Policies should be prudent during economic downturn

The weak economic data of the first quarter this year has been predicted. I has predicted in my article early this year that “In 2014, fixed asset investment growth will reduce to around 18%; industrial added value growth rate will reduce to around 9.1%. Deflation based on PPI indicators will continue and is hard to turn positive throughout 2014. Chinese economic growth rate may fall to around 6.9% in 2014.”

The macro-economy appears to follow the track in general.

There are many analyses on the factors leading to the economy weakness. In my view, the major logic is that the two major force supporting the slight economy rebounds of 2013 occurred failure.

First, the short and weak inventory increase movement comes to the end. Production Price Indicator (PPI) returns to the weak position, demonstrating the difficulty of entity economy under the great excessive capacity pressure. After the release of the first-quarter data, the agreed biggest adjustment lies in the large-scale decline of PPI. Earlier economists expected slow climbing of PPI this year, which turns out failed. The current situation is consistent with my negative expectation. PPI indicator may stay lower than -1.5% in a short future.

Second, the passionate leverage rising movement appears speed cut. Economy growth in 2013 is of a low speed. Yet debt leverage ratio (coverage of enterprise and household debt in GDP) keeps rapid and large-scale climbing. Such mad and unsustainable speed decelerates now. This is due to the impact of the credit crisis last year and is partially influenced by the downfall of real estate investment growth, joint effected by decrease in interest-sensitive investment.

In 2013, China ranks first in the world in terms of economic leverage rising and the increase proportion of excessive capacity and debt leverage ratio. In 1990, Japan was in the first place in the proportion of excessive capacity and debt leverage ratio. It took 20 years to reduce the ratio; and on the same period, coverage of governmental debt in GDP rose from 40% to around 180%. While today, China takes that position. Under the pressure of great excessive capacity and debt burden, China experiences continuous downfall in return on asset. By far the ratio has fell to a bottom.

In one word, excessive capacity is caused by mismatch in resources, with debt as a reflection on financial indicators. With mismatch in resources, low return rate of asset seems inevitable. It is hard to recover unless the resource mismatch is solved. To achieve this goal, dramatic new investment is not dominant. Traditional painful methods are necessary: clearing, enterprise bankruptcy and restructuring, debt default, etc. Without experiencing such pain, the situation cannot achieve essential recovery.

Under the realistic system conditions, invalid capacity and zombie companies are protected and supported with continuous financing.

With the funding flowing to invalid capacity, valid investment opportunities cannot receive support. Sadly, no matter how monetary policy trend goes and how interest rates changes, possible credit is losing its past pulling force on economy.

Those interest-insensitive investments (local government financing vehicles, industries with excessive capacity, zombie companies, and real estates) are usually invalid investment. If the increasing credits support such investments, the effect wouldn’t last long, for such invalid investments will produce other excessive capacities and hardly will benefit the overall economy. Being restricted by the current record low return on assets, interest-sensitive investments are unlikely to rise in large scale.

To predict in our model, the second quarter is unlikely to see major changes. The track in the first quarter will last. Considering the industrial added value increase rate, possible local bottom will appear in the third quarter. PPI will face with continuous pressure. CPI is difficult to rebound. Few highlight points will appear in import and export. Real estate market will worsen. A hard season is awaiting us.

In such situation, government should make proper policies, taking necessary measures and leaving the rest alone.

First, active fiscal policy should be strengthened in effect.

Fiscal income increase rate downturn is hard to be reversed. The government should expand fiscal expense and fiscal deficits. Stronger tax reduction (may combine with tax reform) may be considered. Tax reduction should have actual effects and achieve a rather strong extent. Excessive expending is no better than less gathering.

Second, debt roll-over with high interest should be changed, particularly for local governmental debts.

Comparing with local government rolling over with high interest payments and supported by central government credit finally, it would be better to incur low-interest debt with central government credit and help local government in debt roll-over. As for the incentive incompatibility issues between central government incurring debts and local government spending, we can learn from the experience of Korea and some other countries, to design transparent debt allocation program and establish clear relationship between local governmental debt management performance and debt allocation.

Third, during the economic downturn, reform measures shall be classified according to urgency, particularly the impact on financial risks shall be carefully considered.

As for some measures that may aggravate financial risks, such as rapid RMB internationalization and lifting interest, shall be taken prudently. RMB exchange rate should be kept on a stable basis or depreciate slightly. Banks can expand provisions for bad debts and meanwhile enhance capital, and start to sell partial stocks of state-own enterprises in small batches regularly.

It may not be a good idea to establish local asset management company. Asset management business need to expand, yet an asset management company under the control of local governments can do little help.

Some reform measures may be correct, yet they should have been taken in economic uprising rather than now. At this moment, monetary policies should be conservative rather than proactive. The top priority is to keep the risk at base line. This means that not only reform should be slowed down in the overall scale, but reform policies beneficial to ease financial risks should be pushed forward as soon as possible. And other measures such as enhancing financial transparency, budget management and social security system reform can be taken now.

Published on China Reform 6th Volume, 2014  | 2014-6-1