Supply-Side Revolution China Style Seen Hinging on Demand Push

  • Zhu slashed rates, boosted fiscal spending to help ease pain
  • China plans to cut excess capacity, 'zombie' enterprises

China’s yuan is facing intense depreciation pressure, deflation is biting into corporate profits, and the nation’s premier is launching a plan to slash bloated state enterprises.

That’s not today, but a chain of events that unfolded in the late 1990s and early 2000s under Premier Zhu Rongji. He responded by aggressively easing monetary policy and ratcheting up fiscal spending to prevent an economic slump, smoothing the way for millions of job cuts at state enterprises. He also resisted depreciation pressure on the yuan in the aftermath of the Asian financial crisis, maintaining the currency as an anchor of regional stability.

This time round a rapid surge of debt stemming from the policies rolled out by his successors after the global financial crisis gives China less room to maneuver. Still, like then, it’s critical to keep demand kicking so that supply-side reforms aren’t derailed. Data released Monday showed the official factory gauge signaled deterioration for a record sixth straight month, suggesting the economic outlook may be dimming.

"It is imperative for monetary and fiscal policy to pull more weight stabilizing growth to create a stable environment conducive to structural reforms," said Liang Hong, chief economist and head of research at China International Capital Corp. in Beijing. "China’s not in the intensive care unit yet but it can get to that point if you let the cyclical side deteriorate."

Structural Reforms

History and recent events show that a failure to backstop structural reforms with demand-side supporting policies risks setbacks, says Liang, who formerly worked for the International Monetary Fund.

Zhu eliminated 31 million jobs at state enterprises, according to CICC. To ease the pain, he cut both the main lending rate and the required reserve ratio for big banks by about half. Zhu also allowed the fiscal deficit to expand to 2.6 percent of gross domestic product from 0.7 percentage point, according to Liang.

Now, Premier Li Keqiang and China’s other top leaders are again vowing to press ahead with supply-side reforms that will cut the number of "zombie" state-owned enterprises that survive on government largesse.

Steel, Coal

Plans to cut steel production capacity may eliminate 400,000 jobs, a state-run metals industry consultancy said last month. Coal production also is to be cut on "a relatively large scale," according to a statement from the State Council, China’s cabinet.

"If they’re really going to go ahead with SOE reform, deregulation, streamlining the supply side of the economy, we have to have stimulus at the same time to make sure demand doesn’t collapse," said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong. "China should be coming out and using fiscal policy as it presses ahead with structural reforms."

Fiscal spending jumped 15.8 percent to 17.6 trillion yuan ($2.7 trillion) last year, while revenue rose 8.4 percent to 15.2 trillion yuan, the Finance Ministry said Friday. That fiscal deficit amounts to 3.5 percent of GDP, according to Nomura Holdings Inc. The government had previously set the fiscal spending limit at 2.3 percent of GDP.

Fiscal Pump

Fiscal stimulus can help on another front too because priming the fiscal pump will push up long-term interest rates, thereby attracting capital back into the country, said Neumann.

Room for monetary easing is seen as further constrained due to fear it would exacerbate the exodus of capital. That leaves fiscal policy needing to do more work.

Details on the extent of fiscal easing are likely to be revealed at the National People’s Congress meeting in early March.

"The message is so clear that China will run a larger fiscal deficit," said Liang. "The increase will be used for tax cuts, and they will increase government bond issuance to finance larger fiscal spending."

Rate Cuts

China’s central bank already cut the lending rate six times since late 2014 to a record low, and reduced required reserve ratios that the biggest banks must hold as reserves to 17.5 percent. Still, concerns over exacerbating the hangover from a stimulus binge after the global financial crisis has prompted policy makers to attempt a targeted channeling of funds instead of re-employing the fire hose.

Growth slowed from 9.9 percent in 1996 to 7.6 percent in 1999 before rebounding over subsequent years as Zhu’s structural reforms paid dividends and China entered the World Trade Organization. Zhu got a boost from powerful new growth engines -- the property industry, and a surge in exports after joining the WTO -- to smooth the way through state-enterprise layoffs.

Now the nation is again searching for new growth engines as old ones run out of steam. China’s expansion last year sunk to a 25-year low of 6.9 percent and this year the economy is likely to expand 6.5 percent, according to a Bloomberg survey of economists.

To successfully juggle supply-side reforms while also propping up growth, China may need to emulate the policies of both former U.S. President Ronald Reagan and former U.K. Prime Minister Margaret Thatcher.

"They ran very large budget deficits," said HSBC’s Neumann. "So even their classic supply-side revolution was accompanied by Keynesian demand management to help ease the pain and ease the transition."

— With assistance by Kevin Hamlin

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