Stimulus Measures Expose Weakness Since Third Plenum

Executive Summary:

• Two major developments have followed the Third Plenum in July. First, a series of economic data releases indicated that the plenum had done nothing to improve the country’s short-term outlook. Second, a series of stimulus measures were announced over a two-week period, that have so far failed to reinvigorate the economy.
• The government is unlikely to enact the reforms necessary to support consumption due to high public debt and limited fiscal capacity, as doing so would require cutting subsidies central to the country’s industrial policy. This would contradict Xi Jinping’s focus on innovation.
• The People’s Bank of China may need to continue interventions in both the sovereign bond market and the stock market, though this could reduce foreign investor interest in Chinese financial markets.
• The government’s stimulus measures so far have largely been aimed at stabilizing asset prices rather than addressing the deeper issues of demand and overcapacity.

For more than a decade, the rate of economic growth in the People’s Republic of China (PRC) has been slowing. This trend first accelerated in the wake of the trade war initiated by the United States in 2018, and then even more so after the end of the Zero-COVIDpolicies in late 2022. The causes of the slowdown are both structural and cyclical. Examples of the former include a declining population, while overinvestment—leading to diminishing returns, overcapacity in many sectors, and deflationary pressures—is an example of the latter. The collapse of the PRC’s once massive real estate market has further worsened the country’s economic outlook since 2021. Considering these challenges, there was hope that the Third Plenary session of the 20th Central Committee of the Chinese Communist Party (CCP), held from July 15–18, would introduce structural reforms (China Brief; July 23, July 27).

Prior to the plenum, analysts focused on three possible reforms that could revitalize the PRC’s domestic economy: reducing the Party-state’s involvement in the economy to empower the private sector; fostering domestic consumption to reduce reliance on exports; and rebalancing away from the manufacturing sector and toward consumption as a driver of growth. The reforms introduced at the plenum disappointed on all three fronts and indicated that PRC President Xi Jinping has no intention of changing the overall direction of his economic policies. A string of weak data in the interceding months has finally persuaded the leadership that stimulus measures are necessary, yet a series of press conferences making vague announcements of further stimulus has done little to assuage concerns. It appears that further announcements will only be made at the end of the National People’s Congress Standing Committee meetings, which will likely be held at the end of the month (South China Morning Post, October 15).

Third Plenum Sparks Muted Initial Response

The “Decision (决定)” document released after July’s Third Plenum diagnosed the country’s problems and offered some solutions (People’s Daily, July 23). It highlighted three major challenges: the real estate sector, local government finances, and systemic risks within the financial system (People’s Daily, July 22). Three key measures were announced to address these issues: accelerating urbanization by reforming the rural-urban land system; centralizing fiscal policy to support local governments; and reaffirming the importance of innovation in advanced technologies and manufacturing (Gov.cn, July 18).

The proposed policies fail to address a key underlying cause of the economic slowdown—weak demand. Urbanization reforms may spur demand for housing and infrastructure in the short term, but once urbanization reaches its limits, the PRC’s shrinking population will further strain productivity, especially in cities (China Leadership Monitor, May 30). Support for local government finances in the Decision, while necessary, lacked concrete details, particularly on how much revenue will be transferred from the central government. Local governments’ finances have been strained since land sales—their primary source of revenue—collapsed in mid-2021. The focus on technological innovation in the Decision echoes President Xi Jinping’s previous calls for “new quality productive forces (新质生产力)” (China Brief, March 15; May 10). Phrases like “improve the new system for mobilizing resources nationwide (健全新型举国体制)” (section 4) and “deepening institutional reforms for talent development (深化人才发展机制改革)” (specific task 15) were emphasized (Gov.cn, July 21).

Since the plenum, ministries have begun implementing policies based on the Decision’s directives. In early August, the Ministry of Industry and Information Technology (MIIT) announced new research funding rounds, paid for by the central government through the National Key Research & Development Projects (NKP) program (MIIT, August 9). The Ministry of Finance (MOF) and three other agencies also issued measures to improve access to financing for innovative small and medium-sized enterprises (SMEs), in line with the plenum’s objectives for further industrialization and moving up the value chain. The MOF measures focus on the national financing guarantee fund, which is intended to encourage banks to grant more loans to SMEs, by providing surety for a share of the loan amount (MOF, August 23).

While these policies could be a departure from existing, innovation-centric industrial policy and not just a continuation, they do not indicate a pivot from the PRC’s supply-driven growth model. This reflects Xi’s desire to reduce the country’s dependence on the United States and achieve self-reliance in a number of areas, including in certain technologies. Focusing on production risks exacerbating overcapacity, however. This is compounded by global reluctance to absorb the PRC’s increasing output, especially amid rising protectionism not only from the United States but even from some Global South countries (South China Morning Post, April 23; Business Standard, June 27; CNN Indonesia, July 5; Bangkok Post, August 28).

Weak Data Sparks Stronger Intervention

Two major developments have followed the Third Plenum. First, the PRC’s economic slowdown has worsened, with particularly weak data in August. Consumption, as measured by retail sales, fell to 2.1 percent over the previous year (National Bureau of Statistics [NBS], Sep 14). This indicates that the country could fall short of its target topline annual growth of 5 percent. The growth rate of fixed asset investment also hit its lowest of the year (3.4 percent), with real estate a sizable drag and infrastructure investment providing minimal contribution (NBS, September 14). Investment in manufacturing provided a rare bright spot, remaining robust, though this only increased concerns about overcapacity, as evidenced by deeper deflationary pressures, especially in producer and export prices (NBS, September 14; September 9).

The resistance to a move toward a consumption-driven growth model may be political. It is possible that the leadership believes that such a model would be deleterious to the regime, as more consumer choice would entail less government control. An alternative explanation is that there is simply too little fiscal and monetary space to introduce consumption-oriented reforms. The PRC’s public debt has already reached 100 percent of GDP, the highest among emerging economies and very close to that of the United States (Natixis Research, May 7). On the monetary side, two constraints on the People’s Bank of China (PBOC) prevent it from following a course of quantitative easing. First, lowering rates could exacerbate the outflow of capital from the PRC, weakening the currency. Second, PRC banks need to grapple with an increasingly low interest rate margin. This is particularly important in the PRC as its state-owned banks are responsible for carrying out government policies, including stimulus measures and industrial policy.

In the last week of September, four sets of new measures were finally announced. On September 24, PBOC governor Pan Gongsheng (潘功胜) unveiled the first set of stimulus measures, followed by further measures following the Politburo meeting on September 26 (PBOC, September 24; Gov.cn, September 26). These injected liquidity into the banking system by lowering the reserve requirement ratio by 50 basis points, as well as lowering the cost of short- and medium-term (7-day and 1-year) funding.

The second set of measures targeted propping up the stock market by offering financing for purchases of stocks and for share buybacks (PBOC, September 24). An additional 500 billion renminbi (RMB; $70 billion) may be introduced in subsequent phases. The PRC is also considering establishing a stock stabilization fund to provide RMB 800 billion ($110 billion) in initial liquidity support for the equity market. As part of this initiative, the PBOC plans to create an RMB 500 billion ($70 billion) swap facility to allow securities firms, funds, and insurance companies access to liquidity for stock market investments. There are also proposals for an RMB 300 billion ($40 billion) specialized relending facility to assist banks in supporting listed companies and major shareholders. This is the first time the PBOC has used its balance sheet to save the stock market, something that did not occur when the government stepped in to prop up the stock market in 2015.

A third set of PBOC measures aims to support the ailing stock market by lowering the benchmark rate for mortgages while allowing households to refinance their mortgages from fixed to variable rates. The latter should allow households to save on interest payments as the PBOC continues to cut rates. On the real estate front, local governments, especially in Tier 1 cities, are lifting macroprudential regulations such as high down payments for second homeowners that were introduced in previous years to avoid a spike in housing prices.

These measures collectively point to a potential further worsening of banks’ solvency. This would explain recent rumors of a government-led recapitalization of the banking sector. In other words, in exchange for their support to revitalize the PRC economy, banks are likely to receive recapitalization funds from the state (Bloomberg, September 25).

Finally, the PRC plans to issue special sovereign bonds worth around RMB 2 trillion ($280 billion) this year as part of a fresh fiscal stimulus, though there are no details yet on how this will be implemented (Reuters, September 27). This amount remains small relative to the size of the PRC economy, at around 1.5 percent of GDP. The announced stimulus leans more on the monetary than on the fiscal side and prioritizes boosting asset prices, whether stock or housing prices. A fiscal “bazooka” is yet to be unveiled, despite ample opportunity to do so: There have been a number of press conferences over the last week, including by the National Development and Reform Commission (NDRC) on October 7, the MOF on October 12, and the Ministry of Housing and Urban-Rural Development (MOHURD) on October 17 (SCIO, October 8; MOF, October 12; Xinhua, October 17). These have only produced vague measures, with no concrete numbers.

More than a fiscal stimulus, the PRC seems braced for a rescue package to address all the country’s growing risks to financial stability. First, the government intends to recapitalize banks when needed but also support local governments financially regarding hidden debt. Second, Beijing expects banks to support real estate developers by providing local governments with the requisite resources to buy unfinished or unsold housing units. These measures are bound to be costly, but the ultimate size of the rescue package remains unknown. Such a rescue package could be a pre-condition for the PRC to move to a stimulus package that is focused on supporting consumption, though this is not expected to happen in the near term.

Elements of the economy initially reacted positively to the policies. At the end of September, the PRC’s major stock market indices had their best single-day gains for 16 years (CNBC, September 30). Within two weeks, however, those gains were largely erased (MarketWatch, October 16).

No Basis for Expectations of Structural Reform

One rationale for the shift to stimulus measures, which departed from the long-term strategy outlined at the Third Plenum, could be as a response to data on low economic activity that came in below expectations. Confirmation by the Federal Reserve of continued monetary easing, which came in mid-September with an interest rate cut of 50 basis points, could be another crucial factor (Federal Reserve, September 18). The large cut, and the expectations of further cuts in the near future, allow the PBOC to cut without the fear of a rapid depreciation of the RMB. Still, PRC policymakers will need to deal with the negative impact on banks.

Despite stock market gains, some investors are skeptical that the announced stimulus will prove effective. One data point in this regard is yields on sovereign bonds, which continue to plummet (MOF, September 30). In other words, fixed income investors still expect very low nominal growth in the long term. This could have corollary effects on the financial stability of banks and insurance companies, which hold the bulk of PRC sovereign bonds. This also means that the PBOC’s intervention to prop up sovereign yields, which occurred through state-owned commercial banks, may need to continue, alongside support to the stock market. A second-order effect of continued—or even increasing—PBOC intervention in the PRC’s financial markets will likely reduce appeal for foreign investors.

Certain signals would trigger optimism among investors that the ongoing stimulus can indeed improve the PRC’s growth prospects. The most important of these would be the announcement of fiscal stimulus geared toward supporting household consumption. This would be difficult to engineer, as it entails moving away from investment in the manufacturing sector, which is the country’s main source of growth. If incentives such as government subsidies were to disappear and be redirected toward consumption, this could cause significant damage to growth in the short term.

Boosting consumption will also not be possible without major reform of the tax system and welfare state. In the absence of such structural reforms, there is no quick fix to the PRC’s economic woes and structural imbalances. This also means that the PBOC’s stimulus might prop up stocks but not prices, leaving the problem of structural deflationary pressures unresolved. The absence of measures to support retirement or the unemployed in the Third Plenum, for example, indicates that such moves could still be a long way off. The PRC has instead announced policies to raise the retirement age and increase the compulsory contribution period for households to be eligible for a pension.

Fiscal constraints are equally significant in reducing the likelihood that the PRC will make the reforms necessary to support consumption. For a country with 100 percent of GDP in public debt and a GDP per capita of barely $13,000, a generous welfare state would require a massive reduction in other government expenditure (Gov.cn, February 29). This would have to start with subsidies to corporations, which are at the core of the country’s industrial and innovation policies—an unlikely prospect, as it would go against President Xi’s mantra of supporting “new quality productive forces” and the necessary innovation to reduce the technology gap with the United States (Asia Times, July 22).

Conclusion

The Third Plenum failed to prevent the PRC’s economy from further deteriorating, as it did not offer sufficient proposals to alter the country’s economic trajectory. Deflationary pressures stemming from oversupply and underconsumption, coupled with the fear that the annual growth target will not be achieved, led to a sudden announcement of stimulus measures by the central bank on September 24. These aim to lift asset prices after years of underperformance, but crucially are not intended to support domestic consumption or reduce overproduction in the manufacturing sector. Boosting domestic consumption would require reforms to the core of the PRC’s fiscal model, which currently favors supporting companies rather than building out a welfare state. No such reforms were announced at the Third Plenum. The recently announced stimulus looks to be a temporary patch to the country’s ongoing economic malaise, not a definitive solution.