rethink its approach to the South China Sea by perhaps adopting a more cooperative approach jointly with ASEAN.
The bottom line
If past performance is a good predictor of the future, China’s policymakers are likely to turn around the economy and deliver a reasonably robust growth rate this year. That will help Southeast Asian economies by boosting external demand.
However, where the longer-term challenges of reducing its vulnerability to hostile foreign action is concerned, the outlook is mixed. China may turn more inward-looking in its economic policies, limiting import growth. However, if it chooses to invest its savings in hard assets in fast-growing Southeast Asian economies rather than US dollar paper assets, that will help the regional economies. If it adopts a more accommodative posture towards the South China Sea in future, a thorn in China-Asean relations could be removed. Whatever the approach taken, China’s efforts in this area will have a very substantial effect on our region.
Manu Bhaskaran is CEO at Centennial Asia Advisors