China - Running out of options
Emerging markets (EM) economic growth has continued to disappoint over the first half of the year and risks remain tilted to the downside. Although slowing EM growth is due to a combination of cyclical and structural factors, weak Chinese demand seems to present the largest risk to growth over the medium term. China has responded to weaker than expected growth with numerous interest rate cuts and limited fiscal spending, yet as data continues to deteriorate it is unclear how the economic game plan will evolve. Following weak August data, it’s worth looking at how should (or could) Chinese policymakers act if growth weakens substantially from here.
Policymakers have responded with limited stimulus measures, but nothing resembling past crises. Monetary easing has had some impact but, with credit demand extremely weak, it is unlikely to sufficiently boost growth. Additionally, a stimulus program similar to that used in 2009 may neither be possible nor would it be impactful. Following the collapse of Lehman Brothers, former Chinese president Hu Jintao was said to believe only state-owned enterprises (SOEs) could be trusted to support growth. As a result, state banks distributed nearly $600 billion to SOEs to fund infrastructure projects and massive increases in manufacturing capacity. In China’s current situation, those same SOEs are riddled with overcapacity and there are far fewer infrastructure projects that will offer a return on investment. Chinese SOEs largely exist in fading sectors and there are fewer opportunities for the government to directly fuel investment in faster-growing industries. Additionally, following the massive increase in private sector debt, a similar credit boost would only heighten the risks to China’s banking sector. Simply put, China’s options are limited. Based on underwhelming SOE reform plans and increased chatter by the Ministry of Finance, it appears China is resorting to an old play from their well-worn playbook: increased stimulus for infrastructure investment. They are not pushing ahead on structural reforms that will remove barriers to private sector investment in dynamic industries, but instead will funnel money to trusted companies to boost growth in what they believe will be a dependable manner.
This all ignores a sizeable problem: infrastructure investment spending is already growing at record levels and has little room to increase. Growth is, and should, continue to fall. Due to investment dwindling across most other sectors, and that the private sector now accounts for roughly two-thirds of investment spending, the state has a diminished ability to significantly boost growth. This all makes the imperative of SOE reform, and a reduced role of the state in economic affairs, that much starker. With declining investment levels across most sectors, it is only a matter of time before wages, employment and thus consumption exhibit more strain. It is unclear what policymakers have determined as their acceptable “floor” for growth, or how much labour market or consumer weakness they would tolerate before substantially increasing fiscal stimulus measures. What is clear, however, is that a response focused on infrastructure stimulus may marginally support growth in the short term - but as the impact shrinks, China will be out of options.
Alex Wolf, Emerging Markets Economist, Standard Life Investments
First appeared in the Hong Kong Economic Journal in September 2015