China's stimulus package: Will it work, and what's next?

China Daily
China's stimulus package: Will it work, and what's next?
Updated: 2008-11-26 10:28

Initially, the impact of the growing financial crisis on China was muted: China's banks had only minimal exposure to subprime losses.

However, as the financial meltdown continued to unfold, US consumers' demand for Chinese exports slumped, and it became apparent that any hopes that China would be able to decouple from the slowing global economy were in vain.

In the first three quarters, China's growth rate slowed to 9.9% -- the first time it has slipped into single digits since 2003.

"Given that net exports account for about 20 percent of China's GDP, and that exports plus imports are as much as 70 percent of GDP, China is clearly not immune to the adverse impact of the current global financial crisis," says Wharton marketing professor John Zhang. "The slowdown in the Chinese economy partially reflects this impact."

Manufacturers in China's export sector, already under pressure from the yuan's appreciation, rising costs and stricter enforcement of safety standards, have taken a heavy blow. Industries such as textiles, shoes and toys have been prone to widespread factory closures.

The International Monetary Fund (IMF) now predicts that Chinese output will fall from 11.9 percent last year to 9.7 percent for 2008, and drop further to 8.5 percent in 2009.

In response, on the evening of November 9, China's government unveiled a massive stimulus package. Officials gave the headline figure as 4 trillion yuan ($586 billion), to be spent over the next two years -- exceeding even the size of China's robust response to the 1997 Asian financial crisis. This marks the first time in almost a decade that China has officially adopted a "proactive" fiscal policy.

The plan will benefit areas including transport and other infrastructure projects, healthcare, education, low-income housing, environmental protection and schemes to promote technological innovation.

Credit policies will also be relaxed, and value-added tax revamped with savings for industry of 120 billion yuan, according to government estimates.

But will it work, and what is the outlook for the Chinese economy? Though some would like to see more done to encourage domestic consumption, for instance, or to support small businesses, reception has been broadly positive.

Some early analysis suggests that the stimulus package could contribute in excess of 2 percent or 3 percent to growth, fending off any risk of a hard landing.

Moreover, experts pointed to many signs of resilience in the Chinese economy, and stressed that the global crisis in fact represents an opportunity for savvy Chinese companies to shop abroad for useful acquisitions.

Amid the pressure of a global slowdown, China will have to do something concrete to shift its growth engine from exports to consumption, which it has attempted to do for many years.

Stimulating reaction

Initial reactions to the central government policy among businessmen in China, markets and international leaders have been generally favorable.

Robert Zoellick, president of the World Bank, which along with the IMF had advocated for a fiscal stimulus package, described himself as "delighted" by the move. "China is well positioned, given its current account surplus and budget position, to have fiscal expansion," he commented.

On top of its $1.9 trillion in foreign reserves, the country enjoys low levels of domestic debt and has maintained a fiscal surplus in recent years, he noted.

Despite recently downgrading their Chinese growth forecast for 2009 from 8.2 percent to 7.5 percent, analysts at Morgan Stanley meanwhile praised the Chinese authorities' "unprecedented efforts to boost confidence and growth."

The policy moves send a message to the markets that the authorities will do all that is necessary to achieve their desired growth rate for 2009, which they are targeting at around 8 percent to 9 percent.

Wang Qing, Chief Economist of Morgan Stanley China, and colleagues outlined the stakes in a November 16 research note: "Without this stimulus package, the economy would likely head toward a hard landing (e.g., 5 percent) in 2009. With this fiscal package, the risk of a hard landing scenario (i.e., below 7 percent growth) has diminished substantially, in our view.... If this current policy package were to prove insufficient, we have no doubt it will be augmented."

In Morgan Stanley's view, the economy is likely to continue to decelerate over the next three quarters, before bottoming out by mid-year 2009, and staging a modest recovery in the second half of 2009 as external demand picks up and the pro-growth policy starts to kick in.

"The Chinese government is proactively and constructively addressing the implications of the global downturn on the domestic economy, turning an external economic threat into an opportunity to strengthen the domestic economy," says Wharton management professor Raphael "Raffi" Amit. "A very wise move in my view."

This said, some analysts have questioned certain aspects of the plan.

Shaun Rein, managing director of Shanghai-based China Market Research Group (CMR), notes the package's concentration on large, public enterprises and public investment at the expense of smaller companies, which he believes will be important employers and contributors to growth in the future. He would like to see more done to help China's entrepreneurs, he adds.

Perhaps the most common criticism of the plan stems from its emphasis on infrastructure projects. "The current stimulus plan focuses very heavily on infrastructure projects, which are obviously wise long-term investments," notes Zhang. He and others would like to see more spending on stimulating consumption.

China has a high savings rate, at approximately 60 percent of GDP, which correlates to low domestic consumption. "Consumption only accounts for about 40 percent of China's GDP, while in the US, for instance, the comparable number is more like 60 percent to 70 percent," says Zhang. "Thus, there is quite a bit of room for stimulating domestic consumption."

Franklin Allen, a finance professor at Wharton, notes that in a global recession workers may be fearful of spending in case they lose their jobs, making them reluctant to spend. At a more basic level, however, observers chalk up Chinese consumers' high propensity to save to the necessity of putting money away for health and education expenses given the relatively underdeveloped nature of China's welfare net.

"Some spending on beefing up social safety nets will go a long way to reduce precautionary savings and stimulate consumption demand from average households," says Zhang.

Boosting consumption

Central to the stimulus package is its extension of well-planned railway expansion plans, which had been put on hold due to fears that the economy was in danger of overheating. The centerpiece of this, meanwhile, is the new high-speed passenger line stretching through central cities to Guangzhou.

"The main purpose of this dedicated passenger line will be consumption -- tourism and leisure," says David Dollar, the World Bank's chief China economist.

"It is the same for the accelerated investments in water and sanitation and urban transport. These investments will raise the quality of life and not have much direct effect on the country's production capacity. Also, some of the investments will be in housing, schools and health facilities. So it is not fair to portray the investment program as primarily aimed at building up the industrial and export capacity of the country."

Following speculation as to the real size of the fiscal stimulus package, central government officials held a joint press conference on November 14, clarifying that 1.18 trillion yuan will be funded directly by the central government over the two years.

However, Morgan Stanley analysts note that central government officials also hinted that some local governments may be permitted for the first time to run deficits to be financed by debt issuance, subject to approval from the central government.

In their view, this means it is safe to say that local governments can be expected to add fiscal stimulus at least as large as that to be provided by the central government.

Moreover, the policy shift is likely to spur further spending by companies. The analysts note that some State-owned enterprises may respond to the call from policy makers by boosting investment.

To assess the final macroeconomic impact of the stimulus package, economists employ a measure called a "fiscal multiplier," which is a measure of the degree to which the government's fiscal intervention stimulates an increase in national income and consumption.

Academic research suggests that in China, this is roughly equal to a multiple of 1-1.5 the size of the original stimulus. On this basis, taking into account only the central government-derived stimulus, Morgan Stanley estimates that the package would contribute around 2 to 3 percentage points to GDP growth. Once the combined effect of central and local government stimuli, plus newly mobilized non-government capital, are factored in, the effect could be greater.

Meanwhile, CMR's Rein highlights hopeful signs on consumption. While those aged over 40 have a savings rate of 50 percent to 60 percent, he places great confidence in younger Chinese consumers.

A CMR survey of individual consumers between the ages of 22 and 30 in ten cities across China suggests that people in this bracket have zero savings rates, pointing to a sharp generational difference.

Based on his observations, he believes that the country's savings rate will fall to 20 percent within 20 years. Moreover, China's young are not heavily exposed to losses on China's tempestuous stock markets. Rein is therefore extremely bullish on the consumer front.

Recent high-profile government initiatives may also have the potential to support a shift to a more consumption-led economy, suggests Markus Boehm, CEO of SIG Combibloc in Suzhou.

Though painful for many companies, improvements in protection for workers under the recent labor law will lead to higher salaries for Chinese employees, hence to increase spending. Chinese consumers will need more financial instruments in order to convert their savings into consumption, though, he adds.

The approval in October of measures that are expected to legalize the transfer of rural land use rights also points the way to greater consumer demand in the agricultural sector, he says.

Crisis to opportunity

While noting that China's slowing real estate sector is a cause of concern, Rein points to the underlying strength of China's economy, describing himself as a cautious optimist.

Inflation, he points out, dropped to 4 percent in October, on the back of a dramatic fall in food inflation. At the same time, investment is playing a more pronounced role, while the export sector's role is shrinking.

Indeed, some experts and business practitioners sense opportunity amid the crisis. The current export slowdown provides an opportunity for China to reconfigure its export sector, getting rid of high-polluting, low-value-added businesses, leaving the economy stronger for it, suggests Joyce Qian, a Wharton alumna who is based in Shanghai.

Some well-positioned companies see this as an opportunity to catch up, she says. For the majority of the export industry, companies that are in trouble depend on a cheap labor model. This is a time to improve the industry level, she says, to move China to next level.

How can companies capitalize? One way is to take their cash abroad. With global companies' assets depreciating, this is an ideal opportunity for Chinese companies to look at mergers and acquisitions, stock swaps, technology and brand purchases, says Han Jing, Treasury Regional Manager of DuPont China.

For those companies that have relied on low-value manufacturing, have underdeveloped R&D capabilities, and lack well-established brands, this is an opportunity to sharpen their long-term competitive edge and move to a more sustainable economic model, she says.

"In this financial crisis, cash is king, and China has plenty of it," says Wharton's Zhang. "China can deploy the cash strategically to acquire resources, technologies and companies that are otherwise off limits for China."

By providing a low-cost environment for many of China's enterprises to grow, lower commodity and energy prices should also help Chinese companies, he adds.

"Those companies that act now and are proactive will not only survive but will emerge stronger and more profitable from this financial tsunami and economic earthquake," notes Wharton's Amit.

Firms need to be "proactive... realizing that we are in a new economic order." This will require "rapid adaptation to the new realities, adjusting the scale and scope of operations, redoing business plans, business models and budgets to maintain profitability in the new economic environment."

Zhang also sees opportunities at the government level. "As China has adequate foreign currency reserves and the revenue growth for all levels of government has been very strong, the crisis can be turned into an opportunity in a number of ways.

"China has already gained quite a bit of credibility in the world in managing its financial resources cautiously and independently." The country has the potential to play an important role in shaping the future of global financial systems by participating in their design, he notes.