Dealing with a Double Whammy

By most measures China's economy has slowed quickly since the last quarter of 2011. Electricity production, the National Bureau of Statistics reports, grew 1.7 percent in April and May from last year. Over the past decade the annual growth rate was 12 percent. Also in April and May, the railroad ton-kilometer figure grew by 1.3 percent compared to the same months last year, down from the 6 percent growth seen from 2005 to 2011.
 
Due to the resulting decline in commodity prices, the inflation situation has improved, which lessens pressure on the household sector. At the same time, the slowdown has not caused widespread reduction in employment. There may be some impact on construction jobs already, but, as the labor market was very tight before the slowdown, the employment picture remains healthy.
 
There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.
 
State-owned enterprises reported 11 percent growth in sales but 10 percent decline in profits in the first five months. Private enterprises may have fared worse. It appears that the slowdown has impacted government revenue and business profits rather than labor income.
 
Asset markets have fared badly this year. The stock market is depressed. Despite some pickup in the last two months, the property market is depressed and may remain so for several years. As the slowdown disproportionately hits business profits, asset prices will likely remain depressed.
 
Cutting Taxes

Government spending and property development have become grossly overextended in the past five years. There is a strong argument in favor of the current adjustment. The difficulties in these areas could not support a case for stimulus.
 
It is possible that, if the downward trend continues, the slowdown will impact the labor market. There is a case for some stimulus to stabilize the economy. The only effective tool is to cut taxes and issue fiscal bonds to plug the revenue shortfall. About 1 trillion yuan (2.1 percent of 2011 GDP) is needed to be effective.
 
The tax cuts should include reducing the top marginal income tax rate to 25percent from 45 percent and consumption and value-added taxes by 20 percent. These cuts will improve economic efficiency in addition to stimulating the economy.
 
Igniting Inflation

A labor shortage, the result of three decades of the "one-child policy,” and rising inefficiency due to the rapid expansion of the state sector make the economy prone to inflation. The money stock is too high for comfort. While falling commodity prices have eased inflationary pressure for the time being, it would be unwise to ignore the big picture. Cutting interest rates carries a serious risk to stability.
 
Cutting interest rates stimulates the economy by encouraging borrowing. Businesses and local governments have reached their limits in terms of borrowing. Their main collateral, land, is depreciating. Cutting interest rate alone won't ignite borrowing from them.
 
The household sector has 14.5 trillion yuan in debt. In theory, there is scope for the household sector to increase debt. However, the market value of the residential property under development is over 20 trillion yuan. The government needs to create a massive household debt bubble to digest the whole amount. So much debt created will likely lead to massive inflation, too.