Why China's domestic demand continues to lag

Chinese industrial policy needs more unfettered market competition. Meeting inflation targets entails greater consumption.

Our briefing on critical economic and financial developments in China as of Friday 13 September, 2024:

• Former CASS researcher Zhang Bin (张斌) identifies faltering credit growth, not worsening income inequality, as the key accelerator in China’s cycle of weakening domestic demand.

• Jiang Fei (蒋飞), chief macro-economist with Great Wall Securities, believes China can only hit inflation targets by boosting household wealth and domestic consumption.

• Leading Chinese economist Huang Yiping (黄益平) believes free market competition lies at the core of effective industrial policy.

• BOC International’s Guan Tao (管涛 says China could face greater balance of payments deficits as net investment outflows increase.

Why China's domestic demand continues to lag - faltering credit, not worsening income inequality, could be the culprit

Zhang Bin (张斌), former chair of the Global Macroeconomic Research Office of the Chinese Academy of Social Sciences (CASS), writes that policymakers in China are still struggling to boost faltering levels of domestic demand and consumption in the wake of the Covid pandemic.

"In recent years China has adopted multiple measures to deal with insufficient demand, but until now we have yet to exit the situation of demand being inadequate," Zhang writes in a recent opinion piece.

"There are signs that the threat of insufficient demand is further expanding."

Many Chinese commentators have pointed to worsening income inequality as the chief culprit for weak demand, calling for fiscal adjustments in the form of tax breaks to boost the incomes of poorer households.

Zhang, however, disagrees with this assessment, given China's recent economic history.

"The most popular explanation for inadequate demand has been worsening income allocations, with poor people lacking money to spend, and money going to the wealthy who are unable to spend that much,” he writes.

"However, just looking at historical data, during periods when China's income allocation gap has rapidly widened, insufficient demand hasn't been a severe problem at all.

"On the contrary, it's been in the past decade - when the income allocation gap has held steady, that the problem of insufficient demand has become more pronounced."

Zhang instead points to faltering credit growth as one of the chief causes of China's ongoing domestic demand woes.

"Looking at historical experience, in the negative cycle of weakening demand, the biggest accelerator is declines in credit," he writes.

"Comparing the two periods of 2012 - 2019 and 2021 - 2023, nominal GDP growth dropped from 9.0% to 4.7%.

"Broad lending during the latter period decelerated 5.8 percentage points compared to the former, which tells us that in the past several years, inadequate demand has mainly been the result of declining credit."

For this reason, Zhang believes the most effective policy tools for snapping the negative cycle are reducing the Chinese central bank's policy rates, and expanding treasury bond issuance to fuel greater government spending.

China needs to increase household wealth and consumption to hit inflation targets

China saw its core consumer price index (CPI) growth continue to ease in August, declining 0.1 percentage points from July to a year-on-year rise of 0.3%.

Jiang Fei (蒋飞), chief macro-economist with Great Wall Securities, says China's weak inflation has yet to relent, pointing in particular to:

• Continued declines in YoY CPI growth.

• Downward volatility in global commodities prices, which will undermine any impetus in China's domestic PPI gains.

In order for China to achieve its inflation targets, Jiang Fei believes it is necessary to further increase household wealth and income growth expectations, which can in turn drive consumption demand.

Jiang also sees further room for looser monetary policy from the Chinese central bank, particularly given the strong likelihood of a rate cut from the Fed in September.

"We believe that if asset prices continue to decline, and the domestic and international outlook continues to fall short of expectations, the necessity of rate cuts will be considerable."

Huang Yiping says free market competition must play greater role in Chinese industrial policy

Leading Chinese economist Huang Yiping (黄益平) has called for Beijing to give greater play to the role of market competition in its implementation of industrial policy.

In a recent online opinion piece Huang, currently a professor at Peking University's China Economic Research Centre, outlined four proposals for Chinese industrial policy at present, including:

1. Placing the focus of support for innovation on cutting-edge innovation. "Industrial policy must support technological breakthroughs, and not reduplication in capacity."

2. Industrial policy should permit more market-based development of innovation, instead of restricting competition. "The government should focus on enabling industries to overcome certain bottleneck sectors and technologies, instead of helping specific enterprises to develop.”

3. Industrial policy needs withdrawal mechanisms. "When technologies achieve breakthroughs in emerging sectors, and enterprises are capable of successful production, unlimited subsidies can no longer be provided."

4. Local governments and financial institutions cannot "blindly" proceed in a given direction. "Economic accounts must be reckoned with when supporting innovative activities."

China could face more balance of payments deficits as net investment outflows increase: Bank of China economist

Guan Tao (管涛), chief economist at Bank of China subsidiary BOC International, says China has quietly undergone a major shift in its balance of payments circumstances since the Covid pandemic.

In a recent online opinion piece, Guan points out that current account surpluses and direct investment net inflows have long enabled China to "run a strong basic balance of payments surplus, providing a vigorous safeguard for China against short-term capital shocks."

According to Guan, this safeguard involved China's reserves falling and exchange rate declining whenever the country met with significant capital outflows.

Guan believes the latest set of preliminary data on China's balance of payments from the State Administration of Foreign Exchange (SAFE), indicates that these conditions may have shifted.

SAFE figures indicate that in the second quarter of 2024, China posted a basic balance of payments deficit of USD$30.7 billion.

This marks the third such deficit in a period of just three years, with the other two arriving in the second quarter of 2020 (-$42.7 billion) and the third quarter of 2023 (-$4.5 billion).

According to Guan Tao, this shift is mainly due to direct investment outflows increasing.

"In the second quarter, direct investment continued its consecutive net outflows since the third quarter of 2022, with net outflows of $85.6 billion in the quarter, for an on-quarter increase of $57.9 billion," Guan writes.

"This led to the basic balance of payments shifting from a surplus of $11.5 billion in the previous quarter, to a deficit of $30.7 billion."