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