China: Fiscal Stimulus and Monetary Loosening

UNCLAS SECTION 01 OF 06 BEIJING 000829 SIPDIS SENSITIVE STATE FOR EAP/CM AND E/YON TREASURY FOR OASIA/DOHNER/WINSHIP TREASURY ALSO FOR IMFP/SOBEL/CUSHMAN NSC FOR LOI E.O. 12958: N/A TAGS: ECON EFIN PREL CH SUBJECT: China: Fiscal Stimulus and Monetary Loosening Keep Economy Growing Ref: a) Beijing 0728 b) 2/25 Loevinger-Treasury email c) 08 Beijing 4665 BEIJING 00000829 001.2 OF 006 Summary -------------- ¶1. (SBU) Many Chinese economic contacts remain optimistic China can attain eight percent GDP growth in 2009, although some local and foreign economists recently have lowered their forecasts to 6-7 percent or even lower. The World Bank expects no contribution to real GDP growth from net exports, with no other significant potential growth sources apparent. Most interlocutors view the Government's fiscal stimulus measures positively, estimating they will add one percent to GDP growth in 2009 and 2010, while the rising fiscal deficit (to three percent of GDP in 2009) does not raise concerns about the sustainability of public finances. Government efforts to rebalance the economy away from exports in favor of domestic consumption are welcome, but some question their effectiveness and adequacy. China's "appropriately loose" monetary policy since October has led to a larger than expected surge in new credit, in particular to finance stimulus projects, with some concern among regulators that this could sow the seeds for future growth in non-performing loans. See Comments in paragraphs 22-24. End Summary. ¶2. (SBU) During a February 25-27 visit to Beijing, U.S. Treasury DAS Robert Dohner discussed economic and financial issues with the following officials and economists: Vice Chairman Ma Xiaohe of the Academy of Macroeconomic Research, National Development and Reform Commission (NDRC); Director General (DG) Zheng Xiaosong, International Department, Ministry of Finance (MOF); DG Liu Chunhang, Research Department, China Banking Regulatory Commission (CBRC); DG Xia Bin, Development Research Center (DRC); DG Zhang Xin, Financial Stability Department, People's Bank of China (PBOC); DG Yin Yong, Reserve Management Department, State Administration of Foreign Exchange (SAFE); DG Shi Gang, Department of National Economy, NDRC; Managing Director Arthur Kroeber, Dragonomics; Resident Representative Tarhan Feyzioglu, International Monetary Fund; Chief Economist Shen Minggao, "Caijing" magazine; and Country Director David Dollar, World Bank. Comments by SAFE DG Yin and MOF DG Zheng were reported separately in refs a and b. Eight Percent GDP Growth Still Possible? -------------- ¶3. (SBU) As late as December 2008, most local and foreign economists believed China would be able to achieve about eight percent GDP growth in 2009, albeit with "big risks on the downside" (ref c). Now, however, while still more optimistic than foreign observers, our Chinese contacts are noticeably less unanimous and less positive. At the top of the optimism scale was NDRC DG Shi Gang, who said there remains "great room for growth" in China. Capital and labor are plentiful, prices of imported commodities are falling, and China still offers an attractive and stable investment climate. While the government's policy measures will need time to have an impact, maintaining eight percent GDP growth in 2009 is still possible, especially if the U.S. stimulus package is effective quickly. While growth will be slower than 2008, Shi said the recovery will begin in the second half of 2009. DRC DG Xia also thought eight percent growth is likely, although he said the focus on this number is based on the need to maintain social stability. Xia agreed that China pins considerable hope on a relatively rapid U.S. recovery to support its own growth, although "personally" he is not optimistic about the near-term prospects for the United States. ¶4. (SBU) The IMF, like many others, has lowered its forecast for China, and Resident Representative Feyzioglu said this is the first time he has seen such "tremendous" variations in views about growth in China. He estimates 2009 GDP growth will reach 6.5 percent, although eight percent remains possible "if China is lucky." Despite the decline in the price of imported commodities, China's trade surplus may increase in real terms in 2009, and it definitely will grow in nominal terms, as China still enjoys a competitive advantage in many light industry BEIJING 00000829 002 OF 006 sectors and has been gaining market share and opening new markets in Latin America, Europe, and elsewhere. ¶5. (SBU) The World Bank's Dollar said he is "very worried" about China's growth prospects for 2009. He expects no contribution to real GDP growth from net exports, and no other significant potential growth sources are apparent. Investment will be unable to compensate, as manufacturing investment (about one-third of total investment) has stopped; real estate, about one- fourth, is weak; and infrastructure, which had been about twenty percent, is unlikely to increase enough to offset the other declines. (Note: In its "Quarterly Update" report issued March 18, the Bank lowered its 2009 GDP growth forecast to 6.5 percent. End note.) Proliferating Pessimism -------------- ¶6. (SBU) Three other economists provided worrisome views. Kroeber of Dragonomics said underlying conditions have worsened in recent months. In 2009, exports will decline for the first time in memory, forcing a severe downward wage adjustment in the export sector given China's exceptionally flexible wages and leading to real exchange rate depreciation (based on relative unit labor costs). As a result, China's exports will decline less than those of other regional economies; with lower commodity prices reducing imports, China's trade surplus will grow even as exports decline. Kroeber opined that China's growth is not helpful to other countries in the region, because even as China "gets its own house in order" it will adversely impact the growth of its neighbors. ¶7. (SBU) Shen of "Caijing" magazine, noting a tendency for the aggregate weighted average of provincial GDP growth rates to exceed by several points the national GDP growth rate, noted that local governments are projecting "only" about seven percent real growth for 2009. Shen believes that "fast" growth (nine percent) this year under the current economic model would lead to "disaster," due to huge over-capacity, and even eight percent growth would not necessarily lead to social stability, because that growth would benefit upstream rather than more labor intensive downstream sectors. NDRC's Ma observed that China's domestic consumers cannot compensate for the slump in export demand, even if the government asks them to "show their patriotism" by buying more goods. As a result, excess productive capacity will mean fewer jobs, weak growth in wages, household income, and consumption. Stimulus is Working? -------------- ¶8. (SBU) Chinese economists were positive about the Government's efforts to stimulate the economy, including a fiscal stimulus (which will increase the budget deficit in 2009 from 0.5 percent of GDP to at least 3 percent), looser monetary policy, and ten sectoral consolidation plans. According to NDRC's Shi and DRC's Xia, the new policies are intended concurrently to boost growth, promote economic restructuring, upgrade technology levels, and create or preserve jobs. Xia believes the fiscal package demonstrates that the Government has both the determination and the means to address the economic situation. Underpinning that package are literally hundreds of policy changes issued by the State Council and other ministries to boost demand and consumption. ¶9. (SBU) NDRC's Ma estimated the central government's fiscal stimulus would add roughly one percent to GDP growth in 2009 and 2010. In addition, thus far 28 of 31 provinces have initiated their own stimulus plans. Central and local authorities have taken various other steps to stimulate domestic consumption, including subsidies for household appliance and automobile purchases by rural residents, consumer vouchers, and provincial and local tax benefits to encourage property purchases. Ma said these stimulus measures seem to be having some effect, although it was not yet clear whether the economy has turned around. ¶10. (SBU) Both the World Bank and the IMF have welcomed the stimulus measures. Dollar said there is "a lot of good stuff." Some large projects slowed in 2008 due to BEIJING 00000829 003.2 OF 006 economic over-heating can quickly and easily be restarted. While domestic content regulations limit access for foreign firms in some sectors, many other infrastructure projects are open, although requirements vary. Feyzioglu said he was impressed by the Government's rapid reaction to the crisis, noting that a higher near-term fiscal deficit, even as much as five percent of GDP, would not be a concern. Shen of "Caijing" believes the Government wants to keep the fiscal deficit under three percent of GDP, although if local government borrowing were made explicit China's actual deficit already would be "huge." (Comment: Some Chinese officials appear focused on limiting the fiscal deficit to three percent of GDP, which MOF officials have characterized as a prudent international threshold. Ironically, this came from Europe's Maastricht Treaty, which was based on Europe's much lower potential growth rates. Most Western analysts believe China could prudently run a much larger deficit. End Comment.) ¶11. (SBU) According to Shen of "Caijing," provincial and local governments are optimistic about 2009 but complain of insufficient funding. Only the central government is permitted to issue bonds, and during the previous crisis (late-1990s) it did so on behalf of the local governments, which never repaid Beijing. Nonetheless, the central government is issuing RMB 200 billion in bonds for local use, which constitutes about forty percent of the local share of fiscal stimulus financing. Shen also believes the stimulus package is overly focused on upstream industries and primarily will benefit state-owned enterprises, so any supplemental stimulus package should focus more on downstream industries. Rebalancing: Old Advice, New Urgency -------------- ¶12. (SBU) DRC's Xia said China will "do everything possible" to rebalance from an export-driven economy toward a more consumption-driven model, something which Dollar said the World Bank has been advising China to do for years. The Bank also is encouraging China to further liberalize trade and investment in services. IMF's Feyzioglu noted several Government measures to boost consumption, such as the rural voucher system and a huge rise in health care expenditures. He recommended accelerated reform of the pension and health care systems to boost consumption, together with an increase in the minimum taxable income threshold. NDRC's Ma believes China's per capita income remains too low for "mass consumption" to take hold. ¶13. (SBU) Dragonomics' Kroeber questioned the Government's willingness to grapple with the need for structural change, as well as its ability to find a substitute for external demand and an "alternative productivity driver" after the short-term effects of the fiscal stimulus have worn off. He detects little determination to push through structural reforms that would reduce reliance on industry and support growth of services. Shen of "Caijing" observed that an increase in consumption would benefit both China and the world, but the "Chinese Government has not done anything significant" in this regard. This, he said, is due in part to conflict between the central and local governments; the latter only care about investment, not consumption, so they do not view tax cuts and social welfare spending as particularly useful. (Note: Some analysts argue that the fact that manufacturing is taxed more heavily than services may encourage government officials to promote manufacturing investment). Unemployment Worries -------------- ¶14. (SBU) China's rising unemployment problem plays a prominent role in most discussions of economic policies. Kroeber of Dragonomics said current measures will get "enough" people employed, meaning that "stability" will not become a problem. World Bank's Dollar said real wages are fairly flexible in China, and wage levels have been declining since the onset of the crisis. He believes manufacturing employment in China may have peaked permanently, and in any event has not been a significant net job creator in recent years. According to Shen of "Caijing," about 20 million migrant workers BEIJING 00000829 004.2 OF 006 already have lost their jobs, with each one percent decline in exports costing another 200,000 migrant jobs. He believes the Government has taken little real action, although it worries about negative social consequences (crime). Shen also argues that raising the competitiveness of Chinese industries, a key component of the ten-sector revitalization plan, may conflict with the need to increase employment; in the long term, however, both are essential. Any loss of skilled labor during the crisis would affect companies' efficiency in the long term, so the Government wants to minimize lay-offs. Monetary Policy: Appropriately Loose -------------- ¶15. (SBU) CBRC DG Liu outlined monetary policy measures taken since last year to bolster the economy. In October 2008, the PBOC lifted the lending quota, which had suppressed financing needs, leading to the lending surge since November (PBOC also reduced reserve requirements, its sterilization operations, and interest paid on excess reserves). Although January credit levels normally are inflated, as many projects are negotiated at year end, the stimulus package provided a further boost. Regulators are monitoring closely to ensure lending addresses official priorities: government projects, including infrastructure, housing, and "green" investments, as well as small and medium-sized enterprises, which Liu said the banks tend to avoid. Liu said banks will have no difficulty meeting lending needs for fiscal stimulus projects; encouraging Chinese banks to lend is not difficult, as the problem always has been holding them back. The Government has not instructed banks to increase lending by a certain amount. ¶16. (SBU) Liu said new lending surged sharply in January to RMB 1.6 trillion, of which about 600 billion was for discounting bills, 600 billion for long-term loans, and 400 billion for short-term loans. Liu believes "most of these loans are real" (for new projects). Other reasons for the huge increase include the refinancing of high interest rate loans that had been secured from non-bank financial institutions (both formal and informal) during times when the credit quota meant banks could not fulfill demand. Liu said there was no way to discern if some of the new credit was used for stock market purchases, but CBRC was trying to minimize such "leakage." ¶17. (SBU) NDRC DG Shi described China's current monetary policy as "appropriately loose," supporting Government policies to increase investment and promote private sector lending, and said commercial banks are willing to support central Government projects. PBOC DG Zhang said he was not surprised by the huge January lending, but is concerned that more than one-third of the new credit was for discounting bills, in which, given the low lending rates, there are arbitrage opportunities and corporate borrowers can earn a higher rate in corporate time deposits. Shen of "Caijing" observed that the Government wants to ensure its control of the financial system and maintain control of credit growth, so the pace of reform will slow, especially with regard to the financial sector, interest rate liberalization, and opening of the sector to private investment. Feyzioglu said the IMF has recommended that China raise deposit rates, which the government resists because that would lower bank margins. He said very low deposit rates mean the opportunity cost of investing also is very low, so enterprises tend to invest a lot. 2009 Will Test China's Banks -------------- ¶18. (SBU) CBRC DG Liu said the global crisis has not had any substantial direct impact on China's banks, but "the indirect impact is coming". Thus far, non-performing loan (NPL) ratios have not increased significantly; in 2008, the stock of NPLs actually declined by one-third (to about 2.3 percent, the lowest ever) due largely to Agricultural Bank of China restructuring (which moved some NPLs off of ABC's and the banking sector's balance sheets),although the Sichuan earthquake in May caused NPLs to rise. China's banks are well-capitalized: 204 of 205 commercial banks meet capital adequacy requirements, with an aggregate level near twelve percent. In 2008, regulators increased provisioning requirements against BEIJING 00000829 005 OF 006 bad loans, and the coverage ratio is now about 117 percent. Bank profits in 2008 rose thirty percent to a record high, due to China's very strong economic fundamentals. ¶19. (SBU) Nonetheless, said Liu, "stress is coming" and "2009 will be a true test of risk management and corporate governance in the banks." With GDP growth falling Liu expects NPLs to increase. In a partial relaxation of policy (and acknowledgement of realities), CBRC is asking banks to adhere to prudential principles and maintain their NPL ratios, but their NPL stocks will be permitted to grow. CBRC also is watching closely to ensure there is no "mucking around with the data," and Liu believes regulators will know quickly if problems are developing. Local governments are pushing for more lending, prompting complaints from the banks, but so far there have been no "breakdowns" and risk management in the big banks is "holding up well." The smaller and regional banks are under more pressure due to decline in real estate prices, so they are not as "robust." According to IMF's Feyzioglu, NPL ratios may rise to 4-5 percent, which the large banks can handle. The small city banks, however, have been hurt by real estate and export slumps, and China has no explicit deposit insurance. ¶20. (SBU) DG Liu said one of the highest risk sectors is real estate, although China's "bubble" is not as large as earlier ones in Japan and the U.S. The government promptly issued new regulations and guidance at the peak of the bubble (mid-2007),so mortgage NPLs (about one percent) have not increased. Regulators and lenders are "sticking to the rules," although the minimum housing down payment has been lowered to 20 percent to encourage sales. Despite a serious drop in sales volume in 2008, Liu believes China's real estate prices need to decline further. Foreign Banks Face Different Issues -------------- ¶21. (SBU) DG Liu noted that last fall concerns about counterparty risk temporarily made it difficult for foreign banks in China to access RMB liquidity, but the CBRC, SAFE, and PBOC acted quickly to create a new liquidity facility. PBOC DG Zhang said foreign banks encountering liquidity difficulties can borrow from the PBOC with collateral, or can obtain capital from overseas. DG Liu observed that some of the foreign banks had loan to deposit ratios of up to 300 percent, far above the CBRC limit of 75 percent, but the regulator "tolerated this behavior" and extended a five-year grace period for compliance. That the foreign banks now have declining loan portfolios in China is due to contraction of their parent banks, which now are "reconsidering their business model." Comment -------------- ¶22. (SBU) Heading into the second quarter of 2009, the three primary macroeconomic questions for China remain: 1) will China's domestic consumption grow so it makes a bigger contribution to global demand; 2) will the surge in bank lending translate into sustained growth; and 3) will the government cut spending when revenues come in under budget. First, while the sharp drop in exports has helped catalyze a consensus on the need to promote more "home-grown" domestic demand-led growth, few economists expect a meaningful decline in China's current account surplus (as a percent of GDP),and some expect an increase. Thus, as most analysts expect net exports to make no contribution to GDP growth, and even if China is able to meet its growth target, its net contribution to aggregate global demand is expected to be only slightly positive, at a time when global demand is collapsing. ¶23. (SBU) Regarding bank lending, while there has been significant official "jawboning" of banks to increase lending, there is no evidence of official enforcement mechanisms should lending growth fall below desired levels. In contrast, when the government was concerned about overheating, banks with excessively high loan growth rates were required to purchase "penalty bonds" with below market interest rates. Rather than being BEIJING 00000829 006 OF 006 caused by excessive moral suasion, the recent surge in bank lending appears to be due mainly to a rational commercial response to the lifting of a binding credit quota as well as uncertainty about when it might be re- imposed, combined with a large increase in liquidity (due to reduced reserve requirements and less sterilization) and a lowering of the interest rate on excess reserves. ¶24. (SBU) Finally, Western and Chinese officials and economists tend to have different concepts of "fiscal stimulus." While the former tend to think of a stimulus in terms of the public sector's contribution to aggregate demand (usually due to an increase in the public sector's deficit),Chinese economists tend to focus on increased spending even if it is financed through higher taxes (which subtract from private sector demand). As a result, Chinese officials can talk about a RMB four trillion "stimulus" (14 percent of GDP) with only a 2.5 percent increase in the fiscal deficit. (Though given excess capacity and an uncertain labor market, the government's propensity to save is likely to be less than that of households and corporations. As a result, tax-funded spending could still contribute to aggregate demand). PICCUTA