The ruling Chinese Communist Party’s third plenum will be held in mid-July. The third plenum is often the occasion for substantial policy shifts, so hopes have risen that the high-level meeting will decide on a more aggressive policy stimulus. However, three factors will determine what the third plenum decides and these suggest that such hopes may be mostly disappointed. First, policymakers recognise the downside risks in the economy but seem to believe that they are manageable. Second, China’s leaders are also aware of the risks in the global environment — but their focus is on the longer term strategic issues rather than short-term headwinds that might slow export growth. Finally, President Xi Jinping’s view on where the priority areas are matter — here it is clear that the shift in policy priorities that he brought about, towards national security rather than maximising economic growth remains. Consequently, our view is that there will be incremental moves to boost demand but that the overall approach would be to focus on structural issues, rather than boosting demand in the short term.
Current position – production not backed by demand
The good news for China is that the economy has stabilised. Despite the sharp downswing in the real estate market, excessive debt, rising protectionism and over-capacity, policymakers have done enough to avoid a sharp recession. However, the economy continues to struggle with strong headwinds and remains vulnerable to unexpected shocks.
The central weakness in the short term is that demand remains unsteady while supply has increased. For example, industrial production grew 5.6% y-o-y in May, slowing only a tad from April’s 6.7% y-o-y.
Investment demand remains weighed down by the painful adjustment in the real estate sector. Overall fixed asset investment decelerated to around 3.5% y-o-y in May, the slowest pace in a year, with the contraction in property-related investment worsening. Despite central government efforts to boost it, infrastructure investment growth has also slowed to the weakest pace in two years. The bright spot is manufacturing investment which is expanding at close to double-digit rates, helped by policy initiatives such as incentives to upgrade equipment.
Digging deeper into the causes of weaker investment, what emerges is an anxious private sector: much of the capital spending in May was state-driven. The domestic private sector and foreign investors seem wary of committing more capital. Note in particular, the worsening picture for foreign direct investment — China attracted RMB412.51 billion ($76.92 billion) worth of foreign direct investment in the January to May period, down 28.2% y-o-y. Surveys show private entrepreneurs remaining nervous about prospects and unwilling to step up capital spending or hiring.
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At the same time, the consumer also remains downbeat about spending. Retail sales improved only marginally despite the government support efforts such as attractive incentives to trade in old appliances for new ones. The Chinese consumer is careful about spending on big-ticket items, with demand concentrated in low-value discretionary spending. This was evident during the recent Dragon Boat Festival when the average spending per tourist was 12.3% below the 2019 level.
On closer examination, we still see a strong desire to save rather than spend among ordinary Chinese. Household sector deposits with banks have increased from RMB82 trillion to RMB138 trillion (about a 15% compounded rate) since the onset of the Covid pandemic — this vastly outpaced the 3% increase compounded rate of increase in consumer spending in the same period.
There are very good reasons for this. First, residential property accounts for a highly disproportionate 59% of total gross household assets in China — the equivalent figures for the US and Australia are 28% and 57% respectively. So, falling house prices destroy wealth and deter consumers from spending. Another reason is that incomes are not growing as in the past. For example, the average annual salary of top executives at Chinese listed companies fell for the first time in two decades last year.
If the consumer and the corporate sector are not willing to spend, then the only source of demand support is external demand. China has been helped by the tentative recovery in global demand. Exports rose 7.6% in May to a one-year high up from just 1.5%YoY in April. In the near term, export growth should be maintained at roughly current levels.
Policymakers likely unfazed by the continued weakness
While the fragility of the economy alarms outsiders, policymakers take a more nuanced view. Their concern was that excessive debt and over-reliance on the property market had to be reined in so as to ensure a sustainable economy in the long term. They knew that deflating the property bubble would slow the economy and they accept that reducing leverage in the economy would also hurt demand. When they look at the economy, they see an economy that is gradually correcting these excesses and still able to grow. Resorting prematurely to large-scale stimulus would only encourage more debt and contribute to even more excess capacity in the future, unravelling the progress they have made in correcting the imbalances in the economy.
In addition, the policymakers may also feel encouraged that the necessary adjustments in the economy are reaching a peak and the pain they cause should therefore also ease in the coming months.
For example, the International Monetary Fund’s analysis of the fundamental drivers of demand for housing in China suggests that the corrections in the property market may be close to finding a floor. It sees new housing starts to average 715 million square metres which are not very far from current rates. Likewise, with new housing construction now at less than half its 2021 peak, China’s property sector is almost where the US and Spain were when their respective property crisis began to stabilise after their property busts. These imply that the property sector is gradually, but certainly, finding its bottom.
The property sector will also benefit from government efforts to stabilise it. Several major Chinese cities such as the big metropolitan ones of Shanghai, Guangzhou and Shenzhen, as well as large cities like Hangzhou, have issued statements to encourage local state-owned enterprises to clear unsold home inventories. While progress has been slow in this inventory management exercise, we expect further measures will be announced to expedite the process.
Similarly, in the labour market, young Chinese are making adjustments to adapt to the new realities. In the early months of this year, the number of youths applying for blue-collar jobs — which were once disdained — rose 165% compared with the same period in 2019.
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In the corporate sector, surveys show large companies being more willing to provide easier payment terms to their customers. Companies were found to be particularly willing to providing easier credit terms, with 79 per cent offering payment terms in 2023, up from 50 per cent in 2022. Such efforts at providing informal financing support for purchasing activity will also help to stabilise the economy.
Thus, from what we can see from the many statements that have been issued after high-level meetings in recent weeks, the policymakers are prepared to do more to support demand in specific areas but do not see a need to bring out the bazookas. Having already swallowed the bitter pill and endured its worst effects, we do not expect policymakers to reverse their efforts by yielding to calls for large-scale stimulus.
Xi remains preoccupied with economic self-sufficiency
Ultimately, it is President Xi’s views that matter. Reading between the lines of recent statements, it is clear that his strategic priority remains intensely focused on the longer term. The constant exhortation of “high-quality development” and “new productive forces” suggests that Xi very much prefers to channel fiscal resources towards sectors that will feature prominently in the Fourth Industrial Revolution. The readout from a recent Politburo meeting noted that “the complexity, severity and uncertainty of the external environment have spiked.” A recent article about the upcoming third plenum published in Qiushi, an authoritative journal of the Chinese Communist Party, also promises more supply-side reforms to come.
So, how will policy respond?
In short, expectations for stronger stimulus should be tempered by the divergence between how policymakers interpret recent economic data and the market consensus. Pronouncements by top economic policymakers show a recognition that a weak economy is part of the unavoidable adjustments that the country needs. For example, central bank governor Pan Gongsheng recently implied that it was not surprising to see credit growth remaining weak amid the shift from a “high-speed” economy to “high-quality development’.
Hence, we should not expect a major set of demand stimulus measures to be announced at the third plenum. China’s leaders will take note of persistently weak consumer and business confidence, and offer incremental step-ups in some of the stimulus policies previously announced. The approach is very much in line with the leadership’s preference for testing out innovative policies at a small scale before expanding them. Thus, consumer spending will benefit from increased support for the aforementioned trade-in programme while de-stocking among property developers will accelerate with a ramp-up of the initial CNY300bn lending facility. We also expect more fiscal spending given that there is still a lot of room within the budget for increased fiscal support to the economy. We do not expect major moves in monetary policy.
Beyond these cautious and highly calibrated moves on the short term trajectory of the economy, the main emphasis of the third plenum, will be to promote Xi’s core ideas for the future of China — an economy with “common prosperity” and where “new productive forces” will be utilised to promote “high quality development”. Some of the areas where substantive policy changes are likely include:
There will be a big emphasis on technology development and innovation. The Plenum is likely to discuss ways to promote education and research & development, vital building blocks of a successful innovation system.
The Plenum will also be a good opportunity to reflect on Xi’s industrial policies to promote new cutting-edge industries. While good progress has been made in areas such as electric vehicles, batteries and solar power, there is now a need to respond to external pressure from the US and Europe against such policies.
Given the weak state of the finances of local governments, we will not be surprised if policymakers use the Plenum to introduce amendments to the tax system that will allow local governments to retain a larger share of fiscal revenues. A related reform could be that state-owned enterprises (SOEs) are required to deliver more dividends to the state, boosting central government revenues. Another way to raise local revenues would be a form of property tax — this has been talked about in the past but this could be the moment when it is actually implemented.
State-owned enterprise (SOE) reforms could also be on the agenda. The Chinese authorities have emphasised in their various commentaries in the lead-up to the third plenum on the need to step up total factor productivity (TFP) growth. TFP growth is an overall measure of how productive the economy is so China’s deteriorating TFP performance in recent years is a source of concern. One area of clear underperformance in productivity is the SOEs – on many measures of efficiency, SOEs look woeful compared to their private sector counterparts.
Another area where reforms have been called for over a long time has been the “hukou” system by which migrants from rural areas to the cities are managed. Restrictions on their access to education, welfare and housing would go a long way to boosting consumer spending.
The third plenum will probably expand measures to ensure a strong structural basis for China’s long-term development. That will be the priority area. Recognising that the economy faces challenges in the near term, the Plenum will probably offer some additional stimulus but these are likely to be highly calibrated. This should suffice to allow the economy to achieve its roughly 5% target for growth this year — so long as there is no major shock such as a surge of protectionism directed against Chinese exports.
Manu Bhaskaran is CEO of Centennial Asia Advisors
