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Editorial: How China Should Tackle Its Economic Dilemma

The topic of how China should adjust its macroeconomic policy in the second half of the year has sparked heated debate. The State Council meeting convened on July 23 called for the country to maintain macroeconomic stability instead of adopting indiscriminate strong stimulus policies. Policies should be targeted and fine-tuned based on changing situations in order to keep the economy running within a reasonable range, according to the State Council. The central government’s position is clear, but the market is still debating the extent to which policies will be relaxed.

The debate has its direct roots in the increasing downward pressure faced by the Chinese economy. However, the deeper reason is that policymakers are once more faced with navigating between two undesirable extremes: excessive easing on the one hand, which would waste years of capacity-cutting and deleveraging efforts while worsening the problems of local government debt and financial risk; and excessive tightening on the other, which would likely cause the Chinese economy to suffer a “hard landing.” The U.S.-China trade conflicts have caused an unprecedented increase in uncertainty over external conditions. Central and local governments will see their wisdom and strength tested in the second half of this year as they attempt to navigate their limited policymaking space. The coming months will also test how well policies can be maintained after implementation.

China’s economy delivered a mixed performance in the first half of this year. Its manufacturing industry rebounded, consumption grew significantly, and exports exceeded expectations. However, the growth rate of infrastructure investment clearly declined, and the growth rate of real estate investment also slid, causing widespread worry. The gross domestic product (GDP) grew by 6.8% year-on-year during the first half of the year, according to data from the National Bureau of Statistics. It is worth noting that this growth was achieved before the effects of the U.S.-China trade war became fully apparent. It remains to be seen how the situation will develop, and what the full impact of trade conflict will be.

The consensus is that China’s economic growth will slow in the second half of this year, but there is disagreement over when and where growth will rebound. What lies behind this debate is the fact that China is still in the midst of deleveraging. The external tightening of liquidity is accelerating the exposure of previously hidden risks. The problem of local debt has yet to be effectively solved, and China’s economic policy once again faces a dilemma. Policymakers have realized that it is necessary to keep policies strong but flexible in order to continue meeting strict financial regulations and avoid hindering the deleveraging effort, while at the same time maintaining reasonable liquidity to provide a good monetary and financial environment for supply-side reforms and deleveraging. But this is all easier said than done.

The recent clash between fiscal and monetary policy reflects, in some ways, the difficult choices faced by policymakers during China’s economic transition. Both types of policy have their own advantages and disadvantages, and neither should be favored at the expense of the other. The State Council meeting pointed out that the two wings of macro-control policies should work in tandem to serve the real economy and improve the macroeconomic situation more effectively. In order to achieve this, objectively speaking, fiscal policy in the second half of this year should be more active and effective, while prudent monetary policy should have an appropriate and moderate level of tightness.

It is worth thinking about why the Chinese economy has repeatedly experienced policy dilemmas, especially since the global financial crisis. It is true that policymakers everywhere have to balance factors that include the needs of different industries and regions. However, China is currently faced with unique contradictions: It is in transition between old and new economic drivers. In particular, many entrenched institutional flaws remain unresolved. Take local debt as an example. The constant growth of government debt despite repeated attempts to clamp down has been blamed on shortcomings in taxation, the unsound issuance of municipal bonds, and even the performance-appraisal system for local officials. However, the crux of the problem is that local government budget constraints have simply not been “hard” enough, while central and local governments remained unclear about their respective powers and responsibilities. If the root cause is not eliminated completely, the difficulties caused by it will also persist, and could even get worse as time passes.

The solution is clear. Supervision should maintain a vigilant grip, policies should not be comprehensively relaxed, and efforts should be made to accelerate institutional and structural reforms.

First, China must speed up the mixed-ownership reform of state-owned enterprises, raise the enthusiasm of private investors, increase support for small and midsize enterprises, and resolutely eliminate “zombie” enterprises in order to increase the vitality and the efficiency of the real economy.

Additionally, China must actively promote changes in the fiscal relations between the central and local governments. Fiscal relations should be made more rational, not only between the central and provincial governments, but also for local governments below the provincial level, as proposed many years ago. The financial resources of local governments should also be strengthened through the allocation of fiscal powers. Hardening local government budget constraints is part of the nationwide construction of a better governance system. The effort will take time to bear fruit and must be relentlessly promoted despite a lack of short-term results.

Finally, China should deepen supply-side structural reforms, and expand access for domestic and foreign investors in the fields of transportation, oil and gas, and telecommunications, while promoting the steady growth of effective investment.

None of these are new themes, but the fact that the tasks of reform have become platitudes show exactly the close relationship between deepening reform and resolving the dilemma faced by China’s economic policy.

The State Council meeting, responding to the concerns of businesses, emphasized the reduction of taxes. However, measures to reduce taxes in recent years have been scattered and small-scale due to rigidity of public expenditures as well as the government’s high administrative costs. It is difficult to achieve a breakthrough in this area in the short term. The market is also paying close attention to another statement by the State Council: the call for financial institutions to ensure that financing platforms’ financing demands are reasonable and adhere to the principle of marketization, while avoiding cutting off funding for necessary projects currently in progress. While this statement is clearly aimed at solving the economic dilemma, it has also caused greater expectations of easing. Deciding which financing needs are “reasonable” and which projects are “necessary” will certainly involve some intense maneuvering by the parties involved. In order to achieve results, China needs decision-making that is scientific, democratic and guided by rule of law, which in turn needs to be safeguarded by a complete set of institutional arrangements.

With Europe signing a free trade agreement with Japan, and in active talks with the U.S. about a similar deal, China faces a fast-changing international environment. The Chinese government has repeatedly said it will not use indiscriminate strong stimulus measures. This should be a fixed criterion, and what is more important is for the country to fulfill its commitments to open up as soon as possible while pushing for major progress in related domestic reforms. In accordance with usual practice, the Political Bureau of the Communist Party of China’s Central Committee will soon discuss the country’s economic situation and policies in the second half of the year. We hope that the meeting will be more responsive to the market’s focus on the degree of policy while making new arrangements for reform and opening-up.

Translated by Teng Jing Xuan (jingxuanteng@caixin.com)

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