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China stimulus: Almost out of ammo

With economic growth sluggish and deflation threatening, Chinese policy-makers are bravely talking about new stimulus. And there is some. But not much. With its debts and government deficit already high, China simply does not have the scope for big new fiscal stimulus And cutting interest rates risks accelerating capital flight. Targeted measures to help the property sector may be the best hope.

GDP rose just 3.2% annualised in Q2 and consumer prices were flat y/y, that is 0%. Core inflation was 0.6% y/y. Part of China’s problem is the world-wide goods recession as consumers switched to services over the last year. Part reflects China’s ongoing property woes as potential buyers hold back and developers try to sort out their balance sheets.

The goods recession will pass, although international buyers are increasingly trying to source outside China, in south east Asia or India. The property cycle will turn up too, but the days of rampant construction are likely over as the move to cities approaches its limits. A big part of China’s malaise though is a general decline in confidence in the economy, which may not come back.

When economic growth bounds along at 6% plus as it has for decades, businesses are bullish about hiring and investing because expanding demand will take care of them over time. If that confidence goes, businesses become more cautious. Ratcheting up growth again is difficult.

This slowdown has been coming for a long time. Through the 2010’s growth was only kept going (albeit at a slowing pace) with the help of expanding debt, particularly to households and government.

Household debt rose from 20% of GDP in 2009 to over 60% today. National Accounts show household income at only 55%% of GDP which would make that household debt equal to 109% of income, a very high level. In fact, household income is probably a little higher than that if adjustments are made for payments in kind of various sorts. Still, the ratio is up towards 100%. While this doesn’t spell ‘crisis’ it does mean that the scope for expanding the property sector and therefore the economy with more household debt is limited.

Meanwhile general government debt has risen from 34% of GDP in 2009 to 77% today. Again, this is not a crisis level, but the scope for increasing it further is limited. In fact, the wider ('augmented') definition of government debt published by the IMF puts it at 120% of GDP.

In a low inflation/low growth environment the dynamics of government debt quickly change. With economic growth of 4% and no inflation, debt ratios starting at 100% or so, will rise unless the deficit is kept under 4%. This is just arithmetic. But in 2023 the government’s budget deficit is running at about 7% of GDP. So the debt ratio is heading up already and any further increase in the deficit will add to it. Again, the IMF publishes an ‘augmented deficit’, including borrowings by local governments and their financing vehicles (LGFVs) and this is over 16% of GDP. Local governments have traditionally funded themselves substantially with land sales, but these are depressed at the moment as developers try to improve their balance sheets.

The government is well aware of these debt constraints which is why it is trying to stimulate the economy without using a bazooka this time (in contrast with 2009). Instead it will add fiscal stimulus at the margins, try to encourage more property buyers by relaxing restrictions and probably ease monetary policy again slightly. But there is little sign of major economic reforms to kick-start growth. Confidence is likely to stay weak.

Is China heading for a crisis?

Probably not. All governments try to avoid crises and a crisis for China would threaten the legitimacy of the Communist Party. And its grip on power. So the CCP will do everything it can to avoid one. That’s why it is trying to limit debt – and indeed has been doing so for 10 years now after the blow-out following the 2008-9 crisis.

But it also has closer control than in market economies which makes a panic less likely. Away from consumers, most of the debt in the system is owed to government-owned entities or is borrowed by government-owned or controlled entities, or both. Any defaults should be containable, though possibly only at the cost of adding more debt. And China still has a current account surplus and very high FX reserves, so it won’t face a balance of payments crisis.

In the end, higher inflation may be the answer, including a devaluation. But the government does not want to go there either. High inflation is very unpopular. It was a key reason for the unrest back in 1989 which culminated in the Tiananmen Square massacre. And a devaluation would be humiliating for a government which fancies the idea of replacing the US dollar with the Yuan.

So, the most likely outcome is that China will muddle through, with much slower growth than in the past but without a crisis. I still think there is a chance of a crisis. Call it 33%. If we are all talking about ‘the China crisis’ in a year or two we will probably look back and say it was obviously coming. But, at the moment, it still looks avoidable.

In a coming blog I will look at the implications of China’s slowdown for the rest of the world.

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