The Real Reasons Behind China’s Stimulus Talk

March 16, 2015 Updated: April 24, 2016

When things don’t quite go according to plan, central planners often resort to an old trick: Talk about potential stimulus.

If all goes well, the talk is enough to convince markets, and the actual stimulus needed will be very little. But talk is cheap.

For China, things aren’t really going according to plan at this moment. So far this year, GDP growth dipped to 7.3 percent, the lowest in two decades, and a variety of economic indicators like industrial production, retail sales, and fixed asset investments came in below expectations.

So in good old-fashioned bureaucratic speech, Chinese Premier Li Keqiang promised markets to “step up our targeted macroeconomic regulation,” if needed and “We still have a host of policy instruments at our disposal.”

This promise comes after the People’s Bank of China (PBOC) had already lowered interest rates twice over the last couple of months and the country revised down its GDP growth target for the year to 7 percent.

The stock market duly rallied more than 2 percent in Shanghai, but the following questions remain when one wants to understand China’s stimulus plans: What have they already done, why are they really doing it, and what can they actually do.

What Have They Done Already?

There are two sectors where central planners can stimulate. The first is fiscal, the second monetary. After spending $640 billion in the wake of the financial crisis of 2008, measures on the fiscal front have been rather quiet, although there has been some activity of late.

The preferred mechanism used recently was monetary stimulus in the form of $160 billion in “pledged supplementary lending” to the China Development Bank in July 2014, which usually splurges on large infrastructure projects, such as the Three Gorges Dam. Of course, there won’t be another dam on the Yangtze River, but the money will find its way into the economy anyhow.

The PBOC then extended $80 billion in short-term lending to smaller banks in September and stocks were off to the races, rising 50 percent over six months. This rather small easing package signaled an accommodative policy stance to traders who ramped up their margin speculation.

The Shanghai Composite Index:

For good measure and also to support margin trading and the origination of new loans, the PBOC also lowered its required reserve ratio.

Why Are They Doing It?

There are a couple of considerations for China to tweak its economic performance. First of all, Chinese stocks underperformed on the S&P 500 for the last five years by a whopping 63 percent, so pushing in liquidity and encouraging margin trading was a simple fix for that. After all, if the Fed can do it, so can the PBOC.

The performance of Shanghai Composite Index compared to the S&P 500 Index over the year prior to March 16, 2015. (Google Finance Screenshot)
The performance of Shanghai Composite Index compared to the S&P 500 Index over the five years prior to March 16, 2015. (Google Finance Screenshot)

Another reason is the exchange rate, which had been rising against the dollar until the regime launched the two stimulus measures and the Fed stopped its version of QE entirely.

A rising exchange rate is bad for China because it makes exports less competitive—and the export sector is still responsible for many jobs, so the regime doesn’t want it to collapse entirely.

U.S. Dollar Versus Chinese Yuan:

However, jobs are also the reason the regime hasn’t stimulated more. 

According to Richard Koo of Nomura, “It is quite possible that a sharper slowdown would prompt additional fiscal and monetary stimulus from the authorities, but I think one reason why their response thus far has been relatively tepid is the extreme tightness that continues to characterize China’s labor market.”

The job offers to seekers ratio compared to the GDP growth rate (Nomura)
The job offers to seekers ratio compared to the GDP growth rate (Nomura)

Despite falling GDP growth, there are still many more job offers than job seekers. The scarcity puts pressure on wages, leading to inflation—and the regime fears inflation as much as it does unemployment because Chinese are especially sensitive to food prices.

“If the government were to unveil a large-scale stimulus package at a time when the labor market is so tight, it could fan the inflationary fires and create obstacles to a more efficient allocation of resources,” said Koo.

Leland Miller of the China Beige Book, an on-the-ground survey of the Chinese economy, agrees: “GDP is for public consumption. It’s a political narrative; it’s more of a media narrative than anything else. The Chinese are not going to stimulate to get to a certain target, but the central bank will stimulate in order to keep the labor market in good shape. They want to avoid societal breakdowns, so we’re talking about employment growth; we’re talking about inflation.”

What Can They Do?

Once one of these issues gets out of hand, the regime will have a problem: Don’t stimulate at all and you will have unemployment, stimulate too much and you get inflation.

This is why the regime keeps talking about stimulus and launches modest monetary stimulus whenever it feels the financial markets need it. Future rate cuts or reductions in the required reserve ratio as well as lending through the development bank and extra financing through the PBOC will remain options.

Don’t stimulate at all and you will have unemployment, stimulate too much and you get inflation.

In addition, the regime has increased government spending on the central level while reducing the financial excesses of local governments. Overall, government spending is up 10.5 percent over the year in February, with central government expenditures growing faster than local.

“The January−February fiscal situation is consistent with our view that fiscal policy will be more proactive, with the central government spending more while local government revenue is constrained by tighter controls over debt and weaker land sales revenue due to the property market correction,” wrote Nomura in a note. So in order to stimulate a little bit, China is willing to risk a deficit of 2.8 percent of GDP in 2015.

So far, this strategy of jaw-boning and small adjustments has worked well. But will it in the wake of a full-blown real estate crisis?