Zhang Ming warns of over-securitization in China
Chinese Academy of Social Sciences economist recommends Beijing focus on economic growth, boost affordable housing, elevate deficit to 4%, and implement a new round of fiscal reforms.
Zhang Ming is Senior Fellow and Deputy Director of the Institute of Finance & Banking (IFB) as well as Deputy Director of the National Intitution for Finance & Development (NIFD) under the Chinese Academy of Social Science (CASS).
In an article originally published in the Caijing Magazine on Jan. 29, Zhang warned against China falling into a "pan-securitization" trap. Quite creatively, he suggested that developed countries, particularly the U.S., might be provoking China into prioritizing security over economic and social development through heightened international tensions and China-U.S. confrontations, just as what Washington did to Moscow in the Cold War. This, he argued, would potentially ensnare China into an overemphasis on security, luring the country into diverting excessive resources towards security and undermining its economic growth.
Additionally, Zhang called for more assertive fiscal policies, advocating that the ratio of the central government's fiscal deficit to GDP should surpass 4%, which was beyond the present target of 3% set in the Government Work Report in early March. Even when accounting for the $139 billion in ultra-long special treasury bonds highlighted in the report, which raises the deficit ratio to about 3.8%, it still does not meet Zhang's proposed benchmark.
Zhang also recommended reallocating fiscal funds towards individuals and businesses. He stressed the importance of aggressive, expansionary macroeconomic policies to bridge the persistent negative output gap and fuel economic recovery.
The original Chinese article is available on 大势看财经 Macroeconomic Trends with Caijing, the official WeChat blog of Caijing Magazine, and has also been cross-posted on 张明宏观金融研究 Zhang Ming's Macroeconomic Studies, Zhang's personal WeChat blog.
How to Cope with Critical Changes Emerging Both in and Outside of China
The current international environment is undergoing significant changes unseen in a century, characterized by the intricate interplay of political, economic, and military factors. China's domestic economy is also in a phase of adjusting its growth model, facing the dual challenge of overcoming insufficient aggregate demand and preventing and defusing systemic financial risks.
I believe that China's current domestic development and international environment feature four critical changes:
Escalating geopolitical conflicts
Restructuring of global value and supply chains
Transformation and adjustment of China's real estate market
Reshaping of fiscal debt relationships between central and local governments
To better respond to the changes, the dynamics of macroeconomic policies, especially fiscal policies, need to be revamped, and it is urgent to introduce new rounds of reform and opening-up measures.
Critical change one: escalating international geopolitical conflicts
Following the global financial crisis in 2008, the world economy fell into long-term stagnation. Driven by sluggish domestic growth, the governments of certain countries have attempted to project their internal conflicts outward, claiming that their domestic economic problems are the results of "unfair" economic and financial globalization.
In 2016, Britain voted for Brexit and Trump came to office. In 2018, the China-U.S. trade war started. From 2020 to 2022, the COVID-19 pandemic further exacerbated the ebb of globalization. The China-U.S. competition is set to be prolonged and persistent, while conflicts in Ukraine, Palestine, and the Red Sea crisis bring new uncertainties to the international political and economic environment.
Due to significant changes in the international landscape, China's development strategy has shifted from emphasizing growth and development to coordinating development and security. The core logic of growth and development focuses on the optimal global sourcing of resources. Meanwhile, the core logic of security lies in ensuring secure and efficient value and supply chains and requires the holding of sufficient reserves. Emphasizing security is both essential and prudent. However, it is undeniable that, in some aspects, development and security act as substitutes for each other, implying that they can have a mutually diminishing effect.
For example, regarding state-owned enterprises (SOEs) reform, if the focus is on growth and development, the optimal strategy might involve steering the growth of major SOEs while easing control over smaller ones. This could include dismantling monopolistic SOEs to boost competition and redirecting the focus of SOEs from profit-oriented sectors to strategic industries. Conversely, if security is emphasized, the preferred direction would be to enlarge and strengthen SOEs in all respects. After all, the operations of SOEs are more stable and politically aligned, which is defined by their intrinsic feature, even if their efficiency is lower than private enterprises. The above points can be fully illustrated by the recent progress in the mixed-ownership reform of SOEs in China.
Ultimately, however, for a developing country like China, development is the foremost security; without development, there is no security.
China's current priorities should remain on economic growth and social development, and avoid the trap of "pan-securitization." I would go as far as to say that just as the U.S.'s Star Wars Program in the 1980s enticed the Soviet Union into an arms race, eventually leading to its economic collapse, developed countries led by the U.S. might seek to lure China into a trap of "pan-securitization" by creating international tensions and escalating China-U.S. confrontations, thus compelling the Chinese government to invest too much energy and resources in security at the expense of economic and social development.
How should this be addressed? I believe that it is imperative to deeply understand the importance of continuity for China's development. On one hand, it's essential to staunchly protect core national interests. On the other, there's a pressing need to invest more effort and resources into fostering high-quality economic and social progress within China. After all, only with further enhancement of the country's comprehensive strength can China help to build a more secure international environment. The Central Economic Work Conference at the end of 2023 proposed five points that should be upheld in future work, including "we must uphold high-quality development as the unyielding principle of the new era," "we must uphold a healthy interaction between high-quality development and high-level security," and "we must regard promoting Chinese modernization as the foremost politics," indicating that the Chinese government places a strong emphasis on development.
Critical change two: the restructuring of global value and supply chains
After the outbreak of the COVID-19 pandemic, many developed countries have begun to reconsider their over-reliance on one singular country in the global value and supply chains. This dependence, under certain disruptions, could jeopardize the security of their own value and supply chains. Consequently, there is a growing emphasis in these countries on developing value and supply chains that are not only geographically closer to their markets but also more diversified. This indicates a shift towards more fragmented, localized, and regionalized global value and supply chains. The concepts of "nearshoring" and "friend-shoring" proposed by the U.S. and the "China plus one" strategy (C+1) by major developed economies are clear examples of this trend.
The restructuring of global value and supply chains – from a globally centralized model to one that is more diversified and fragmented – will undoubtedly have two major impacts:
Firstly, this will reduce the efficiency of global resource allocation, which subsequently elevates mid-to-long-term production costs for many products, thus contributing to an increase in global inflation. After all, more emphasis on security would translate to a loss of efficiency.
Secondly, it will weaken the pivotal role of Chinese companies in the global value and supply chains, posing challenges to the growth of China's foreign trade and foreign direct investment (FDI).
China has seen a marked decrease in FDI inflows post-pandemic. This is particularly evident in the third quarter of 2023 when China experienced its first net outflow of FDI. Such a phenomenon warrants serious attention. The decline in inbound FDI can be attributed to various factors, such as the slowdown in China's economic growth, rising domestic costs, and international companies' perceptions of a worsening business climate in China. More fundamentally, this shift reflects the strategic realignment of global transnational corporations' value and supply chain configurations.
So, how should China deal with these trends?
Firstly, given the trend of regionalization, diversification, and fragmentation in global value and supply chains, China must strive to maintain its critical role in Asia and regions along the Belt and Road. This means that China should leverage the RCEP and the Belt and Road Initiative (BRI) more effectively, and should also actively seek to join the CPTPP.
Secondly, China should continue to be a champion of globalization. China needs to strengthen high-quality opening up to attract FDI again and maintain value and supply chain connections with developed economies like the U.S. and Europe through various efforts.
Critical change three: transformation and adjustment of the domestic real estate market
Since the housing commercialization reform in 1998, China's real estate market has experienced rapid development over several decades, especially from 2003 to 2018. The development of the real estate market enhanced residents' wealth and welfare levels, increased local government fiscal revenues, and spurred growth in commercial bank loans, and propelled China's economic growth. However, it gradually brought issues like uneven wealth distribution, local governments' overreliance on real estate for revenue, and substantial exposure of commercial banks' capital to risks.
The "houses are for living in, not for speculation" policy, introduced in 2017, has achieved gradual success. This approach has fundamentally altered the development expectations of developers, homebuyers, and local governments towards the real estate market. The new round of real estate regulation policies implemented around 2020, represented by the "Three Red Lines" [which stipulated that real estate companies must have a liability-to-asset ratio of less than 70%, a net gearing ratio of less than 100%, and cash to short-term borrowing ratio of at least 1] and the Real Estate Loan Concentration Management System [a regulatory framework that mandates that the proportion of outstanding real estate loans and the proportion of individual housing loans within these banks' portfolios must meet the regulatory requirements set by the People's Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC). Specifically, these proportions must not exceed certain caps determined by the PBOC and CBIRC.], has led to slumping real estate transactions and falling house prices. However, an excessively deep, swift, or severe adjustment to the real estate market could precipitate systemic financial risks.
Since the first Central Financial Work Conference, the Chinese government has taken various measures to alleviate the liquidity shortage of top private developers. These measures have considerably reduced the immediate risk of widespread collective debt defaults and potential bankruptcies among private developers, a significant concern due to liquidity crises. However, the primary risk within China's real estate market, characterized by an oversupply of properties in third and fourth-tier cities, remains largely unaddressed.
I believe that the development of China's property market is already quite mature. Future demand within the real estate market is expected to be driven primarily by migrant workers relocating to urban areas and recent college graduates, both groups typically possessing limited purchasing power for properties. Consequently, diverse forms of affordable housing will be the dominant part of the new real estate supply in cities of all tiers in the coming years.
In first and second-tier cities, where the housing supply and demand are relatively balanced, affordable housing is expected to constitute a significant share of future housing developments. In third and fourth-tier cities, considering the large number of unsold properties and the great demand for affordable housing, a feasible solution could involve local governments establishing funds to acquire unsold properties at reduced prices and converting them into affordable housing to satisfy the needs of new urban residents. Considering the typically constrained fiscal capacity of local governments, these funds could potentially be sourced from the central government through special national bonds.
The future holds considerable potential for the expansion of China's real estate market. For one thing, the development of three major projects, meaning affordable housing, public infrastructure for both normal and emergency use, and the renovation of shanty towns in cities ("a new development mode for the real estate market" proposed at the Central Economic Work Conference in December, 2023) will likely accelerate; for another, there is a great demand for the refurbishment of aging urban properties. With the real estate market's focus shifting from the development of new projects to the management of existing assets, financial instruments such as Real Estate Investment Trusts (REITs) and Mortgage-Backed Securities (MBS) are expected to witness rapid development.
Critical change four: reshaping of central-local fiscal and debt relationships
The tax-sharing system reform in 1994 significantly enhanced the fiscal capacity of China's central government and its ability to direct local government actions. However, one of the consequences of this reform is the serious imbalance between the fiscal revenues and spending commitments of local governments, compelling them to explore diverse revenue sources to achieve budgetary balance. During the boom phase of the real estate market, local governments were able to secure substantial income from land transfer fees—a critical element in "land finance"—and also secure sizable loans for infrastructure initiatives, using land as collateral through Local Government Financing Platforms (LGFPs), which is another dimension of land finance.
The gradual cooling of the real estate market due to the implementation of the "houses are for living in, not for speculation" policy, posed challenges to the sustainability of land finance and its associated financial strategies employed by local governments. Additionally, the three-year pandemic, which led to reduced local fiscal revenues and increased expenditures, exacerbated the challenge, forcing local governments to borrow through various channels, including hidden debts. As the central government tightens regulations on local government debt, the sustainability and potential risks associated with local government debt have increasingly attracted attention.
Since 2023, the Chinese government has implemented a new policy package for debt resolution, which includes:
Twelve heavily indebted provinces are allowed to issue 1.4 trillion yuan [194 billion U.S. dollars] of special refinancing bonds to defuse maturing debts, using the difference between the actual balance and the limit of local bonds.
The People's Bank of China (PBOC) is to set up a special SPV to provide liquidity support for local government debt resolution.
From 2024, local government investment in the above 12 heavily indebted provinces will be classified and guided by the central, with strict control over new projects, support for essential projects, and deceleration or suspension of ongoing projects.
Local governments have begun negotiations with commercial banks on debt restructuring.
The recent debt resolution plan has notably eased the immediate principal and interest repayment pressures for provinces with high levels of indebtedness. However, several challenges remain:
The approach of special refinancing bonds for debt resolution relies on debt swaps to extend maturity periods and lower interest rates, yet it does not reduce the principal amount owed.
The 1.4 trillion yuan debt resolution quota is relatively small in comparison to the local governments' collective debt, which amounts to several tens of trillions of yuan.
The capacity to issue special refinancing bonds in 2024 is significantly constrained.
There is a wide disparity in negotiation capabilities among local governments when dealing with commercial banks, leading to substantial variations in their debt restructuring plans. The restructuring plans of those with weaker negotiation abilities will likely fail to improve the sustainability of their debts, maintaining a low likelihood of successful debt resolution.
I believe to effectively resolve the current local government debt risks, a reformation of the fiscal and debt relationship between central and local governments is essential. This strategy involves several key measures:
Adjusting the distribution of fiscal revenues and spending commitments between the central and local governments is crucial. An even distribution of revenues and commitments is key to preventing the accumulation of new local government debts. It is increasingly necessary for the central government to coordinate the expenses related to education, healthcare, social security, and pensions.
In the future, important infrastructure investment in various places should be financed more by issuing national bonds and provincial government general bonds. This approach is key to aligning the maturity periods of the bonds with the period over which returns on these investments are realized, as well as ensuring a balance between the costs incurred and the benefits derived.
For some heavily indebted provinces in central and western China, it is essential for the central government to play a more significant role in leveraging financial support. The focus should be on developing measures that minimize moral hazard, emphasizing the implementation of support mechanisms over the simple execution of debt swaps.
Policy support: reframing macroeconomic policy and implementing a new round of reform and opening-up measures
After the global financial crisis in 2008, major developed countries, led by the United States, made great changes in their macroeconomic policies and achieved notable success. China can draw valuable insights from their experiences. Key lessons include:
When faced with a persistent negative output gap, the government should take decisive action in employing expansionary macroeconomic policies to close this gap.
The government should take decisive action in implementing proactive fiscal policies, which include raising funds through the issuance of national bonds, while also ensuring micro-entities like households and businesses are the main beneficiaries of the fund allocation.
The government should take decisive action in cutting interest rates to reduce real interest rates, to stimulate consumption and business investment, as well as to reduce the cost of issuing national bonds.
Currently, the Chinese economy faces both cyclical downward pressures and structural challenges like economic and demographic adjustments.
To better tackle the cyclical downturn, it is imperative to carry out more expansionary fiscal and monetary policies. This means:
Fiscal policy should play a vital role. The central government's fiscal budget deficit to GDP ratio should be increased to above 4%. This involves escalating the issuance of national bonds and directing fiscal funds more towards residents and businesses, alongside investment in infrastructure projects that yield higher social value or economic returns.
Given the persistent negative growth of the Producer Price Index (PPI), the PBOC should undertake substantial interest rate cuts. This move is necessary to mitigate the negative impact of rising real interest rates on production and investment activities.
The prevailing fiscal policy logic that "expenditure is decided by revenue" requires modification. Expanding the issuance of national bonds will not only secure additional funding sources for fiscal policy implementation but also continually provide high-quality financial assets to the financial market. The expansion of national bond issuance should become a critical mechanism for harmonizing fiscal and monetary policies.
To better address structural downward pressures, China urgently needs to implement new reforms and further its opening-up policies:
Introducing new reform and opening-up measures is crucial to increase total factor productivity and foster the development of new productive forces, thereby boosting the confidence of micro-entities, such as households, businesses, and local governments.
Providing more development opportunities and a wider operational scope for private enterprises is essential to tackle the current issue of youth unemployment.
To fully leverage the domestic market, it's imperative to remove restrictions on the cross-regional movement of various production factors and ensure their free and full mobility.
The performance evaluation mechanism for local governments needs to be reformed, e.g., linking economic growth to local debt levels in assessments and considering the cross-regional movement of production factors as key indicators.
A new round of high-quality opening-up is necessary to attract large-scale inflows of long-term foreign capital. Advancing the high-level development of initiatives such as the Regional Comprehensive Economic Partnership (RCEP) and the Belt and Road Initiative (BRI) is also important.
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