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China’s Fiscal Dilemma

The Chinese government is likely to face a tricky economic policy choice in the second half of this year. If it loosens its fiscal stance, public finances will worsen significantly. But if it cuts expenditure to offset the pandemic-related revenue shortfall, growth will be lower, with dire consequences.

BEIJING – COVID-19 hit the Chinese economy hard in the first quarter of 2020, causing real GDP to contract by 6.8% year on year. But since the city of Wuhan emerged from lockdown in early April, the economy has gradually returned to normal, and grew by 3.2% in the second quarter. According to the consensus view, China’s current potential GDP growth rate is 6%. If it achieves this in the second half of 2020, the economy could post full-year annual growth of 2.5%.

But achieving this outcome will require a demand boost. Lack of effective demand has impeded China’s growth for years, and the pandemic has made the situation much worse.

Consumption, which accounts for 55% of China’s GDP, fell by 3.9% in terms of social retail sales in the second quarter, on top of a 19% decline in the first three months of 2020. Some argue that consumption will now surge and become the main growth driver in the remainder of the year. But this is unlikely, because households will be anxious to replenish the savings they depleted during the lockdown. The government can and should provide relief to households affected by COVID-19, but it cannot do much to stimulate consumption.

China’s exports and imports fell by 3% and 3.3%, respectively, in the second quarter. But because the share of net exports in China’s GDP is less than 1%, export performance will in any case have a limited impact on growth in the second half of 2020.

Although fixed-asset investment turned only marginally positive in the second quarter, this was a significant improvement on the 16.1% contraction in January-March. A back-of-the-envelope calculation suggests that, given the likely growth rates of consumption and net exports, fixed-asset investment would have to increase at a double-digit rate in the second half of 2020 in order for the economy to grow by 2.5% for the year as a whole.

In China, fixed-asset investment consists mainly of three categories: real estate, manufacturing, and infrastructure. Real-estate investment grew by 1.9% year on year in the first half of 2020, and is expected to increase at a 5% rate for the remainder of the year. Manufacturing investment, meanwhile, shrank by 11.7% in the first half, and will most likely continue to be a drag on growth in fixed-asset investment for many quarters to come.

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So, the only way for fixed-asset investment to show double-digit percentage growth in the second half of 2020 is for infrastructure investment to grow much faster still. Such an outcome would be nothing new in China. In the middle of 2009, for example, infrastructure investment grew at an annual rate of 50%, owing to the CN¥4 trillion ($570 billion) government stimulus package introduced in November 2008. Only since 2018 has infrastructure investment growth fallen rapidly to low-single-digit rates, largely as a result of deliberate policy choices.

Today, Chinese policymakers should draw several lessons from the implementation of the 2008 stimulus package. One of the most important is that infrastructure investment should be financed mainly by issuing government bonds, rather than by bank loans to subnational authorities through so-called LGFVs (local government financing vehicles). China still has sufficient financial resources to support a big infrastructure investment drive, but this time the central government should be responsible for funding the bulk of it.

When the Chinese government announced early this year that it was aiming for a total budget deficit in 2020 of CN¥3.76 trillion, equivalent to 3.6% of GDP, it implicitly assumed that nominal GDP would grow by 5.4%. This is now obviously unrealistic, so budget revenues will be lower than forecast. And if the government does not cut expenditure, China’s fiscal position may worsen rapidly in the second half of 2020.

But if the government decides to reduce spending to prevent the deficit from increasing, the economy may grow by less than 2.5%. That would make it impossible for China to create as many jobs as planned, and would also significantly increase its financial vulnerability.

The Chinese government is therefore likely to face a dilemma in the second half of this year. If it loosens fiscal policy, public finances will worsen significantly. But if it cuts expenditure to offset the revenue shortfall, growth will be lower, with dire consequences.

In my view, China should be firm in adopting an expansionary fiscal policy aimed at accelerating economic growth. The government should issue more bonds to finance additional infrastructure investment, and the People’s Bank of China should adopt various policy measures to facilitate this, including quantitative easing (QE) if necessary.

The resulting problems – a worsening fiscal position and a rising debt ratio – can be dealt with later. Chinese policymakers should never forget Deng Xiaoping’s famous maxim that “development is the only hard truth.” And right now, China urgently needs a growth boost.

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