State Council Signals Resolve with 4-tril.-Yuan Stimulus Package for China

Why 4 tril. Yuan?

Some domestic commentators have compared the proposed steps central government would like to take as tantamount to a "New Deal with Chinese characteristics", referring to the range of policy reforms and social institutions created in the wake of the Great Depression in the United States. However, it is unclear how much of this total is incremental new investment. A significant portion of the investment in transportation, for example, was already planned as spending for 2009. It is important to keep in mind that current circumstances in China are not dire by historical standards, considering growth might in a pessimistic scenario be flirting with 7% for next year. But for an economy which depends so much on rapid growth and has had rickety social safety net programmes in the best of times, a deceleration approaching five percentage points, a growth recession, stings like a real one. Growth for the third quarter of the year came in at 9% year-on-year (y/y), and many domestic think tanks and investment banks have since downgraded their outlooks for 2009 to around the 7% range.

In the context of increasing inter-agency gridlock, a crisis, real or exaggerated, is necessary to push through such a broad range of initiatives that have been watered down when pushed individually. For certain senior leaders, especially affiliates of President Hu Jintao with support networks based on the provincial bureaucracies, this stimulus package will empower their protégés held back until now by central restrictions on credit growth. The State Council statement explicitly admits that the current crisis provides an opportunity for China to spend on upgrading the national industrial structure, as well as attract human resources from abroad. The preliminary estimate quoted by the State Council for the initiative below comes in at 4 trillion yuan (US$587 billion) through the end of 2010. For the fourth quarter of this year, the government will boost investment in central government projects by 100 billion yuan, with the vague promise to stimulate "local and social" investment by 400 billion yuan without a time market. The 2009 budget of 1 trillion yuan for earthquake reconstruction in disaster areas will be raised by a further 200 billion yuan. Key questions surrounding these measures include how the expenditure increase will be monitored and managed, and how corruption might factor into the equation.

In short, this stimulus package speeds up virtually every social or policy initiative to have stalled or been slow in taking off in the past five years:

The Agenda

• Speed up construction of low-income housing, and increase capacity of this to be leased to migrant workers, while repairing run-down rural housing.
• Speed up rural infrastructure construction, providing natural gas and clean drinking water.
• Speed up railway, expressway and airport construction to facilitate passenger flows and energy resource transportation. Build trunk and supporting airports in western China, and speed up improvements to the power grid.
• Speed up the development of medical care, sanitation, and cultural and educational enterprises, including speeding up construction of rural school houses and special schools in western China.
• Increase construction related to the protection of the environment, including waste water and garbage treatment, water pollution prevention, forestry and other natural resource protection, as well as construction related to energy conservation.
• Speed up innovation and the adjustment of the industrial structure in high-tech, cultural and technical areas, as well as supporting services.
• Quicken the pace of reconstruction projects in earthquake disaster areas.
• Raise rural incomes and minimum grain purchasing prices, as well as agricultural subsidies for equipment, social programmes for low income groups and subsidies for retirees and special needs groups.
• Implement production-based VAT reform throughout the country, encourage technological transformation, and reduce the burden on enterprises by 120 billion yuan.
• Increase financial support for the maturation of the economy. Cancel credit quota restrictions on commercial banks, reasonably increase the scale of credit, and strengthen financial support for focal projects, including rural support policies, small to medium-sized enterprises (SMEs), and technological transformation, as well as directed support for the encouragement of consumer credit services.

Raising 4 tril. Yuan

With official figures for government debt at less than 20% of GDP, the Chinese authorities have far more room for grand spending initiatives than most of their peers around the world. Even if the total is significantly underestimated, as many believe, the government's fiscal position is still better than the OECD powers with whom it will meet in the coming weeks to discuss the reshaping of the global financial order. For a developing country, government debt levels in China might look a little high, but the government still has strong debt-raising capacity. Government bonds will fund some of this spending plan, but indications are China will rely on the "financial system", loosely interpreted as commercial banks sharing some of the burden.

Recent reserve requirement cuts, and the announcement of a relaxation of lending quotas that have hampered commercial banks this year, are intended to increase the rate of money supply and credit growth for the fourth quarter and into 2009. The general response to this has been positive. However, recent history has repeatedly shown that, during times of perceived economic distress in China, commercial banks are pressured by politicians to lend against economic and credit cycles, boosting levels of lending to sectors that face dimming prospects and rising risks.

There are probably unrealised losses already, and lending against the cycles to industries that will not be direct beneficiaries of the stimulus package itself could increase portfolio risks.

The chaos in global financial markets has drawn attention away from the fact that the Chinese stock market crashed this year, vaporizing more than 15 trillion yuan in market capitalisation, a figure equivalent to 65%+ of GDP. Unsurprisingly, corporate profitability has suffered as a result, with many firms, listed and not, having suffered direct or indirect losses from the decline. One year ago, reinvesting profits in share markets rather than the core business, not to mention cross shareholding schemes to pump up their own share prices, was a ready alternative to actual improvements to operating performance. The prevailing wisdom has been that Chinese banks have not been hurt by the tanking stock market. This is hard to believe and unlikely. Before regulators stepped in to stem the practice (thereby confirming such behaviour exists despite public denials), many individual and corporate speculators borrowed money, perhaps in the form of a mortgage or as working capital, and invested in "sure-thing" opportunities in the stock market. These positions are probably well under water now, after a loss of 2,000 points on the Shanghai composite index and property markets turning soft. These losses, like related ones in the corporate sector, have not yet been realised, and could well be significant despite the bloated asset bases of the major commercial banks.

Regional Governments Want their Piece of the Package

Regional officials, like their peers in Beijing, are keen to boost spending on projects they can claim credit for. For example, Huang Huahua, the provincial governor in Guangdong, has pledged to spend some 2.3 trillion yuan over the next five years on various projects in the region, including 5 billion yuan on the high-tech sector. Regional governments in Shandong and Anhui have made similar announcements in the past week, and more are likely to follow. The "investment hunger" of regional governments is a lever of fiscal stimulus that would make Keynes grin, but the problem is that past growth cycles in China have shown that the means of effecting this stimulus is mostly financial, not fiscal. The burden of lending is put on the commercial banks, as government revenue growth at all levels slows, and the government itself is unwilling to allow the issuance of such a large amount of new public debt for fear of losing face.

Historically, the easing of lending quotas has allowed regional officials to pressure commercial banks to fund their own programmes in addition to those sponsored by the central government. The test this time will be how well the financial system can restrain redundant and misguided investment into industrial capacity. Another challenge will come in how efficiently various levels of bureaucracy can spend what amounts to, in some cases, such as rural infrastructure, health and education, large budgetary increases. Aspiring officials in China will be happy to spend budgets as quickly as possible, but this does not necessarily mean that they will spend them well.

Local Chinese media reports that 12 provincial governments in "focal regions" will be able to "receive approvals or start work" on projects totalling 1.5 trillion yuan "within 100 days". Exact details on total incremental investment, or how the amounts will be spent, remain unclear. The regions cited in the report are the top twelve in terms of GDP. This means Guangdong is on top of the list, where the export sector has been battered by recent developments, followed by Shangdong, Zhejiang, Jiangsu and other costal regions with large external exposures that have seen below average investment growth so far this year. Smaller inland regional economies have been outperforming the national trends in terms of output and investment growth already this year.

Emphasis will be put on railway construction, which will account for 29.95% of the total, or 444.1 billion yuan, with a reported 199.4 billion of the total to go to Hebei. A reported 116.7 billion yuan of this comes from projects already under way. Another large chunk of this total, 122.4 billion yuan, will be directed to the high-speed rail link between Beijing and Shanghai. A reported 127.3 billion yuan will be directed to rail projects in Guangdong, accounting for a reported 68.3% of the total investment quota for the region under this programme. Airport investment in Guangdong will also be a significant portion of the remaining amount.

In Beijing, investment in policy-backed housing will take up 201.6 billion yuan.

Energy development will also feature prominently in investment programmes for Anhui and Hebei, with the two regions to receive 50 billion and 38.3 billion yuan respectively. Power generation projects in Anhui will be a focal point of investment in that region, with any surplus to be sent to the Yangtze River Delta area. A similar scenario is described for Hebei as a power base for northern China.

A reported 4.7 billion yuan will be spent on environmental protection projects, a small amount intended to ease worries that the rush to stimulate growth will mean setbacks to efficiency and environmental protection targets.

Outlook and Implications

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