David Daokui Li's "China's Economic Development Outlook for the Second Half of 2024"
The Tsinghua economist urges Beijing to guard against risks, discard stereotypies about national debt, and reform fiscal system to focus on welfare instead of infrastructure investment.
On July 6, 2024, the Academy of Chinese Economic Thought and Practice (ACCEPT) at Tsinghua University, held the 47th China and World Economy Forum themed "2024 Mid-Year Macro Forum." David Daokui Li, Professor and Director of the ACCEPT, led his team to deliver a report.
Below is the summary of the report from a July 9 WeChat blogpost by ACCEPT.
David Daokui Li, Director of ACCEPT
ACCEPT researchers Lu Lin (top left), Wu Shuyu (top right), Li Bing (bottom left), and Guo Meixin (bottom right) jointly released a macro report titled "China's Economic Development Outlook for the Second Half of 2024."
The report begins with an overall assessment of the current economic situation in China. ACCEPT believes that, over the past forty-plus years of reform and opening-up, China has achieved remarkable accomplishments, creating the largest scale of growth in world history. Currently, China’s economic growth potential remains immense, but in recent years, the growth rate has consistently been below the potential growth rate. This necessitates a heightened awareness of potential risks to prevent short-term cyclical factors from evolving into long-term trends due to untimely policy responses. Should this become a long-term trend, the economic growth rate will continue to decline in the long run, hindering the full release of future economic potential, thereby affecting output, employment, and potentially introducing instability into society. Specifically, to address the persistent slowdown in domestic demand due to issues such as real estate, local government debt, and insufficient consumption, comprehensive deepening of reforms is essential. The report emphasizes that with the achievements and experiences gained from over 40 years of reform and opening-up, there is great confidence in the future of China’s economy. It is firmly believed that through comprehensive deepening of reforms, China’s economy can address any current issues and regain a path of rapid growth and high-quality development.
The report points out that the potential growth rate of an economy is the rate at which an economy can sustain maximum output over the long term. This is a fundamental concept in macroeconomics, crucial for assessing short-term economic conditions, selecting macroeconomic policies, and formulating and adjusting long-term national development strategies. Generally, the potential economic growth rate is relatively stable, determined mainly by factors such as labor (human capital), capital stock, and total factor productivity. Even if there is a gradual decline over the long term, the decrease is usually limited. If the actual growth rate deviates from the potential growth rate trend and this deviation is not corrected in the short term, it can trigger pessimism about economic development, thereby affecting the long-term accumulation of material and human capital and productivity enhancement, ultimately leading to a decline in the potential growth rate. This was observed in the United States following the financial crisis, where active policy intervention later reversed the trend, providing valuable experience. In contrast, Japan’s delayed policies turned a short-term recession into a prolonged period of stagnation for 30 years, serving as a lesson that China must strive to avoid.
The report averages estimates of China’s potential growth rate from existing literature, finding that the average rates for 2021-2025, 2026-2030, and 2031-2035 are 5.81%, 5.31%, and 4.77%, respectively. However, from 2010 to 2019, China's actual GDP growth rate fell from 10.6% to 6.0%, averaging a decrease of about 0.5 percentage points per year. The compound average growth rate for 2020-2023 was only 4.7%. Currently, China’s CPI and PPI remain low, consumer and business confidence indices are sluggish, PMI is at a low level, and youth unemployment continues to rise. If this downward trend persists, the actual GDP growth rate will be far below the potential growth rate estimated in the literature. Therefore, while maintaining confidence, China must be highly vigilant against this situation becoming a long-term problem and should have a strong sense of urgency. Looking abroad, the U.S. economy is currently overheated, experiencing a “three-three economy,” with around 3% inflation and 3% unemployment, the lowest unemployment rate in 50 years. In comparison, if China does not curb the trend of economic growth falling below its potential, it will be at a disadvantage in international competition and the global landscape in the long run.
Three Major Issues
The three main issues affecting the current economic operation:
1. Local Government Debt. This is the most significant issue impacting current macroeconomic operations. Local government debt continues to grow, nearly matching GDP, while local governments’ debt repayment capabilities are continually declining, making interest payments challenging, let alone repaying the principal. More importantly, local governments are constrained by repayment pressures, leading to a contraction in total expenditure. Over the past four years, the broad fiscal expenditure as a proportion of GDP has fallen from 41.2% to 37.4%, a decline of 3.8 percentage points, greatly impacting China’s economy. Currently, fiscal expenditure is not counter-cyclically expanding but is actually contracting, exacerbating macroeconomic shrinkage during an economic downturn. The report argues that the core factor behind the persistent economic sluggishness is not real estate but government spending contraction.
2. Real Estate. The real estate market remains sluggish. Since 2023, despite repeated central government emphasis on preventing and resolving real estate risks and the introduction of various policies, these policies have not met expectations, and the severe situation in the real estate industry has not been alleviated. High inventory levels, weak sales, falling prices, and lack of buyer confidence evidence this. Meanwhile, real estate companies are facing financial and funding difficulties, and new construction areas have shrunk significantly. The report highlights that due to the substantial contribution of real estate to the macroeconomy and its impact on local finances and financial markets, the sluggish real estate market is a major risk to the stable operation of the macroeconomy.
3. Consumption. Current social demand lacks vitality, and consumption recovery is weak. This is mainly due to the slowdown in residents' income growth, unstable expectations for economic development, lack of confidence, declining marginal propensity to consume, and people’s reluctance or inability to spend. Additionally, the employment situation remains severe, and national consumer confidence is low, especially among young people who, facing employment and wage pressures, increase preventive savings and are reluctant to consume.
Three Major Responses
The three main issues requiring attention for medium and long-term reforms:
1. Improving Government Risk Warning and Disposal Mechanisms. The current downward pressure on China’s economy is largely influenced by real estate contraction and excessive local government debt. In addressing these two major risks, China has exposed several issues in its risk warning and disposal mechanisms, including inadequate risk awareness, limited feedback mechanisms, and insufficient macroeconomic coordination between economic management departments in the government. There needs to be a heightened sense of urgency to proactively and effectively prevent and mitigate systemic risks. Recommendations include: (1) Establishing a systemic risk emergency management team that prioritizes interrupting the contagion of risks, rather than obstructing risk disposal speed and intensity to prevent moral hazard; (2) Promoting a due diligence exemptions system to encourage leaders at all levels to promptly handle risks at the first sign of trouble, avoiding buck-passing or the fallacy of composition among economic management departments.
2. Reevaluating the Nature and Role of National Debt in China’s Modernization. The report notes that national debt is not merely government bonds issued by the central government to cover fiscal deficits but possesses richer attributes and implications. For instance,
(1) National debt is an important tool for a sovereign central government to create and enhance national wealth and symbolize government capability. Without national debt, local governments would bear the debt burden, making long-term construction projects, especially strategically significant infrastructure projects, difficult to execute. The deficit rate should be viewed in relation to fiscal revenue, government assets, and national savings, indicating that issuing national debt does not necessarily mean 寅吃卯粮 “borrowing against future generations” and should not be demonized;
(2) National debt is a fundamental financial asset of a country, forming the base of the capital market pyramid. It serves as a crucial support for the healthy development of the capital market provided by a sovereign state. It is not something to be issued only when the country runs out of money. Rather, it should be fully recognized and issued when the country is financially healthy and the economy is relatively stable, to leverage the irreplaceable role of national debt;
(3) National debt is crucial for advancing the internationalization of the RMB. For international investors, holding Chinese national debt is the simplest, safest, and most liquid way to invest in China. Currently, about 12% of China’s national debt is held by foreign investors.
The report suggests that in the coming period, increasing national debt issuance should be a key measure to promote economic development, which is both necessary and feasible. The necessity arises from the “scarring effect” post-pandemic, where consumer recovery will be slow in the short term. In investment, the real estate industry remains challenging, and the confidence and vitality of the private economy cannot be fully restored in the short term. Therefore, the government should actively utilize the important tool of national debt to guide the economy back to normalcy. The feasibility lies in the central government’s ability to issue national debt to replace local debt, changing the government debt structure, reducing local government debt pressures, and revitalizing the economy. The aim of issuing national debt to replace local debt is not to allow local governments to offload their burdens and reinvest similarly as before but to activate the stagnant funds owed by local governments and revitalize their activities.
Regarding national debt issuance, the report also addresses and clarifies some concerns from academia and industry:
- Will issuing national debt trigger high inflation like in the U.S.? The report believes that China and the U.S. face different problems. China’s main issue is insufficient total demand, low capacity utilization, continuous low prices, and a low-interest-rate environment. The Chinese government has enough production capacity to suppress inflation. Thus, China has better conditions for issuing debt compared to the U.S., and large-scale national debt issuance is unlikely to trigger inflation. Currently, it is an excellent window to issue debt to create a favorable environment for economic growth.
- Does China have sufficient national debt issuance capacity, space, and repayment ability? The report states that: (1) Currently, China has a high national savings rate and large central government net assets. By the end of 2017, China’s sovereign net assets had reached 101.8 trillion yuan, accounting for 124% of GDP, ranking among the top in major countries worldwide and continuing to accumulate in recent years, indicating ample assets and strong debt issuance capacity. (2) Although local debt faces significant repayment pressure, the national debt-to-GDP ratio is relatively low. In 2023, central government debt accounted for only about 22% of GDP, far below the over 100% in Europe and the U.S. and Japan’s nearly 216%. Therefore, China’s overall government debt scale is safe, with significant space for future national debt issuance. (3) Compared to the U.S., China’s cost of issuing national debt is lower, making it easier to replace local debt. For example, the latest 10-year national debt yield shows a China-U.S. interest rate spread of nearly 200 basis points. Assuming China issues about 50 trillion yuan in 10-year national debt, replacing about half of the outstanding local debt, annual interest costs could be reduced in the amount of about 1.5% of GDP. Given these factors, especially with strong national credit support, there is no need to excessively worry about China’s national debt issuance and repayment capabilities.
In a situation where government infrastructure investment returns are very low, is there still room for spending the money raised via national debt? The report asserts that there is. For many years, the government has heavily invested in infrastructure like power, transportation, and water conservancy, facing declining returns. However, government investment in scientific research, health, culture, education, and public administration remains relatively low, and infrastructure investment related to social welfare still offers considerable returns. Therefore, the report suggests that the government’s future focus should not only be on projects and investments but on effectively increasing the supply of basic social welfare. On one hand, the central government should issue national debt to increase welfare fiscal expenditure and expand domestic demand. On the other hand, efforts should be made to guide local governments to prioritize improving social welfare in their future work focus.
3. Reforming the Fiscal and Tax System to Shift Local Government Focus from Investment and Production to Consumption and Resident Income. The report states that the fiscal and tax system is closely related to local government incentives, influencing their behavior. As we enter a new development stage, with high government debt, declining investment returns, and insufficient domestic demand becoming the biggest challenges to China’s economic growth, there is an urgent need to shift government policy orientation from investment and projects to providing basic social welfare and helping people increase disposable income to boost consumption. This means reforming and adjusting government incentives and roles. In the past, China’s taxation system focused on taxing enterprises at the production stage, and officials’ promotion systems centered on economic growth, encouraging local governments to attract investment and production, leading to repetitive investments, overcapacity, local protectionism, and slow industrial iteration. More importantly, low consumption and public service resulted in high preventive savings among residents, suppressing potential consumption. The report suggests shifting taxation to the consumption stage and partially delegating it to local governments, changing local government economic incentives. Politically, adding indicators for resident income growth and consumption growth in local government assessments can improve resident welfare and promote consumption.
The report emphasizes that the key to solving current issues lies in the effective implementation of deepening reform policies. In simple terms:
First, regarding local debt, it is recommended to significantly increase national debt issuance to replace local government debt, establish a new borrowing mechanism, and set up a national infrastructure investment company to centrally manage local infrastructure project planning, financing, construction, and supervision, matching terms with cost-benefit.
Second, for real estate, it is recommended to accelerate the implementation of urban real estate financing coordination mechanisms, grant sufficient credit to leading enterprises, ensure commercial banks’ real estate loan decisions are made with due diligence exemptions, and comprehensively lower mortgage rates.
Third, regarding consumption, it is recommended to shift some tax collection from production to consumption locations, changing local government incentives to focus more on resident income growth and consumption market cultivation, and direct government investment towards public services. The report predicts that if reform policies are implemented effectively, China’s economic growth should reach 5.1% in 2024 and continue to stabilize and recover.
At his forum, David Daokui Li also assembled a team of Chinese experts to telegraph policy advice to decision-makers ahead of the Third Plenary Session of the 20th Central Committee of the Communist Party of China scheduled July 15-18.
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