Xu Chenggang on Chinese Economic Reform: Government Stimulus Cannot Sustain Long-Term Growth

GDP growth should come from companies and income, not stimulus 

2017 is set to be a crucial year for the Chinese economy. The central government will need to juggle many tasks while maintaining economic growth and avoiding a stock market crash like the one that occurred in 2015, when the stock market plunged and lost 30% of its value. If that happens again, the whole economy will be affected, says Professor Xu Chenggang at the Cheung Kong Graduate School of Business.

As an expert in political economics, Xu has been studying ways to understand the incentive mechanisms needed for China’s transitioning economy, both at the government and enterprise level. He notes that maintaining economic stability and pushing real institutional reform will be a priority for Chinese government, which has to be cautious as domestic demand remains weak and government debt is piling up. Authorities are well aware that the export-oriented and investment-led economic growth model cannot sustain itself, so the government has been implementing a variety of policies to encourage consumption. But will the government-led campaign work? How can small- and medium-size enterprises (SMEs) benefit? Xu analyses these issues and gives his answers on the kind of reforms China needs and the specifics of the reform measures.

This interview consists of two parts and the first focuses on stimulating domestic demand, reducing government debt, currency exchange reforms. In the second part, Xu talks about how the rising housing prices is linked to government fiscal revenue, the major challenges of pushing reforms in China and how state-owned enterprises and local governments should roll out these reforms.

Between 2009 and 2011, China’s GDP growth exceeded its potential level of output, with a massive amount of investment and low productivity. In that period, the average total factor productivity (TFP, a variable used to measure how efficiently the input is utilized in production) was only half of the number before 2008 and returns on investment continued to decrease. The Chinese government has taken active fiscal and monetary easing policies, but still relies heavily on government-led infrastructure investments, mostly executed by SOEs. How should we view this growth model?

Even before the eruption of the global financial crisis, economic academics had started to reflect on the growth model of the Chinese economy—excessive reliance on investment and exports would not sustain stable growth in China, which was transforming from the fourth largest economy to the third largest. Large-scale investments had helped to maintain a high growth rate but also resulted in low returns on investment. In fact, the main problem of the Chinese economy has been the weak demand in the domestic market that manifested clearly in 2006 and 2007. It just became more obvious against the global financial crisis.

The government had good reasons to stimulate the market at the time of the crisis, and it’s also something a government should do under those conditions. But stimulus should only be a short-term solution. China has to face its own problem: weak demand—which had been dragging down the country’s economy before the global financial crisis. But after 2008, China maintained high-speed growth for some time just because of the fiscal stimuli.

Speaking of domestic demand, recently the State Council, China’s cabinet, released a new document, saying it will boost the supply of services to release potential pent-up demand. There have been many policies encouraging consumption, but they didn’t seem to work very well.

We have to identify the key cause of this weak demand: low income. As long as people’s income level remains low, other measures will not work very well. Compared to other countries, Chinese people’s disposable income relative to GDP is low and that’s also a result of our system and regulations, under which grass-root governments increased fiscal income with various means, and for many years the fiscal income grew faster than GDP. Now many people think Chinese people are rich and possess strong purchasing power. But even if only 100 million people out of 1.4 billion Chinese are rich and 30 million of them go shopping abroad, it will give the world the impression that Chinese are rich. But that’s not the whole story. If we apply the poverty threshold standard of developed countries, half of Chinese people are living in poverty. Those people live well and feed themselves, but they do not have extra money to consume.

Now the income gap is widening and moderate and low-income citizens are lowering their income expectations. How do we solve this problem?

Tax reduction. We should reduce income tax and increase family incomes so people feel the raise is not temporary. In this way, people will have a strong long-term income expectations and start buying. Large-scale tax cuts will make ordinary Chinese happy and benefit the development of SMEs and the government’s tax income will also increase. In the last three years, the proportion of family income to GDP has started to go up but that cannot make up for the fall in the 20 years before that. If our government truly cares for long-term economic development, it has to cut taxes further, especially for SMEs to help them revive.

But massive tax cuts may annoy the Ministry of Finance and they’ll probably complain about expenses. Issuing national bonds in both the domestic and international market can be a solution. We’re aware that the global financial crisis originated from the US, but people still like to buy US government bonds after selling their stocks. Why? Because people still believe in the US economic outlook. While most global investors are still confident in the Chinese economy, we should issue national bonds, otherwise when people lose faith in China, the authorities will have no forms of leverage. By issuing bonds and reducing tax, SMEs will have fewer burdens and people’s income increase and that will in turn make the national bonds strong.

Export-oriented business expansion helped boost the Chinese economy but now the country can no longer rely on exports. Now we have to drive domestic demand, as you said earlier, so how do we do it through reform?

Since 2016 private investments have dropped severely and main reason is insufficient demand and overcapacity. When the market faces eye-watering overcapacity issues, private companies, which are constrained by “hard budget constraints” (in contrast to government and SOEs which have “soft budget constraints”) and dare not invest when there is no market demand.

Under such a situation, when the government is still trying to stimulate the economy to maintain GDP growth, it will be hard for private enterprises to participate in the government-led rejuvenation plan. The result is what you just mentioned: SOEs are the main players on the stage, but many of the SOEs have heavy debts that very likely to become bad debts. So in a situation like this, we see more state-owned companies advancing and private-owned companies deteriorating. In China people have talked about this problem for many years but as long as we don’t solve the two problems: insufficient demand and SOE reform, private enterprises will not invest and develop.

What do you think about the problem of overcapacity?

Overcapacity runs parallel to the high debt ratio and the two problems are driven by the “soft budget constraints”. Government departments and state firms are subject to soft budget constraints and can spend money without being concerned about bankruptcy. Unconstrained investment will lead to overcapacity and that will lead to stagnant economic growth. So if we cannot fix these two problems, other measures to stimulate investment or consumption are just temporary “patches”.

What are the economic risks that China should be vigilant about?

The Chinese economy faces two major challenges: one is growth and the other is maintaining stability. What we just talked was mostly about growth, but the stability problem might be more severe. Last year’s stock market crash was a typical result of this stability problem. (In the summer of 2015, the Chinese stock market plunged and many commentators said it was a manifestation of an unstable physical economy.) The stock market crash happened very quickly and the bubble did not expand too much. If, at that time, the policy makers had chosen to keep the bubbles and let them burst in 2016, there would have been a disaster and more than just the financial market would have been affected.

Another ticking time bomb is local government debts. Currently the proportion of debt to GDP is very high (over 250%).

Including the hidden debt?

Yes, we cannot just compare the numbers. If you did it that way it would look like China has lower debt compared to Japan, and since the Japanese economy can survive high-level debt, it wouldn’t be a problem for china. This idea is misleading. The Japanese debts are mainly bonds issued by governments, yet the Chinese creditors are banks that have collateralized debts. That means, for Japan, as long as the bonds have not expired or the government can keep issuing new bonds, there won’t be a crisis. It’s just passing down the debt to the next generation.

But for China, the value of the debts will change as economy fluctuates because the value of the collateral will change. So when there are signs of economic downturn, the price of the collateral falls and the bank’s balance sheet will have to change: asset values go down, leverage ratios go up. Banks will be put under a risky situation. Some people doubt banks will go bankrupt in China because banks are state-owned. If they’re right, and the government is going to save banks anyway, what we will see is serious and unavoidable inflation. China is still an economy in transitional period. The former Soviet Union and eastern European countries witnessed hyperinflation during transitional periods because of piled up debts.

When the debt accumulated to a certain point the economy could not sustain itself？

Yes. The timing is always related to people’s anticipation. If people do not expect China to have a crisis, they will act in this way and if they do expect something to happen, they will do totally different things and that will lead to the eruption of a debt crisis. So what I’m saying is whether GDP grows at 6% or 5.5% does not matter, what matters is the stability of the economy.

Now when people look at the debt problem and they care about its percentage relative to GDP, that’s not the whole picture. You have to look at what kind of debt you have and if we want to solve it we have to reduce the collateralized debts and change them to bonds issued to the public. The majority of China’s debts were lent out from banks by local governments in the name of SOEs. That’s very dangerous.

Speaking of expectations and stabilization, as the US Federal Reserve has confirmed increases to the interest rate, some people worry that there might be more capital flowing overseas, especially when people are also expecting further depreciation of the RMB.

It’s only been a year since the People’s Bank of China carried out exchange rate reform (marketization of the exchange rate of the RMB against the dollar). From my point of view China has missed the right moment to start exchange rate reform, which began, instead, with bad timing. This reform should be done while the RMB is appreciating, not the other way around. Plus, the economic growth slowdown is also related to reform. As long as we don’t have substantial reform, the economy will keep slowing down and RMB will depreciate. The economic fundamentals determine the exchange rate.

So should we worry about capital flight?

The RMB kept appreciating over the past decade as people had high expectations for the Chinese economy and people bought Chinese assets. If the demand for Chinese assets becomes weak and more people want to sell, the pressure for RMB depreciation will continue unless the economic fundamentals improve, so it’s not just about exchange rates.

China’s economic fundamentals are mainly dependent on private companies and people’s income increases, which are all calling for real reforms. Only when the GDP grows, not depending on government stimulus plans, and people can see the fundamentals are improving, will the RMB depreciation trend be stopped.

Prof Xu Chenggang was talking to Caijing’s Wang Yanchun on the sidelines of CKGSB’s 3rd China Economic Symposium.