Lou Jiwei says structural reforms are now imperative

Former Finance Minister says a crisis could serve as a catalyst for reform and drive consensus for change, calling for ending the urban-rural divide and current household registration system.

Lou Jiwei, former Minister of Finance (2013-2016) spoke at the China Europe International Business School (CEIBS) on March 29. CEIBS, co-founded by the Chinese government and the European Union (EU) in 1994, made the speech available on its WeChat blog on May 7.

Although starting with the “signs of stabilizing and recovering,” the former senior government official known in China for straight talk ended his speech with an urgent call for structural reforms, such as dismantling the urban-rural divide by making the rights to use the land freely transferable and eliminating the distinction between urban and rural household registration.

The reform “faces obstacles from significant challenges from vested interests,” he admitted, asking “All regions and government departments” to agree on “increasing the central government's commitments to fiscal spending for equitable basic public services.” A crisis could serve as a catalyst for reform and drive consensus for change, he added.

China has spiked its official budget deficit to 3.8% of the GDP, but Lou believes that's still not enough, especially given the limited effect of monetary policy. Echoing many Chinese experts’ public advice, which The East is Read and Pekingnology have extensively covered, Lou called for direct government subsidies to disadvantaged households.

A Communist Party of China Central Committee and State Council directive in 2016 banning siloed residential complexes, prevalent in Chinese cities, was not implemented, Lou noted. He also assailed the current plan for using money from the government’s special treasury bonds by highlighting its lack of transparency and lamenting the exclusion of the private sector.

Below is a translation of Lou’s speech as made available by CEIBS, whose emphasis has been retained. - Zichen Wang

Signs of stabilizing and recovering

Currently, the Chinese economy faces many challenges, such as insufficient domestic demand, excess supply, and downward pressure on the real estate and foreign trade sectors. However, recent economic indicators show signs of recovery, suggesting that the economy is steadily moving in a positive direction.

Firstly, the economy has gradually recovered after the pandemic. As of 2023, China's GDP exceeded 126 trillion yuan ($17.52 trillion), growing by 5.2% year-on-year. This comes on top of a 3% growth from 2022, putting the average biennial growth rate at about 4.1%, below the potential growth of around 5.5%. In the next five years, the potential growth rate is projected to be around 5% with a gradual decline.

Secondly, domestic demand is gradually recovering. Fixed asset investment went up by a modest 3%. The total retail sales of consumer goods grew by 7.2%, but this is based on zero growth from the previous year, equating to an average biennial growth rate of about 3.6%. Demand for imports and exports has weakened, dragging down economic growth by 0.6 percentage points. Investment in real estate development decreased by 9.6% year-on-year. Clearly, the real estate sector and the import-export sector are the most significant drags on China's economic growth.

Overall, China's economic development is characterized by insufficient domestic demand and oversupply, but there are signs of stabilization and recovery.

• In 2023, CPI edged up by only 0.2%, while PPI fell by 3%. In the first two months of 2024, however, economic data improved, with CPI reversing from a year-on-year decrease of 0.8% in January to a year-on-year increase of 0.7% in February, though it still recorded a slight decline both year-on-year and month-on-month.

• In January and February, the value-added of industrial enterprises above designated size increased by 7% year-on-year, with profits increasing by 10.2%. However, profits of industrial enterprises above designated size did not show significant growth throughout 2023.

• Exports and imports grew by 7% and 3.5% year-on-year, respectively, leading to a slightly larger trade surplus compared to the previous year.

• Fixed asset investment increased by 4.2% year-on-year, accelerating by 1.2 percentage points from last year.

Next, I will review China's economic development from 2023 to 2024, with a primary focus on 2023.

Firstly, consumer demand has weakened.

One reason is consumers' low expectations for future income. As demand shortfall and oversupply lead to layoffs by businesses, individuals are cutting back on consumption and increasing precautionary savings.

Secondly, China's stock market has been persistently sluggish in 2023 and 2024, raising doubts about the effectiveness of countercyclical adjustment mechanisms, prompting an uptick in risk-averse savings.

Thirdly, the long-term slump in the real estate market necessitates structural reform. Although policies like removing purchase restrictions are steps in the right direction, they have yet to significantly boost housing demand. In 2022, household deposits in China surged by 17.8 trillion yuan [$2.6 trillion] to a record 120 trillion yuan [$16.6 trillion], and by 2023, this figure rose further to 137 trillion [$19 trillion], against a GDP of only 126 trillion. Clearly, while it is important to increase people's income, it is even more crucial to bolster their confidence.

Secondly, there is a lack of private investment. Several reasons have contributed to the decline in private investment.

One is the decline in corporate profits. In 2022 and 2023, the total profit of industrial enterprises above the designated size [with annual revenue from their main business of over 20 million yuan ($2.8 million)] fell by 4% and 2.3%, respectively. Although profits showed a growth of 10.2% in January and February of 2024, this increase comes off the back of negative growth in the preceding years. Given these conditions, many businesses, particularly private and small and micro enterprises, are hesitant to invest.

Secondly, private investment, which often funded public projects in the past, now encounters issues with local governments defaulting on payments. This situation stems not only from fiscal challenges faced by local governments but also from local governments' failure to fully honor contractual agreements. A notable example is the situation in Liupanshui, Guizhou [where a businesswoman was arrested after demanding over 200 million yuan [$27.8 million] in unpaid fees from the local government.] This incident has had a broad negative impact.

Thirdly, the number of overseas orders has declined. Foreign trade exports decreased by 4.6% in 2023. Some labor-intensive industries inevitably have to relocate to Southeast Asia. In this context, enterprises need to undergo transformation, develop new technologies, and explore new businesses, all of which necessitate investment. However, private enterprises, particularly small and micro enterprises, are reluctant to undertake investment risks, resulting in a diminished willingness to invest.

A set of financial data can illuminate the severity of the problem. In recent years, M2 (which includes currency, transferable deposits, and long-term fixed deposits) has reached 300 trillion yuan [$41.5 trillion], representing 2.3% of the GDP, the highest proportion among countries globally. The widening gap between M2 and M1 (which comprises currency and transferable deposits) suggests a growing reluctance among enterprises to borrow for investment, as well as a similar hesitancy among consumers to borrow for investment and consumption. The rapid increase in M2 and the expanding disparity between M1 and M2 underscore the seriousness of economic challenges.

Threefold pressure remains unsolved

The Government Work Report released in March 2024 attributes China's current economic challenges to "both cyclical and structural issues." Here are my perspectives on these factors:

The most significant cyclical problem is the impact of the unprecedented pandemic on the economy. As a national event, the pandemic's economic repercussions should be primarily managed by central fiscal policies. However, during the three years of the pandemic, China's countercyclical fiscal and monetary policies have not been as robust as those of developed countries. Developed nations often leverage personal income tax return data to gauge individual and family economic conditions and can directly support those in need with central fiscal funds. In contrast, in China, less than 10% of employed workers pay income tax, resulting in a lack of management foundation for such targeted support.

Consequently, China has primarily adopted policies of tax reductions and fee cuts, which align with its national conditions.

Among these, the VAT refund policy [which allows certain eligible taxpayers to apply for a refund of their excess input VAT] has played an important role. Unlike other countries where such refunds are primarily managed by the central government, in China, VAT revenues are split evenly between the central and local governments. However, the main issue is that the responsibility for VAT refunds falls more heavily on the local governments in the western and central regions of China. In 2022, a spescial policy was implemented where VAT refunds for small and micro enterprises were entirely managed by central finance, which absorbed 92% of the VAT refunds, a 2.2 trillion yuan during the year. Currently, VAT refunds are still shared fifty-fifty between central and local governments, but for the 50% portion of the VAT refund shared by the local authorities, 15% is covered by the region where the business is located, while the remaining 35% is distributed among the regions based on their share of the total local VAT revenue. Hopefully, this policy arrangement will reduce the backlog of VAT refunds.

Another policy proposed during the pandemic was that state-owned enterprises and institutions should reduce or waive rent for small and micro enterprises. However, the implementation has been less than ideal, primarily due to the need for fiscal subsidies which are difficult for local governments to afford given strained local finances. Additionally, China's lockdown approach to epidemic prevention involved issues of formalism and bureaucratism, which further disrupted industrial and supply chains.

Moreover, there has been an overemphasis on achieving the carbon peak and carbon neutrality goals, which has led to "electricity rationing" in various regions. The internet industry has also faced excessive regulation, and there have been stringent crackdowns on the education and training industry, among others.

Overall, the Chinese economy has faced a threefold pressure of supply shock, insufficient demand, and weakened expectations. So far, the economy has not fully recovered.

Relevant departments have introduced some policies based on the basic needs of the people, in line with the direction proposed at the Central Economic Work Conference in 2021.

The Government Work Report of 2024 explicitly stated the principle of "pursuing progress while ensuring stability," emphasizing that "Stability is of overall importance, as it is the basis for everything we do." It calls for all localities and government departments to "adopt more policies that are conducive to keeping expectations, economic growth, and employment stable," and to "take good care in formulating measures that could be contractionary or inhibitive in nature and overhaul or abolish policies and regulations that hinder high-quality development."

Additionally, the Chinese government has called for enhanced coordination across all policies. For the first time, non-economic policies have been included in the assessment of the consistency of macroeconomic policy orientation. This inclusion aims to enhance comprehensive policy planning and direct all policies toward common goals.

These requirements were highlighted in the Government Work Report on March 5, 2024, though they had already been introduced at the 2023 Central Economic Work Conference. A key indicator of this policy shift is to evaluate if non-economic policies align with the consistency of macroeconomic policy orientation, a move away from inhibitive policies. Hopefully, these measures can be effectively implemented and yield positive outcomes.

The real estate sector poses another significant challenge to the Chinese economy. Since the latter half of 2021, certain regions in China have encountered risks in real estate, local government debt, and small and medium financial institutions. The Government Work Report refers to these small and medium financial institutions as harboring "risks and potential dangers." However, these are no longer just potential issues; actual risks have now emerged. At the same time, there has been a decline in local land transfer revenues. These developments are interconnected and indicative of persistent mid-to-long-term structural issues.

Specifically, these issues include:

1. Urban investment companies play a crucial role in the conversion of collective-owned rural land into state-owned urban construction land, before auctioning the land to real estate developers. This practice allows urban investment companies to repay and refinance their debts before real estate development, thereby enabling local governments to generate net income from land transfers. Banks, particularly small and medium financial institutions, place significant trust in urban investment companies and hold a considerable amount of their debt. These banks also issue a substantial number of loans that are secured by the land.

2. In China, real estate companies are increasingly moving toward larger and super-large scales to enhance their capacity for large-scale development. These companies have long been characterized by high debt, high leverage, and rapid turnover; the higher the land prices, the faster the turnover. These trends have all benefited real estate companies. As a result, in various cities, especially in newly constructed urban districts, the development approach often involves building large communities, wide roads, expansive squares, and large gardens, leading to a homogenous urban aesthetic across different cities.

3. Moreover, the phenomenon of "urban diseases" is becoming more severe, characterized by high housing prices, inconvenient living, traffic congestion, and insufficient public resources. This cycle has reached the brink of unsustainability.

In February 2016, the Communist Party of China (CPC) Central Committee and China's State Council issued a directive promoting the block-based urban system in new housing projects and prohibiting the construction of enclosed residential complexes.

However, this directive has not been implemented, underscoring the necessity of addressing fundamental institutional challenges. Currently, persistent structural problems remain unresolved. If housing prices were to decline, real estate companies would encounter liquidity problems, and revenues from land auctions would decrease. This could also expose local hidden debts and lead to a reduction in local government revenue from land sales. Consequently, banks, particularly small and medium financial institutions, are at risk of facing defaults. This is exactly the situation China is currently facing.

Structural reforms are imperative

The last part of my speech will be the analysis of some current policies and their effects.

Firstly, regarding China's fiscal policy, the deficit-to-GDP ratio for 2023 was initially set at 3%. In October 2023, the Chinese government revised the budget, increasing the deficit by 1 trillion yuan [$138 billion], which adjusted the final deficit ratio to 3.8%. For 2024, the deficit-to-GDP ratio is planned to remain at 3%. Additionally, the allocation for special-purpose bonds for local governments is set at 3.9 trillion yuan, marking an increase of 100 billion yuan from the previous year's total of 3.8 trillion yuan [$526 billion].

Next, the effects of these fiscal policies.

In 2024, the Chinese government will continue implementing tax reductions and fee cuts. However, the impact of these measures may decline since most credits carried over from previous taxable periods have already been refunded. Economic data suggests that the CPI has hovered around 0% for a year, and the PPI has been negative for over eighteen months. A substantial amount of funds remains idle in banks, and the effects of monetary policy expansion are limited, highlighting the need for a more proactive fiscal policy.

Despite an increase in the real deficit-to-GDP ratio for 2024, it remains insufficient to meet the economic challenges, indicating that there is room to raise this ratio further. It is advisable to increase current expenditures, with a focus on supporting transfer payments to grassroots governments to alleviate their financial constraints and ensure a strict crackdown on arbitrary government charges and fines. Increased fiscal spending could be used to subsidize rent and utilities for small and micro enterprises, as well as provide cash subsidies to disadvantaged families.

A unified collection system for personal income tax and social security funds should be implemented. This would provide a clearer understanding of family economic conditions, enabling more targeted and accurate fiscal subsidies.

Secondly, special treasury bonds are meant to ensure annual interest payments and principal repayment upon maturity, but based on China's government budget report, the projects have not been able to meet these obligations, creating a situation that is even less transparent than a straightforward addition to the budget deficit. This raises a question: why not allow the private sector to undertake these projects? While there are risks in private sector involvement, these can be mitigated through appropriate subsidies, encouraging private investment rather than adopting the current approach.

Incorporating an additional 1 trillion yuan deficit into the government budget will enhance the transparency of fund usage. However, classifying these expenditures as special treasury bonds, which are managed under the government-run fund budget will make it challenging to specify the exact use of funds.

Moreover, government-run fund-based fiscal policy, often associated with expanded government investment, may no longer be as effective given the relatively complete infrastructure that already exists. Instead, the focus should shift towards increasing expenditures on enterprises, particularly small and micro enterprises, and enhancing residents' incomes. Such measures would align with the goals of improving "quality and effectiveness" highlighted in the Government Work Report.

Thirdly, addressing the risks associated with real estate, local government debt, and financial institutions is a crucial task for the present and future. Governments at various levels have already set in motion a raft of policies including the elimination of property price and purchase restrictions, permitting early mortgage repayment, lowering down payment ratios, and accelerating efforts to ensure the delivery of pre-sold housing projects. Additionally, the Chinese government is extending credit to real estate enterprises experiencing liquidity issues, alongside stringent measures to curb the rise of hidden local government debts and strategies to resolve existing ones.

In recent years, the special refinancing bond program, which allows local governments to replace their outstanding hidden debt, has helped to ease the debt repayment burden on local governments and reduce overall debt costs. This program serves as an emergency measure and needs lasting commitment and enhancement to remain effective.

This 2024 Government Work Report emphasizes the need to "scale up the building and supply of government-subsidized housing." Given the current oversupply in housing, office, and retail properties, as well as in industrial parks, clearing inventory by transforming some of these properties into affordable housing could help facilitate a systematic reduction of the real estate market's surplus and is fundamental for the recovery of the real estate market.

Fourth, the real estate market's downturn, largely driven by mid-to-long-term structural issues, necessitates comprehensive structural reforms to achieve a fundamental resolution. As highlighted during the 2023 Central Economic Work Conference, there is a critical need for "the improvement of related fundamental systems and the rapid development of new models for real estate development." A pivotal aspect of these reforms is dismantling the urban-rural divide, which stands as a significant obstacle to integrated urban-rural development.

To bridge this gap, while urban and rural lands remain publicly owned, the rights to use the land should be freely transferable. It is also advisable to implement property taxes, with revenues earmarked for covering costs and enhancing urban living environments.

Additionally, the distinction between urban and rural household registration should be eliminated. This reform, coupled with policies that allocate fiscal transfers, urban construction land, and infrastructure investment based on the number of urbanized rural settlers, will facilitate more integrated urban-rural development and boost consumer demand.

However, breaking the urban-rural divide faces obstacles from significant challenges from vested interests. All regions and government departments should achieve a unified understanding regarding the need to increase the central government's commitments to fiscal spending to provide equitable basic public services.

Currently, the policy focus should primarily center on gradually improving real estate market conditions to prevent systemic crises and accelerate fundamental structural reforms. These reforms should aim to establish a unified urban-rural market, which is essential for promoting high-quality development as well as social equity and justice. Crises, as catalysts for reform, drive consensus for change. China is currently in a critical period for advancing fundamental structural reforms, and there is an urgent need to build consensus on the necessity.

3rd Plenary Session in July to focus on "further comprehensively deepening reform" and modernization