China’s Stimulus Package: Will It Work, and What’s Next?

Initially, the impact of the growing financial crisis on China was muted: China’s banks had only minimal exposure to subprime losses. However, as the financial meltdown has continued to unfold, U.S. consumers’ demand for Chinese exports has slumped, and it has become apparent that any hopes that China would be able to decouple from the slowing global economy were in vain. In the first three quarters, China’s growth rate slowed to 9.9% — the first time it has slipped into single digits since 2003.

“Given that net exports account for about 20% of China’s GDP, and that exports plus imports are as much as 70% of GDP, China is clearly not immune to the adverse impact of the current global financial crisis,” says Wharton marketing professor John Zhang. “The slowdown in the Chinese economy partially reflects this impact.”

Manufacturers in China’s export sector, already under pressure from the yuan’s appreciation, rising costs and stricter enforcement of safety standards, have taken a heavy blow. Industries such as textiles, shoes and toys have been prone to widespread factory closures, with about half of China’s toy factories closing shop this year. The International Monetary Fund (IMF) now predicts that Chinese output will fall from 11.9% last year to 9.7% for 2008, and drop further to 8.5% in 2009.

In response, on the evening of November 9, China’s government unveiled a massive stimulus package. Officials gave the headline figure as RMB 4 trillion ($586 billion), to be spent over the next two years — exceeding even the size of China’s robust response to the 1997 Asian Financial Crisis. This marks the first time in almost a decade that China has officially adopted a “proactive” fiscal policy.

The plan will benefit areas including transport and other infrastructure projects, health care, education, low-income housing, environmental protection and schemes to promote technological innovation. Credit policies will also be relaxed, and value-added tax revamped with savings for industry of RMB 120 billion, according to government estimates.

But will it work, and what is the outlook for the Chinese economy? Though some would like to see more done to encourage domestic consumption, for instance, or to support small businesses, reception has been broadly positive. Some early analysis suggests that the stimulus package could contribute in excess of 2% or 3% to growth, fending off any risk of a hard landing. Moreover, the experts China Knowledge at Wharton interviewed pointed to many signs of resilience in the Chinese economy, and stressed that the global crisis in fact represents an opportunity for savvy Chinese companies to shop abroad for useful acquisitions. Amidst the pressure of a global slowdown, China will have to do something concrete to shift its growth engine from exports to consumption, which it has attempted to do for many years.

Stimulating Reaction

As is often the case with central government policy announcements in China, precise details remain unclear and will to a degree depend upon how the plan is implemented on the ground by separate provincial governments. More may become clear at the Central Economic Work Conference at the end of November. Nevertheless, initial reactions among businessmen in China, markets and international leaders have been generally favorable.

Robert Zoellick, president of the World Bank (which along with the IMF had advocated for a fiscal stimulus package) described himself as “delighted” by the move. “China is well positioned, given its current account surplus and budget position, to have fiscal expansion,” he commented. On top of its USD 2 trillion in foreign reserves, the country enjoys low levels of domestic debt and has maintained a fiscal surplus in recent years, he noted.

Despite recently downgrading their Chinese growth forecast for 2009 from 8.2% to 7.5%, analysts at Morgan Stanley meanwhile praised the Chinese authorities’ “unprecedented efforts to boost confidence and growth.” The policy moves send a message to the markets that the authorities will do all that is necessary to achieve their desired growth rate for 2009, which they are targeting at around 8% to 9%. Wang Qing, Chief Economist of Morgan Stanley China, and colleagues outlined the stakes in a November 16 research note: “Without this stimulus package, the economy would likely head toward a hard landing (e.g., 5%) in 2009. With this fiscal package, the risk of a hard landing scenario (i.e., below 7% growth) has diminished substantially, in our view…. If this current policy package were to prove insufficient, we have no doubt it will be augmented,” they wrote. In Morgan Stanley’s view, the economy is likely to continue to decelerate over the next three quarters, before bottoming out by mid-year 2009, and staging a modest recovery in the second half of 2009 as external demand picks up and the pro-growth policy starts to kick in.

“The Chinese government is proactively and constructively addressing the implications of the global downturn on the domestic economy, turning an external economic threat into an opportunity to strengthen the domestic economy,” says Wharton management professor Raphael “Raffi” Amit. “A very wise move in my view.”

This said, some analysts have questioned certain aspects of the plan. In the first place, observers point out that the actual new spending is not as large as may have first appeared. Some elements of the package had already been included in budget plans, it turns out. Moreover, much of it will be financed via bank lending, which is not technically fiscal stimulus, as David Dollar, the World Bank’s chief China economist, noted on the World Bank’s website — though overall he strongly approves of the plan, commenting, “Basically, I think that the package is very good.”

Shaun Rein, managing director of Shanghai-based China Market Research Group (CMR), points to the benefits of infrastructure development for rural areas, though he believes the plan is mostly designed to show the outside world that China is being proactive. However, he notes the package’s concentration on large, public enterprises and public investment at the expense of smaller companies, which he believes will be important employers and contributors to growth in the future. He would like to see more done to help China’s entrepreneurs, he adds.

Perhaps the most common criticism of the plan stems from its emphasis on hard infrastructure projects. “The current stimulus plan focuses very heavily on infrastructure projects, which are obviously wise long-term investments,” notes Zhang. He and others would like to see more spending on stimulating consumption. China has a high savings rate, at approximately 60% of GDP, which correlates to low domestic consumption. “Consumption only accounts for about 40% of China’s GDP, while in U.S., for instance, the comparable number is more like 60% to 70%,” says Zhang. “Thus, there is quite a bit of room for stimulating domestic consumption.”

Franklin Allen, a finance professor at Wharton, notes that in a global recession workers may be fearful of spending in case they lose their jobs, making them reluctant to spend. At a more basic level, however, observers chalk up Chinese consumers’ high propensity to save to the necessity of putting money away for health and education expenses given the relatively underdeveloped nature of China’s welfare net. “Some spending on beefing up social safety nets will go a long way to reduce precautionary savings and stimulate consumption demand from average households,” says Zhang.

Dissatisfaction over the plan’s perceived preference for hard infrastructure projects as opposed to stimulating consumption underlies the Financial Times’ portrayal of the stimulus plan as a missed opportunity. “This is the golden opportunity to redirect the pattern of growth towards consumption and away from the previous massive reliance on exports and investment,” the newspaper argued in a November 10 editorial. “Alas, the planned stimulus does not attempt to boost public and private consumption. It aims, instead, to keep the economy ticking over until it can start exporting again. This will not work.”

Boosting Consumption

David Dollar, for one, sees the package in a different light. It is wrong to assume that all infrastructure investment merely fuels the export machine; some is “aimed more at domestic consumption and needs,” he argues on the World Bank’s website. Central to the stimulus package is its extension of well-planned railway expansion plans, which had been put on hold due to fears that the economy was in danger of overheating. The centerpiece of this, meanwhile, is the new high-speed passenger line stretching through central cities to Guangzhou. “The main purpose of this dedicated passenger line will be consumption – tourism and leisure,” he notes. “It is the same for the accelerated investments in water and sanitation and urban transport. These investments will raise the quality of life and not have much direct effect on the country’s production capacity. Also, some of the investments will be in housing, schools and health facilities. So it is not fair to portray the investment program as primarily aimed at building up the industrial and export capacity of the country.”

Following speculation as to the real size of the fiscal stimulus package, central government officials held a joint press conference on November 14, clarifying that RMB 1.18 trillion will be funded directly by the central government over the two years. However, Morgan Stanley analysts note that central government officials also hinted that some local governments may be permitted for the first time to run deficits to be financed by debt issuance, subject to approval from the central government. In their view, this means it is safe to say that local governments can be expected to add fiscal stimulus at least as large as that to be provided by the central government. Moreover, the policy shift is likely to spur further spending by companies: They note that some state owned enterprises may respond to the call from policy makers by boosting investment.

To assess the final macroeconomic impact of the stimulus package, economists employ a measure called a “fiscal multiplier.” (This is a measure of the degree to which the government’s fiscal intervention stimulates an increase in national income and consumption.) Academic research suggests that in China, this is roughly equal to a multiple of 1-1.5 the size of the original stimulus. On this basis, taking into account only the central government-derived stimulus, Morgan Stanley estimates that the package would contribute around 2% to 3% points to GDP growth. Once the combined effect of central and local government stimuli, plus newly mobilized non-government capital, are factored in, the effect could be greater.

Meanwhile, CMR’s Rein highlights hopeful signs on consumption. While those aged over 40 have a saving rate of 50% to 60%, he places great confidence in younger Chinese consumers. A CMR survey of individual consumers between the ages of 22 and 30 in ten cities across China suggests that people in this bracket have zero saving rates, pointing to a sharp generational difference. Based on his observations, he believes that the country’s saving rate will fall to 20% within 20 years. Moreover, China’s young are not heavily exposed to losses on China’s tempestuous stock markets. Rein is therefore extremely bullish on the consumer front.

Recent high-profile government initiatives may also have the potential to support a shift to a more consumption-led economy, suggests Markus Boehm, CEO of SIG Combibloc in Suzhou. Though painful for many companies, improvements in protection for workers under the recent labor law will lead to higher salaries for Chinese employees, hence to increased spending (though he adds that Chinese consumers will need more financial instruments in order to convert their savings into consumption). The approval in October of measures that are expected to effectively legalize the buying and selling of agricultural land rights also points the way to greater consumer demand in the agricultural sector, he says.

Crisis to Opportunity

While noting that China’s slowing real estate sector is a cause of concern, Rein points to the underlying strength of China’s economy, describing himself as a cautious optimist. Inflation, he points out, dropped to 4% in October, on the back of a dramatic fall in food inflation. At the same time, investment is playing a more pronounced role, while the export sector’s role is shrinking. The growing number of unemployed is more a political problem for the government, but as they were on low wages in the first place, this rise in unemployment will not in itself have a major impact on the economy, he says.

Indeed, some experts and business practitioners sense opportunity amid the crisis. The current export slowdown provides an opportunity for China to reconfigure its export sector, getting rid of high-polluting, low-value-added businesses, leaving the economy stronger for it, suggests Joyce Qian, a Wharton alumna who is based in Shanghai. Some well-positioned companies see this as an opportunity to catch up, she says. For the majority of the export industry, companies that are in trouble depend on a cheap labor model. This is a time to improve the industry level, she says, to move China to next level.

How can companies capitalize? One way is to take their cash abroad. With global companies’ assets depreciating, this is an ideal opportunity for Chinese companies to look at mergers and acquisitions, stock swaps, technology and brand purchases, says Han Jing, Treasury Regional Manager of DuPont China. For those companies that have relied on low-value manufacturing, have underdeveloped R&D capabilities, and lack well-established brands, this is an opportunity to sharpen its long-term competitive edge and move to a more sustainable economic model, she says.

“In this financial crisis, cash is king, and China has plenty of it,” says Wharton’s Zhang. “China can deploy the cash strategically to acquire resources, technologies and companies that are otherwise off limits for China.” By providing a low-cost environment for many of China’s enterprises to grow, lower commodity and energy prices should also help Chinese companies, he adds.

“Those companies that act now and are proactive will not only survive but will emerge stronger and more profitable from this financial tsunami and economic earthquake,” notes Wharton’s Amit. Firms need to be “proactive… realizing that we are in a new economic order.” This will require “rapid adaptation to the new realities, adjusting the scale and scope of operations, redoing business plans, business models and budgets to maintain profitability in the new economic environment.”

Zhang also sees opportunities at the government level. “As China has more than adequate foreign currency reserves and the revenue growth for all levels of government has been very strong, the crisis can be turned into an opportunity in a number of ways. China has already gained quite a bit of credibility in the world in managing its financial resources cautiously and independently.” The country has the potential to play an important role in shaping the future of global financial systems by participating in their design, he notes, adding that, perhaps wisely at this point, China appears unwilling to bear the potential costs of playing a leadership role.