As China’s leaders gather for the annual two sessions to set the direction for government policy this year, they face a challenging outlook. After a rapid recovery from the COVID-19 pandemic, growth has slowed considerably in recent months. Several factors contributed to the slowdown.
First, macroeconomic policy was relatively tight last year, as the authorities took advantage of the strong economic rebound and buoyant export demand to rebuild fiscal buffers and return to focus on de-risking the financial sector. The latter, in particular, affected the real estate sector, leading to a dramatic slowdown in private investment.
On top of this, frequent COVID-19 outbreaks of the more easily transmissible Delta and Omicron variants have delayed the normalization of domestic consumption, particularly of services such as retail and travel.
And last, continuing global uncertainties and a tightening of domestic market regulation across a range of sectors, mostly in the digital economy, have weighed on private investment sentiment, although foreign direct investment inflows continued to be strong.
Chinese authorities have already started to recalibrate policy to respond to these challenges. A front-loading of special bond quotas and the carry-over of unspent funds from 2021 is likely to boost local government infrastructure investment. And the Ministry of Finance has announced additional tax relief to small and medium-sized enterprises, which are most affected by the protracted uncertainty.
Additionally, the People’s Bank of China, the country’s central bank, has taken steps to loosen monetary policy as the authorities contend with slowing economic growth. The partial relaxation of restrictions on lending to the real estate sector seems to have led to some stabilization, with housing prices increasing in China’s top-tier cities and the decline in sales moderating.
Despite these efforts, China’s economy still faces large downside risks. Apart from domestic uncertainties related to the future path of the pandemic and the knock-on effects of the slump in the real estate sector, including on local governments’ fiscal capacity, global risks have notably increased, with the devastating developments in Ukraine coming on top of rising inflation and tightening global liquidity. China’s net exports, which added about 1.7 percent to economic growth in 2021, may not add much this year and may even turn into a drag on growth if the global recovery stalls.
China has the monetary and fiscal space to react should downside risks materialize. The bigger dilemma facing decision-makers is not the lack of policy space, but the risk that excessive loosening exacerbates the risks associated with high corporate leverage and in some cases excessive local government debt. A return to the traditional playbook of infrastructure and real estate-based stimulus to keep growth at target would thus be ill-advised.
Instead, policymakers should calibrate support so that it is aligned with the longer-term structural shift in China’s growth model. The following policy options could help China to transition to a more sustainable growth path that is greener, more resilient and inclusive.
Fiscal support could be targeted to accelerating the green transition, for instance, by providing time-bound subsidies for related private sector investments, while at the same time announcing that the “emissions trading system” will tighten from 2023 onward. This would provide companies with the incentive to front-load investments to reduce emissions, creating short-term multiplier effects stimulating the economy while contributing to China’s efforts to achieving its dual carbon goals of peaking carbon emissions before 2030 and realizing carbon neutrality before 2060.
To address limited fiscal space among local governments, including helping them implement the government’s common prosperity agenda, fiscal reforms are urgently needed. The authorities could utilize the central government’s fiscal space to encourage such reforms, by compensating local governments for transitory revenue shortfalls, for example, from the roll-out of a property tax or efforts to pool provincial social security arrangements and extend the coverage of unemployment benefits.
In the face of domestic uncertainty, improved social security arrangements particularly for migrant workers could reduce precautionary savings motives and encourage a shift toward greater consumption.
To mitigate the risk that looser monetary policy exacerbates financial risks, China should develop more effective means for handling the exit of unviable businesses and resolving insolvent financial institutions. This would free up resources and facilitate the reallocation of credit flows to growing sectors including green investments and SMEs.
Moreover, structural reforms could help improve the competitive environment and encourage greater private sector investment. For example, further opening up of the protected services sector could improve access to high-quality services and support the rebalancing toward high-value service jobs. And lifting the remaining restrictions on labor mobility by abolishing the hukou (household registration) system, in all urban areas would equally support the growth of vibrant service economies in China’s largest cities.
Given the considerable uncertainties, China’s leaders should not lose sight of the rebalancing its economy requires. This calls for targeted rather than all-out stimulus and for continued attention to structural reforms.
(First published on China Daily on March 4, 2022 )