China's new stimulus in a shifting policy framework

Introduction

China’s economy continues to suffer from several structural headwinds all culminating in weak domestic demand. The economy grew only 4.7% year-over-year in the second quarter and 4.6% year-over-year in the third quarter, putting the government at risk of missing it’s 5% annual growth target for 2024. The cause of the weak growth has been abundantly clear for many months: the recovery in consumption has been held back by depressed confidence, credit demand overall is sluggish, and the real estate sector crisis continues to cast a shadow over the economy.

A year ago, we wrote that China risked finding itself stuck in a balance sheet recession if appropriate policies (particularly on the fiscal side) were not used to address weak consumption growth and other structural challenges. After months of insufficient and piecemeal policy responses that disappointed markets, economists, and consumers alike, policymakers in China announced a slew of measures in September and October that suggest they too are now concerned about the economy getting stuck in second gear.

Not all the measures are targeted toward getting consumers spending again, or addressing other, deep-rooted structural issues, however. They include larger-than-usual monetary policy rate cuts (which are less effective in a balance-sheet-recession-like environment), support for the stock market through central bank lending tools, and measures to support the real estate sector that can be seen as ‘more of the same’ (e.g., expanded support for a program that encourages bank lending to local governments to purchase excess housing).

But the government also made several pledges regarding much needed fiscal policy support, including subsidies to low-income households, support for highly indebted local governments, support to recapitalize banks suffering from a combination of low net-interest-margins and problematic loans to real estate developers and local government financing vehicles, and an overall pledge to increase debt issuance. What remains unclear, however, is how large fiscal stimulus efforts will be and to what extent policymakers will simply use increased fiscal firepower to boost growth temporarily via more infrastructure spending to reach the growth target. It would be far better for growth in the longer run if the government found ways to directly support households and the private sector.

These recently announced policy measures, however, also come in the context of plans to gradually shift China’s overall macroeconomic policy framework, both from a monetary and fiscal perspective. In June, for example, China’s central bank (PBoC) laid out a vision for moving further toward priced-based (as opposed to quantity-based) monetary policy setting. The next month, policy messages from the Chinese Communist Party’s 3rd Plenum outlined a vision for fiscal policy reform such that there would be more balance between the local and central governments.

Taken together, the signals are clear that policymakers understand the need for a more proactive approach to getting China on a more sustainable growth path. The question remains whether such policy changes will be effectively executed. This research report explores in detail how the proposed macroeconomic policy measures and reforms could have positive impacts on the Chinese economy and why they are increasingly necessary. It is divided into three sections: an overview of the current macroeconomic context, a section on monetary policy, and a section on fiscal policy. The conclusion summarizes the main findings of the report.

Section 1: The macroeconomic context

To understand the need for a major policy response to support the Chinese economy, it is first important to understand, briefly, the current macroeconomic situation in China. The recovery from prolonged pandemic measures has been disappointing, with the economy growing only 2.95% in 2022 and 5.25% in 2023.
Long gone are the days of double-digit growth registered in the early nineties and early 2000s. Some of this slowdown was to be expected. The low-hanging fruit of industrialization and opening up to global trade has been picked, and the authorities have long-recognized the need to switch to “higher quality” growth drivers as incomes have improved, the population ages, and potential growth moderates.

But the recent weakness in growth goes beyond a healthy moderating trend and highlights important fragilities in the economy. The needed switch from infrastructure investment-intensive debt-driven growth to a more services-oriented economy with higher household consumption has not materialized. Part of this is due to structural issues (a weak social safety net, an ageing population) that keep the savings rates in China elevated compared to other major economies. But other elements are at play as well, most notably the years-long downturn in the real estate sector which, combined with severe Covid containment measures until late-2022, has triggered a collapse in consumer confidence and a period of deleveraging. Indeed, consumption contributed only 2.2 percentage points to the Q2 GDP figure and 1.4 percentage points in Q3, its lowest relative contribution since 2022, when strict zero-covid policies were still plaguing the economy (figure 1).

The consequences of the real estate sector crisis, and in particular the growing liquidity and sustainability troubles of real estate developers, have reached beyond households, with local governments, local government financing vehicles (LGFV), and banks all facing pressure. The result is a general economic malaise, with year-over-year GDP growth slowing to 4.7% in Q2 2024 and 4.6% in Q3 2024.

Equally concerning are the deflationary pressures evident in the economy, with core inflation moderating to only 0.1% year-over-year in September, producer prices declining in ten of the last twelve months (figure 2), and nominal GDP growing less than real GDP for the last six quarters.
 

The government’s annual real GDP growth target for 2024 of 5.0% becomes increasingly hard to reach, and while that number in itself is largely symbolic, the larger context suggests that China risks getting stuck in a prolonged period of sluggish growth and deleveraging, making China’s efforts to move from an upper-middle income economy to a high-income economy increasingly difficult. To avoid this outcome, the right mix of monetary and especially fiscal policy is key.

Section 2: Monetary policy - improving transmission in a balance sheet recession

China’s current monetary policy framework is a complicated hybrid of tools and approaches that the People’s Bank of China (PBoC) relies on to communicate and carry out monetary policy. This is partially the result of a long-held focus on implementing monetary policy through quantity-based measures with a gradual shift over the past decade-plus to more price-based measures.¹

Price vs Quantity

The distinction between a price-based and a quantity-based system boils down to the theory that if a central bank’s goal is to maintain price or inflation stability, the transmission channel of monetary policy can either work through interest rates and bond yields (prices) or monetary aggregates (the money supply or quantities). A central bank with a price-based system, e.g., sets a short-term interest rate—often via a corridor system that defines the rates at which financial institutions can borrow and lend from the central bank—and that interest rate (and expectations for future interest rates) eventually trickles through the financial system to corporates and households, impacting investment and consumption demand and therefore prices.

A fully quantity-based system, in contrast is based on the accounting principle that nominal expenditures in an economy are equal to the money supply multiplied by the velocity of money (how fast money changes hands). If velocity is thought to be mostly stable (a highly debatable assumption), targeting the money supply can influence real economic activity and inflation. Tools used to target the money supply can include setting reserve requirements for banks, changing the size of the central bank’s own balance sheet via bond buying and selling (quantitative easing or tightening) and, in general, the printing of money.

Today, for most advanced economy central banks, price-based monetary policy is the main transmission channel used, as the evidence does not point to a stable velocity of money, and in economies with deep and mature financial markets, communicating on interest rates can improve transparency and therefore transmission.² However, in truth, many central banks use a combination of price and quantity-based levers. In other words, interest rates are the main tool, but monetary aggregates are also adjusted through quantitative easing (or tightening), often considered an unconventional or secondary tool. Nor can the price and quantity impacts of these tools be completely separated from each other. For example, yield curve control, as practiced for many years by the Bank of Japan, through the purchase and sale of bonds can impact the aggregate money supply, but the intermediate goal is still to target interest rates along the curve.

China’s particular framework

China’s monetary policy framework, however, is less straightforward than many major central banks. For example, rather than have one main policy rate, the PBoC has many different policy and market interest rates that it can change or influence to ease or tighten policy. This includes ‘guiding’ banks on the one-year Loan Prime Rate (LPR), which is the benchmark for corporate and household loans (i.e. the average rate commercial banks charge their highest quality customers, with all new bank loans priced relative to the LPR³), and which is sometimes, but not always, linked to changes in the PBoC’s Medium Term Lending Facility Rate (MLF) – the rate at which the central bank lends to large commercial banks. Since 2018, changes to the one-year MLF rate and LPR have served as key signals of the PBoC’s monetary policy setting, but in June of this year, the PBoC noted that it wants to move towards using a shorter-term rate, specifically the 7-day reverse repo rate (RR) on open market operations. This brings the PBoC closer to the practice of other major central banks that use a short-term rate as the reference rate.

Meanwhile, the PBoC also uses Reserve Requirement Ratios for banks (calibrated depending on the type and size of the bank) to help fine tune policy. This is more of a quantity-based measure, determining how much liquidity is available for banks to lend out rather than hold at the central bank. And then there are the various structural policy instruments of the PBoC that support key areas of the economy through targeted lending (e.g. innovation, real estate).⁴ So even though the PBoC no longer sets specific M2 and credit growth (total social financing or TSF) targets as it did when the policy framework was far more quantity-focused, direct influence over monetary aggregates and lending activity is still a key element of the policy framework.

A balance sheet recession dictates more changes

The shift in the policy framework is important given the current macroeconomic context in China. As outlined in a previous economic opinion, a balance sheet recession refers to a situation in which a debt-financed asset bubble bursts, households and/or businesses enter a period of deleveraging (repair of balance sheets), and monetary policy therefore becomes less or ineffective because lower interest rates can’t incentivize more borrowing as they usually would. Indeed, over the past two decades, China relied on debt-financed investment in infrastructure and real estate to support economic growth, which led to a rapid rise in the debt of households, local governments, and the corporate sector (particularly state-owned enterprises and local government financing vehicles). Since the government initiated a crackdown on real-estate related debt in late 2020 (the Three Red Lines policy), the real estate sector fell into a crisis which has led to a sharp slowdown in credit growth led by a drop in real estate-related loans (figure 3).

The lack of demand for credit not only makes it such that the incremental cuts in policy interest rates by the PBoC since early 2022 (45 bps to the one-year PLR, 95 bps to the MLF rate, and 70 bps to the 7-day Reverse Repo rate) have been so far ineffective in spurring new credit growth, but also highlights why the gradual move away from quantity-based policy setting is important (figure 4).

The PBoC frames the shift away from TSF targets as a reflection of China’s shift to ‘higher quality’ economic growth, where outstanding loans need to be better mobilized to be used more efficiently rather than focusing on new loan growth.⁶ This is a nice way of saying that the old growth model of rapid debt accumulation to finance infrastructure investment is no longer capable of yielding the same return to growth. Indeed, in the same speech, PBoC Governor Pan Gongshen notes that real estate loans and LGFV loans account for a significant share of outstanding debt in the economy, and their current decline (as part of a much needed deleveraging process) makes achieving the same credit growth rates of the past very difficult (outstanding TSF growth averaged 12.6% yoy from January 2017, when the series was revised, to December 2020 and reached a low of 7.9% yoy in September 2024). Mr. Pan even hinted at elements of a balance sheet recession when he noted, “when the growth of money and credit has pivoted from supply constraints to demand constraints, it obviously runs against the law of economic performance if the emphasis remains on quantitative growth.”

This all suggests that the most recent monetary policy measures introduced in September, which included a 20-bps cut to the 7-day RR, 30 bps of cuts to the MLF rate, and a 50 bps cut to the RRR for banks, will do little on their own to move the needle in terms of Chinese GDP growth if the underlying demand problem isn’t addressed. The same is true for the targeted rate cuts to existing mortgage loans and the measures to reduce the minimum down payment requirement for second homes. While these steps might, on the margin, support demand for home loans, deleveraging is likely to continue as long as confidence in the ability of property developers to finish pre-sold projects remains uncertain. Expectations of further price declines in the market (prices in the primary market have declined 7.9% and prices in the secondary market have declined 14.5% since mid-2021) will also hold back demand, which could be worsened if deflationary pressures in the economy overall become entrenched.

Meanwhile, measures announced by the PBoC to boost the stock market, such as lending liquid assets to institutional investors which can be sold to invest more in equity markets, and providing refinancing loans to banks that extend credit to companies that buy back shares, were well received by the market, which jumped 18% in the month of September. While these measures might help restore confidence and trigger positive wealth effects that can accelerate balance sheet repair, they do little to directly impact the real economy on their own. Indeed, markets have given back some of their gains in October (as of the 28th, the Shanghai composite index is down 4.8% from its 8 October peak), suggesting some reservations regarding how successful the measures will be in terms of boosting the economy.

Section 3: Fiscal policy – addressing major imbalances

Since monetary policy won’t be able to tackle China’s growth problems on its own, fiscal policy has clear role to play. Indeed, the general prescribed remedy for a balance sheet recession is using fiscal stimulus to offset deleveraging from the private sector. But just like China’s monetary policy framework, the fiscal framework in China is not so straightforward. China has for many years run a high fiscal deficit (7% of GDP in 2023). This has also led to a sharp rise in official government debt from only 26% of GDP before the GFC (2006) to 84% of GDP as of 2023 (according to IMF estimates). These figures don’t take into account the off-budget debt accumulated by local governments through LGFVs and SOEs. An augmented measure estimated by the IMF that includes off-budget spending and debt puts the 2023 general government fiscal deficit at a higher 13% of GDP and public debt at 117% of GDP.

In the past, these off-budget items have been an important way for the local governments to support growth through downturns, often by funneling investment into infrastructure projects. But LGFVs have reportedly been increasingly facing financing constraints, and analysis by the IMF suggests that many are not making a return on investment that is enough to cover debt repayments, meaning that new debt financing, which once was used to finance infrastructure projects, goes towards operational costs instead.⁷ These financing strains, together with the downturn in the real estate sector, have increased pressure on the finances of local governments themselves, especially as local governments have often relied on land sales (leases) as a source of revenue (figure 5).
 

A new tactic is needed. But if the local governments are already under pressure, how can fiscal spending be used to get China out of its current economic slump? The answer lies in where the funding comes from and how the funds are used. Because while local governments are heavily indebted, the central government’s balance sheet is in much healthier shape. Compared to the general government balance of -7% of GDP in 2023, and the local government balance of -13.6% of GDP in 2023, the central government had a positive balance of 6.5% of GDP in 2023 (figure 6). Central government debt is also a much more manageable 24% of GDP.

Hence, there’s evident space for a reform of the revenue collection and expenditure balance between the local and central governments. The government acknowledged this during the Third Plenum of the 20th CPC Party Congress held mid-July. They noted that the revenues and expenditures of central and local governments should be better aligned and defined, with local government revenue sources being enhanced. This could be through granting local governments more freedom to set tax rate levels, shifting the collection of consumption taxes to local governments (which would also incentives local governments to boost consumption), and simply increasing the share of central government expenditures with more transfers to the local governments.^8,9

The discussion out of the Third Plenum, together with the fact that central government issuance has been rising, while local government debt issuance has declined this year (figure 7), suggests that policymakers are slowly working towards addressing this imbalance. But changing the fiscal policy framework is only part of the solution. It is just as important, if not more so, that the increased fiscal spending targets the right areas of the economy. It is no longer efficient to simply funnel new financing into infrastructure investment, especially given the already substantial debt burden of SOEs (state-owned fixed asset investment is up 6.1% year-to-date compared to a year earlier while private investment is down 0.2%). While there are some strategic areas (such as in green tech), where state directed investment can still yield high returns, this strategy has also yielded complaints from trading partners, including the EU, leading to investigations and in some cases countervailing duties on products seen to be benefiting from state subsidies (see: Is a green technology war on the horizon? (kbc.com)).
 

Indeed, what the Chinese economy needs instead, are fiscal measures that get households spending more. Some of that might be done through measures to bolster confidence in the housing market. For example, the government announced that it would issue debt that would allow local governments to buy back land and unsold housing stock from developers.¹⁰ Supporting banks through recapitalizations will also help address financial stability concerns that have emerged as banks face waning profitability and higher risks from non-performing loans (figure 8 and 9). Both real estate loans and LGFVs are reportedly responsible for the increase in NPLs, while the combination of lower interest rates and weak credit demand is contributing to an ongoing decline in net-interest margins.

Shoring up the financial system is crucial for keeping confidence from worsening further, but to really get households spending, policymakers need to focus on a combination of long-standing structural issues (such as a weak social safety net that induces high savings) and cyclical issues. These include wealth effects from the housing downturn (See: China's household debt problem (kbc.com) for details on how household balance sheets are tied up with the real estate sector), weakness in the labour market and income growth (official figures show a stable unemployment rate, but confidence indicators (figure 10) and surveys (figure 11) paint another picture), and deflationary pressures that threaten to become entrenched in a downward spiral.

But whether the fiscal pledges will indeed focus on boosting consumption (for example, through direct transfers to households) remains to be seen. Announcements so far indicate that some subsidies to low-income households are on the table, but more details, including on the size of total spending, still need to be communicated. Government meetings in the coming weeks are expected to yield more details.

Conclusion

The Chinese economy has, for a long time, faced several structural headwinds to growth, many of which stem from old growth drivers becoming increasingly ineffective and inefficient. Those structural headwinds seem to be coming to head with a cyclical downturn in confidence, domestic demand, and inflation. The structural and cyclical elements are clearly linked and suggest that for China’s newly announced stimulus push to effectively boost growth in a sustainable and lasting way, it needs to address certain imbalances in the Chinese economy. It is encouraging, therefore, that Chinese policymakers are looking at adjusting policy frameworks in addition to introducing more policy easing. If implemented in a timely manner, and with an eye towards truly targeting new growth drivers, including fueling a recovery in consumption, the Chinese economy may finally find itself on a more promising growth path. Until details and follow-through are confirmed, however, the Chinese economy risks more disappointing results.

<sub>1. Li, Xiangfa & Wang, Hua, 2020. "The effective of China's monetary policy: Quantity versus price rules," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
2. https://www.elibrary.imf.org/display/book/9781513539942/ch07.xml
3. https://www.rba.gov.au/publications/bulletin/2024/apr/chinas-monetary-policy-framework-and-financial-market-transmission.html
4. http://www.pbc.gov.cn/en/3688229/3688335/4738114/5241680/index.html5. https://www.kbc.com/en/economics/publications/debt-decoupling-and-diversifying-growth-chinas-many-challenges.html
6. https://www.bis.org/review/r240621c.htm
7. Local Government Financing Vehicles Revisited. IMF Country Report No. 22/22 Selected Issues. December 20, 2021
8. China: Further takeaways from the Decision of the 3rd Plenum. J.P.Morgan. 22 July 2024.
9. Taxes on domestic consumption accounted for about 7% of total tax revenue in 2023 for the general government according to China’s Ministry of Finance.
10. https://www.ft.com/content/954f761d-4c4c-4746-ba8d-89d9c67b52da</sub>