China’s 4 Trillion Yuan Stimulus Seems to be Losing Steam

On Sunday I suggested that the newly-announced RMB 4 trillion fiscal package would cause markets to surge, but that the rally would not last very long as analysts began examining the numbers more closely. In fact the duration of the rally was even shorter than I expected. On Monday the markets did indeed surge, with the SSE Composite rising 7.3%, but by Tuesday markets had again turned bearish. After running up 0.7% in the first two hours of trading, the market once again lost its legs and the SSE Composite ended at 1844, down 1.7% for the day.

According to an article in Bloomberg the decline was led by financials and consumer companies “on concern a government stimulus package will fail to arrest an economic slowdown.” In fact all day analysts around the world have been weighing in on the fiscal package, with some arguing that this was a major event that would provide a serious boost to Chinese and global growth and others arguing that anywhere from RMB 1 trillion to RMB 2.5 trillion was old spending or overly optimistic projections and that the timing of the disbursements would not have a big enough impact on the immediate contraction in demand faced by Chinese businesses.

Standard Chartered’s Stephen Green, one of the bank analysts for whom I have a lot of respect, says that his reading of the package (and he warns that there are still big holes in his reading since details are so sketchy) suggests that government spending will contribute about 3.5 percentage points of real GDP growth to the Chinese economy in 2009. Since it contributed about 2.5 percentage points in 2008, this means that the total additional impact of the new package will be to boost growth next year by about 1 percentage point – not far from his original expectations.

Deutsche Bank’s Jun Ma was slightly more optimistic than Green about the additional impact of the fiscal plan (he thinks it will contribute an additional 2 percentage points to 2009 GDP growth). His optimism however was more than compensated for by his concerns that the economy is slowing faster than expected, and he actually cut his 2009 GDP growth forecast today from 8.0% to 7.6%.

Meanwhile the government seems clearly to recognize that timing is a problem. According to an article in today’s China Daily:

Premier Wen Jiabao Monday urged local governments not to “waste a single minute” in implementing the 4-trillion-yuan ($586 billion) stimulus plan unveiled on Sunday. “In expanding investment, we must be fast, effective and forceful. We must focus on priorities and adopt a down-to-earth attitude to implement the measures,” he told an executive meeting, which was presided by him and attended by provincial leaders and Cabinet ministers.

For those who are more optimistic about the effects of the stimulus package, one of the key arguments is that previous fiscal stimulus packages have worked in China. For example today’s South China Morning Post has a fairly optimistic report titled “Spending will offset falling external demand” in which the argument is explicitly made:

The mainland’s massive economic stimulus package would rouse the country’s slowing economy by offsetting flagging external demand brought on by the global financial crisis, analysts said yesterday. Shenyun Wanguo Securities macroeconomist Li Huiyong said the success of a similar programme in 1998 indicated that expanded government spending would stimulate fixed-asset investment and economic growth in the short term.

Maybe. But I think we need to be a little cautious about comparing fiscal expansion in 1998 and fiscal expansion ten years later. In the 1990s economic conditions were much tighter and fiscal activity likely to have a larger impact. It was relatively easy for a smallish country to benefit from stimulating fixed asset investment since the world could easily absorb higher production. At that time the US was receiving massive capital inflows – especially from Asian countries looking to shore up reserves after the great scare of 1997 – and its financial system was finding ever new ways to intermediate liquidity to consumers eager to take advantage of rising real estate and stock market prices to increase spending. The US, in other words, seemed able to absorb almost unlimited expansion in Chinese capacity.

But, as I argue in Sunday’s entry, conditions have changed dramatically. First, China’s GDP is about 2.5 times bigger today than it was back then, and exports have grown much faster than GDP, so China is far from being a “smallish” country. More importantly, the world is looking for more demand right now, not more supply. In a global system with so much excess capacity, and with a marked tendency to excess savings (Americans have to save more, Asians don’t want to consume more), I am a lot more pessimistic about the domestic impact of China’s fiscal expansion, especially if the goal is to increase investment. The world will not simply absorb a lot more Chinese capacity. This package is only useful to the extent that it boosts real demand, especially if it boosts household demand, but that doesn’t seem to be in the cards.

At any rate we need to wait a while longer before we can really judge the potential impact of the fiscal package. And we also need more time to see exactly how fast other parts of the economy contract. In that sense my guess is that the government rushed to announce the package partly as a shock to confidence, perhaps because the numbers they are seeing are much worse than what we have been able to see so far.

Of course part of the rushed timing is probably to head off potential trouble at the upcoming G20 meeting. By announcing such a large headline package, China can argue that it is contributing both to the global monetary easing as well as to global fiscal expansion. This will take the pressure off other demands – for example one way China can contribute to global expansion is by a more radical reforming of the currency regime, and it clearly does not want to do that. October’s trade surplus – announced today – was 20% higher than September’s all-time record. This won’t make it easier to argue that they desperately need to keep the RMB from rising too much.

In all the hoopla about the fiscal package, two economic numbers slipped out almost unremarked. Yesterday the National Bureau of Statistics announced that PPI inflation had declined from 9.1% year on year in September to 6.6% in October. Today they announced that CPI inflation declined from 4.6% year on year in September to 4.0% in October.

I am going to be accused of unrelenting pessimism, but I will explain nonetheless why even this “good news” worries me. As regular readers of my blog know, I tend to have a very monetary view of inflation, and I was convinced until two or three months ago that China’s furious money expansion of the past few years was going to lead inevitably to rising inflation. As I see it, when money growth outpaces the needs of the economy for a sustained period of time there are only three ways to adjust. The most benign way is that over a period of time the central bank engineers slower-than-warranted growth in money so that, in exchange for a temporary slowdown in economic growth, money supply and the real economy can get back into line.

The less benign ways consist either of a surge in inflation that causes the nominal value of the economy to rise sufficiently to meet the money supply (which is what I was expecting), or of a rapid and unexpected contraction in the money supply, which usually takes place in the form of a collapse in credit and in asset prices. If the former isn’t happening, then my model says that the latter must be happening, especially since the decline in inflation isn’t just because of food prices. Non-food inflation dropped from 2.0% in September to 1.6% in October.

We know that some of this contraction is indeed happening. Real estate and stock market prices are definitely falling. Loans in the banking system aren’t growing as fast as the government would like to see. But these aren’t new enough, or dramatic enough, to explain the rapid fall in inflation. Could it be that real credit growth is much lower than we think – that perhaps there has been a sharp contraction in off-balance sheet loans and in the informal banking sector? We don’t know, but we need seriously to consider that this indeed may be happening.

The just-released trade numbers have little to bring cheer. Export growth continues to slow (19.2%, compared to September’s 21.5%), but as a warning of how bad domestic demand conditions might be import growth slowed much more sharply (15.6%, compared to September’s 21.3%, and less than half of July’s 33.7%). The consequence was a surge in the trade surplus, which rose by one-fifth over last month’s record number. This is the third month we have broken world records, and this certainly isn’t going to please China’s trading partners who are struggling with their own domestic slowdown.

Money continues to pour into China via the current account – I wonder what is happening in the rest of the country’s balance of payments. Is hot money outflow accelerating? I guess we won’t really know until January’s fourth quarter data release.

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