Leading Chinese economists Q&A: real estate, industry capacity & stock market

Xu Gao, Luo Zhiheng & Lu Feng unpack the major sectoral challenges confronting the Chinese economy at Peking University.

On March 13, 2024, the National School of Development (NSD), Peking University, in collaboration with Baidu Economic & Financial News, held the 68th session of the China Economic Observation event and launched the 30th-anniversary celebration of the NSD.

The NSD also hosted Janet Yellen, the U.S. Secretary of the Treasury last Sunday.

Previously, The East is Read and its sister newsletter, Pekingnology, have highlighted speeches by China's leading economists, along with the first half of their Q&A from the event. In today's newsletter, we will present the latter half of the panel, which also marks the conclusion of the event. The panelists are:

• Xu Gao, Chief Economist and Assistant President of Bank of China International Co. Ltd., leading the research department and sales and trading department of the company, and an adjunct professor of the NSD at Peking University.

• Luo Zhiheng, Chief Economist and President of the Research Institute at Yuekai Securities.

• Lu Feng, Emeritus Professor of Economics and Director of the China Macroeconomic Research Center at the NSD and former Deputy Dean of the NSD, Peking University.

The panel was moderated by Wang Xianqing, Director of the Communications Center at the NSD.

Given that most of the following questions address ideas covered by the speakers' prior addresses, we would recommend reviewing our previous publications before diving into this one. Of course, skipping the earlier speeches will not hinder your comprehension of today's content.

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Q5 (Wang Xianqing, host):

Mr. Xu Gao has also mentioned the plight of the real estate market. In your opinion, what other areas need to be strengthened or rectified to improve the real estate market?

Xu Gao:

According to the latest data, the decline in weekly floor area sold in 30 cities continues to be significant. The current floor area sold is far below the levels of the same period over the past three years. I believe that current policies have not accurately grasped the core of the problem.

The primary issue, as I identified two years ago, is the heightened credit risks faced by developers due to restrictive financing conditions. These risks erode consumer confidence, leading to a significant drop in pre-sale housing sales and perpetuating a vicious cycle. Previous efforts that focused on stimulating demand received only limited results, largely because potential buyers prioritize the financial stability of developers over minor adjustments in interest rates.

Universal support for real estate developers is crucial. Merely aiding specific projects is not enough as stabilizing developers as a whole is necessary to prevent an increase in problematic projects. Despite skepticism surrounding assistance to developers, it's important to recognize that rising housing prices signal a supply shortage, with developers playing a pivotal role in this supply chain.

The tightening of financing policies has led to a substantial decrease in the floor area of new real estate projects, posing huge challenges to future price control.

Thus, the real estate sector's difficulties are the central challenge in the current economic landscape, with developer credit risk being the core issue in the real estate sector. Current policies have yet to address this core issue. The data indicates a persistent and substantial decline in the real estate industry, placing considerable strain on the broader economy.

Given the high economic base in the first quarter of 2023, there may be a downturn in this year's first-quarter year-on-year growth rate. Without decisive action in the real estate sector, such as revising financing policies and deploying public funds to support developers, achieving the 5% growth target could be increasingly challenging.

Q6 (Wang Xianqing, host):

Mr. Luo mentioned that the available fiscal funds for 2024 have increased by more than 30 trillion yuan [4.15 trillion U.S. dollars] compared to last year. How do you think these funds should be allocated and utilized?

Luo Zhiheng:

Firstly, addressing the real estate issue, I believe that ensuring housing supply and stimulating demand can go hand in hand.

1. Despite an 8% decline in real estate sales last year, existing home sales achieved double-digit growth. This indicates that as long as unfinished projects are avoided, consumers are willing to make purchases.

2. In terms of stimulating demand, beyond conventional interest rate adjustments, other avenues can be exploited to stimulate market dynamics. For example, introducing high-quality homes in central areas of first-tier cities, where there is strong demand for such properties, and relaxing existing restrictions in first-tier cities along with those persisting in certain second-tier cities. Due to changes in current supply-demand situations and expectations, these measures do not risk price surges. Moreover, expanding purchasing qualifications based on employment and social security contributions in urban areas could unlock further demand. Adjusting taxes and fees associated with real estate transactions is also essential.

In terms of policy implementation, it is crucial to optimize real estate policies as soon as possible. Prompt and comprehensive policy implementation can gradually shift market expectations, mitigating the wait-and-see attitude among potential buyers and balancing the supply-demand equation. I am convinced that the real estate market will eventually be stabilized with a series of policy optimizations and implementations.

Back to the allocation of fiscal funds, 2024 has an expected fiscal expenditure of 28 trillion yuan [3.87 U.S. dollars]. I believe that the effectiveness of policy implementation is paramount during an economic downturn, ensuring that limited resources are used most effectively.

1. Emphasize direct expenditure over revenue-focused measures like tax cuts, which alone may not sufficiently catalyze investment or consumer spending and could exacerbate debt levels. Fiscal expenditures, on the other hand, can expand aggregate demand and increase corporate or household income, thereby driving economic cycles.

2. Shift from focusing on investment towards a balanced emphasis on both investment and consumption. For instance, enhancing household disposable income through transfer payments is a viable exploration. Additionally, investing in new productive forces by supporting expenditures, for example, additional tax deductions and subsidies for R&D activities, can foster innovation and technological advancements.

Xu Gao:

I'd like to add a few remarks. It's crucial to understand the significant risk of short-term housing price declines in the current real estate market; the floor area of unsold homes in China, reaching almost 700 million square meters over the past two years, clearly indicates that supply has surpassed demand.

However, this should be viewed as a temporary anomaly. On the one hand, the decline in real estate sales is significantly influenced by concerns over developers' credit risks, which hasn't eradicated demand but has made potential buyers hesitant. On the other hand, while most real estate data appears dismal, the floor area of completed properties stays high. Developers have accelerated construction to sell completed houses and recoup funds, exacerbating the supply-demand imbalance.

Yet, the floor area of new construction has plummeted to a third of its early 2021 level (implying a reduced supply in the forthcoming years). The suppressed demand is poised to burst, leading to a tilt in the real estate sector's supply-demand equilibrium toward undersupply. Given the time required to complete new houses, this surge in demand will meet a lag in supply, resulting in a dramatic shift from oversupply to undersupply, which will in turn drive up housing prices.

Hence, to summarize, the current real estate policies have not yet broken the industry's vicious cycle over the past two years. From a medium to long-term perspective, there's accumulating pressure that could lead to future housing price increases. The real estate sector urgently requires effective policies to defuse risks.

Q7 (Wang Xianqing, host):

I have one question for Prof. Lu. Prof. Lu, you've just discussed the issue of overcapacity, which indeed warrants our vigilance. However, from an industrial and policy perspective, overcapacity is also conducive to the emergence of many outstanding companies, since companies, amid overcapacity and vicious competition, are compelled to control costs more effectively and enhance their innovation capabilities. What kind of overcapacity could be considered beneficial to the industry?

Lu Feng:

I haven't provided a comprehensive analysis of overcapacity's theoretical and practical ramifications today; my focus was on its repercussions for the external economic and trade environment—a topic I've explored in various forums, including a China Economic Observation event in the 2000s.

Overcapacity can serve multiple functions, such as driving industry consolidation and ensuring that only the most efficient producers survive, thereby fostering overall industry growth. Additionally, price reductions resulting from overcapacity can boost consumer welfare. Nonetheless, widespread overcapacity across many sectors might indicate a deviation from the most effective allocation of resources. In this sense, it is still a problem that warrants correction in scope.

Moreover, given that China's manufacturing sector contributes to around 30% of the global GDP, significant overcapacity in this sector will inevitably lead to spill-over effects. These effects, in turn, could negatively impact China through the complexities of international trade relationships. Therefore, it's crucial to consider both the positive functions and negative impacts of overcapacity simultaneously, aiming for a balanced approach in addressing this issue.

Q8:

My question is for Mr. Lu on the issue of overcapacity, which appears to be aggravated by the competitive actions of local governments. For instance, last year, around eight cities in China announced initiatives to become "the Capital of Lithium Battery." Similarly, the rush by many cities to create smart computing centers has led to suboptimal outcomes and resource wastage, particularly after technologies like ChatGPT became prominent. These exemplify the pitfalls of overlapping development strategies and blind competition among regions even before official government planning begins.

Looking forward, how can localities avoid the same mistakes? How can they strategize their development plans effectively or improve resource distribution through inter-regional cooperation? Could the concept of a unified national market offer a solution? Alternatively, should there be a greater reliance on market forces for decision-making, with the government playing a more restrained role in planning and intervention?

Lu Feng:

This is a question of very important practical significance.

Over time, China's industrial policy has undergone significant evolution and innovation, particularly in shifting focus from direct infrastructure investment to leveraging government industry investment funds to boost sectors identified as weak points. While both central and local governments have put in much effort, local governments often emerged as the more substantial investors. In sectors such as new energy vehicles, power batteries, and semiconductors, some localities have indeed achieved success, yet others have faltered or failed. This discrepancy indicates that the overcapacity may stem from overzealous investments or rapid expansion. This scenario warrants a critical examination of the role of local governments.

I believe there are two mechanisms for adjustment in this context. Firstly, even in the absence of overcapacity, industries naturally contain a self-elimination mechanism. Some regions excel, recouping investments with profits and boosting the local economy, whereas others fail to achieve any return on their investments. In some sense, this self-elimination mechanism acts as a natural check on local government intervention. On top of that, overcapacity compounds these challenges. Even when an investment appears successful on a small scale, potential shifts in the industry landscape can introduce complications. Therefore, it is crucial to be cautious about local government industry investment funds.

Secondly, governmental investment in China faces entrenched limitations, including issues with incentive mechanisms stemming from the use of public funds for investments. While local authorities can learn from past experiences, benefit from training, and refine their approaches to improve outcomes, adopting a cautious stance and engaging in systematic, empirical research remain essential.

Therefore, it is crucial to summarise lessons learned and instigate market-oriented reforms. As Prof. Luo mentioned, the key question lies in defining the boundaries of government power. Although government support might be necessary during certain stages, entrusting decision-making and operational autonomy to the market and capable companies is advisable for long-term sustainability. This approach is essential to circumvent overcapacity and ensure the healthy development of the economy.

Q9:

I wanted to ask about market barriers faced by private businesses in emerging industries. Currently, such barriers persist, especially in fields like commercial aerospace/aviation. Now the Government Work Report has explicitly stated the nation's support for these industries, how can China further enhance access for private enterprises to these emerging industries?

Lu Feng:

Market access should be maximally open. Reflecting on the approach taken in the early years of the new millennium, where overcapacity was tackled by restricting investments, particularly from private enterprises, it appeared misguided to me, and I engaged in several debates on this issue. Nearly two decades later, although China has significantly liberalized investment, there remains scope for further enhancement. Since foreign investment in China's manufacturing sector is fully liberalized, the same principles should apply to domestic enterprises to avoid discrimination against domestic private entities. It's evident that the central leadership's perspective on this issue has evolved considerably over the past two decades. Even in specialized sectors such as aerospace, China could take cues from companies like Tesla to encourage initiative among Chinese private enterprises. In the current climate, it's imperative to place greater trust in private enterprises. This approach not only bolsters market confidence and invigorates supply but also addresses demand shortfalls.

I also believe that the central leadership's view on this matter has evolved considerably over the past two decades. Even in especially sensitive industries like aerospace, China could learn from companies like Tesla to encourage initiative among Chinese private enterprises. In the current climate, it's imperative to place greater trust in private enterprises. This approach not only bolsters market confidence and invigorates supply but also addresses demand shortages.

Q10:

Prof. Lu, you have just illustrated how changes in U.S. and Western industrial policies, such as the shift toward "nearshoring" and "friend-shoring," have contributed to global overcapacity. To what extent do you believe these policies have precipitated this wave of overcapacity? Or is their impact just beginning, with more significant disruptions yet to unfold?

Furthermore, trade protection measures in the U.S. and Europe are moving beyond the tariff-centric approaches observed in the China-U.S. trade war towards more intricate non-tariff barriers. What impact might it have on China's foreign trade if the U.S. focuses on exports of China's "New Three" export pillars (electric vehicles, lithium batteries, and solar cells) and adopts a series of trade protection actions?

Lu Feng:

Assessing the impact of overcapacity and its quantification requires thorough discussions across different sectors. The changes in industrial policies in the U.S. and Western countries, such as the shift towards increasing onshore, nearshore, and friend-shoring investments driven by geopolitical considerations, seen in the U.S. and its allies, have notably influenced capacity expansions in certain areas. This effect is especially prominent in chip production and, to a lesser extent, new energy sectors.

This supply expansion and resulting changes in trade balances may introduce new tensions in international economic and trade relations, one example being the EU's anti-subsidy investigations against China's new energy vehicles. Additionally, some U.S. politicians observed recently that Mexico's exports to the U.S. have de facto facilitated China's industrial relocation. Despite specific provisions in the US-Mexico-Canada Agreement targeting Chinese exports, it seems that complete blockage of cost-effective Chinese goods has not been achieved. Whether the U.S. will adopt further measures warrants future attention.

Late last year, I wrote about China's strategy to circumvent trade frictions or trade barriers through direct investment. After investing in third countries, export behavior is no longer seen as direct exports from China to the United States but rather exports from third countries to the United States. Nonetheless, should the new wave of overcapacity intensify with China's export competitiveness further enhanced, the U.S. and Western countries might impose stricter restrictions on such direct investments from China.

Moreover, extreme proposals to revoke China's Most Favored Nation status, as mentioned in the "Reset, Prevent, Build" report by the U.S. House Select Committee on the CCP, alongside exaggerated tariff protection measures proposed by Trump during the election year, and the emerging dynamics of overcapacity and trade balance shifts, are all consistent with the growing uncertainties in the international environment highlighted in both the Central Economic Work Conference (December 2023) and the Government Work Report (March 2024). Therefore, it's crucial to closely monitor, analyze, and prepare for these challenges.

Q11 (Wang Xianqing, host):

Mr. Luo, for individual investors or entrepreneurs, what do you think should be the investment focus for 2024?

Luo Zhiheng:

Let me add some observations regarding the issue of overcapacity mentioned earlier. Over the years, many may have noticed a concept called "equity financing," which involves the government establishing guidance funds to incubate high-tech enterprises.

Although this model can promote industry development and yield profits through exits, I believe it should not be hastily promoted nationwide. Otherwise, it will lead to chaos and overcapacity in various regions.

This approach doesn't effectively resolve the inherent conflict between the fiscal funds' low-risk preference and the high-risk nature of the high-tech industry. Additionally, this model is dependent on government departments having market-savvy thinking and corresponding due diligence and accountability systems, etc. The related industrial and human resources are not uniformly available across all areas. The market will definitely identify investment opportunities better than the government.

At the same time, the concept of "equity financing" seems somewhat ambiguous. In a socialist state with public ownership, apart from tax revenue derived from political authority, government revenue is also generated through sales of state-owned urban land. However, should the above-mentioned discussion be taken as the definition of "equity financing," revenues from land transfer fees and the state-owned capital operations budget (dividends of state-owned enterprises for the government), respectively, also fall under this category. Therefore, this concept and model require careful examination.

Back to Mr. Wang's question. This question is tricky, as both the real estate and stock markets are intricately linked to numerous sectors. Given the previous discussions on the real estate market, I'll turn my focus to the stock market.

The recent rise in the stock market, I believe, is largely due to anticipatory sentiments resulting from personnel changes. A so-called "Spring Fever" typically occurs after the Lunar New Year and before the disclosure of January and February's economic data. Even though the economic indicators for the initial two months are still pending, commercial banks are proactively front-loading their lending, leading to favorable financial indicators and fostering a public perception of economic recovery. Moreover, with some time remaining until the release of economic data in March, aligning with the "two sessions," there is an opportunity for market enthusiasm to be amplified through speculative narratives. This is the so-called "Spring Fever" commonly cited in buy-side analyses.

I won't comment on the rises and falls of the stock market, but I do believe that to achieve long-term stability and progress, and to enhance the underlying stability of the stock market as mentioned in this year's Government Work Report, institutional reforms are called for.

1. Firstly, the foundation of a healthy stock market lies in the presence of high-quality listed companies. To this end, it is necessary to facilitate market access for companies and refine the delisting system, which ensures inferior companies can be eliminated through a survival-of-the-fittest process, leaving only the best.

2. Secondly, the dividend distribution system needs to be strengthened to attract more investors. Given China's stock market's dividend yield lags behind counterparts like Japan and the U.S., enhancing dividend policies could significantly improve market attractiveness.

3. Thirdly, the introduction of more medium to long-term funds is imperative, necessitating the reform of th annual assessment mechanism for these funds and the refinement of financial instruments.

4. Lastly, the penalties for violations of laws and regulations within the stock market must be elevated to maintain corporate integrity and the reliability of disclosed information. Implementing stricter consequences can adjust the cost-benefit analysis for companies and intermediaries, deterring them from engaging in fraudulent activities and fostering a transparent and equitable market environment characterized by rational pricing. By enacting such reforms, the stock market will be better positioned to meet the objectives set forth in the Government Work Report, namely, enhancing its underlying stability and fostering a consistent, long-term bullish trend.

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