Is China's economy doomed?

China's economic policy flexibility underestimated -- views from Weijian Shan

I hope this finds you well and enjoying your weekend. Today‘s piece is on China's economy, penned by a renowned Chinese businessman.

To begin with some news: on Friday, Chinese Premier Li Qiang presided over a symposium on the economic situation attended by economists and entrepreneurs. An article detailing the identities of these participants was posted on a WeChat account named 眼镜湖 “Glasses Lake,” which I believe is reliable.

As reported by Xinhua, during the symposium, Li demanded efforts to deliver macro-policy regulation more effectively, strengthen policy prediction and research, and step up nurturing new drivers and advantages for high-quality development. He also highlighted his hope that entrepreneurs will play a bigger role in promoting high-quality development, calling on economists to provide more suggestion regarding high-quality development.

On that same day, the WeChat account of Caijing magazine showcased a piece on China's economy authored by 单伟建 Weijian Shan, regarded as one of the most influential private equity figures in Asia. He is the Executive Chairman and Co-Founder of PAG, a leading Asia-based and focused investment firm with more than USD 50 billion in capital under management.

Shan's article was initially shared on what appears to be his personal WeChat account on October 6. The CEO of BigOne Lab Robert Wu's twitter thread provides a succinct summary of Shan's narrative. Our piece today is a full-text translation of Shan's piece. Within, Shan conveys his agreement with U.S. Treasury Secretary Janet Yellen on the notion that many who observe China's economy frequently neglect its policy potential. He further expounds on this policy space across several pivotal sectors.

Please note that the translation has not received Shan's personal review and should not be seen as reflecting any official standpoint. This remains a personal newsletter.

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Dr. Janet Yellen, the U.S. Treasury Secretary, recently told reporters, "We see China’s growth as slowing over time. That said, China has quite a bit of policy space to address these challenges."

Such candid remarks coming from the U.S. Treasury Secretary are noteworthy, especially at a time when Western media predominantly holds a pessimistic view of China's economy. As a result, her statement has garnered attention worldwide.

Yellen is correct. China's policy space is considerably more expansive than that of other major economies, while this fact is often overlooked by many China's economy watchers.

• Monetary Policy

Compared to the Western world, China adopts a more prudent monetary policy. Currently, the West is not only out of room for monetary easing but also compelled to curb the ongoing inflation by continually tighten, primarily through raising interest rates. In contrast, China doesn't face inflation pressures; its consumer price index (CPI) remains flat, and its producer price index (PPI) consistently shows negative figure. This situation provides China ample flexibility in its monetary policy, allowing for potential cuts in interest rate and reductions in banks' reserve requirement ratios (or RRR, the percentage of deposits banks must keep with the central bank) — something the Western economies, where RRR has been around zero, can only hope for.

• Fiscal Policy

The room for fiscal policy is inversely related to government debt. In other words, the lower the debt, the greater the scope for fiscal expansion.

How much debt does the Chinese government hold? Not a substantial amount. The ratio of central government debt or sovereign debt to GDP is a mere 21 percent, the lowest among the world's major economies. According to estimates from the International Monetary Fund, even when all local government debts (with hidden liabilities included) are added, China's overall level of general government debt is only around 110 percent of GDP. In comparison, the U.S. public debt ratio is approximately 140 percent, and Japan's stands at a staggering 260 percent. Therefore, China's government has a relatively low debt ratio.

Furthermore, one's financial well-being isn't determined solely by their liabilities but also by their assets. For instance, someone who takes out a loan to buy a home may have more debt than a renter, yet the homeowner could be wealthier due to owning an asset. The same principle applies to nations – it's essential to consider both liabilities and assets. What sets China apart from other major economies is the vast ownership of state-owned enterprise (SOE) assets by the Chinese government.

According to statistics, the net asset value of SOEs (total assets minus total liabilities) is around 70 percent of GDP. The median price-to-book ratio for listed central SOEs, representing the market value to net asset value ratio, stands at 1.3 times, which is much lower than the 5.4 times ratio for private enterprises.

However, even with a price-to-book ratio of 1.3, the market equity value of SOEs accounts for over 90 percent of GDP. If calculated at twice the net asset value, it would be 140 percent. Therefore, the ratio of the government's total debts minus the market equity value of SOEs to GDP is notably low, and may even be negative.

Furthermore, all of China's natural resources, including land, minerals, rivers, forests, mountains, grasslands, and more, are state-owned and represent a massive asset.

In contrast, countries like the U.S. and Japan barely have any state-owned equity, with most resources being privately held. The portion that the government can control is rather small.

In summary, China's fiscal condition is significantly healthier than that of other major economies.

Certainly, this doesn't imply that local government debt is a non-issue. There's a significant wealth gap among local governments. Coastal cities, especially those with high-quality state-owned equity, may be overflowing with wealth; whereas remote and impoverished areas might be saddled with debt, struggling to make ends meet. Although they are all local governments, the debts and assets of the wealthier and less affluent ones cannot simply offset each other. This is why the China's Ministry of Finance says, "each family should take care of their own child" [GRR's note: 谁家的孩子谁抱 "each family should take care of their own child", means local governments cannot rely on the central government to bail them out.] If the economy falters, these disparities will become even more pronounced.

Yet, holistically, considering both assets and liabilities, the financial conditions of the Chinese government far surpass that of other major economies.

In conclusion, whether it is monetary or fiscal policy, China has vast policy space. If China decides to stimulate the economy, they have an abundance of tools at their disposal.

• Overseas RMB Sovereign Debt

Another advantage for China lies in its capacity to issue RMB-denominated bonds overseas, also known as offshore RMB (Renminbi) bonds, thanks to the internationalization of the RMB.

China has a minimal foreign currency debt, making up only a minuscule fraction of its total debts. Moreover, China's local currency debts are not limited by the capacity of foreign exchange reserves to make repayments. For sovereign nations, there's no risk of default for domestically issued government debts; in extreme cases, they can simply print more money. While China has the capacity to issue RMB-denominated bonds overseas, the current scale remains limited.

While China has the capacity to issue RMB-denominated bonds overseas, the current scale remains limited.

The U.S. dollar is the world's largest reserve currency, accounting for over 60 percent of the global total. The United States has taken this privilege to the extreme by borrowing through printing its own money. This privilege was dubbed an "exorbitant privilege" by Valéry Giscard d'Estaing, the former French Finance Minister during the presidency of Charles de Gaulle.

Issuing more offshore RMB-denominated bonds can be one stone to kill many birds. Apart from raising capital for domestic economic development, it can also enlarge the market for offshore RMB-denominated financial products, thus facilitating the internationalization of RMB. For instance, when Middle Eastern countries export oil to China and settle transactions in RMB, there's a limited availability of offshore RMB-denominated financial products that can be invested in. This limitation reduces the appeal of the RMB as a reserve currency.

Expanding the market for offshore RMB-denominated financial products naturally promotes holding and using the RMB, which will advance its further internationalization.

• The Real Estate Issue

China's policy space is not limited to monetary and fiscal policies. For example, in light of the current sluggishness in the real estate market, which is the biggest obstacle to China's economic growth and seems to be unsolvable, China does have policy tools to address the issue; it's just a matter of whether they are used or not.

Real estate is of paramount importance to the Chinese economy, making a direct contribution of around 13 percent to GDP, with an indirect contribution of 25 percent. The sluggishness in the real estate market not only affects industries upstream and downstream but also directly impacts consumer spending. This is because homes, being the largest investment for ordinary citizens in China, function as both a store of value and a source of capital appreciation, constituting two-thirds of Chinese household wealth. Consequently, a decline in property prices generates a negative wealth effect on private consumption.

In 2022, Chinese household deposits surged by nearly 18 trillion yuan (about 2.47 trillion US dollars), and this year is even more astounding, with household deposits increasing by another 12 trillion yuan (about 1.64 trillion US dollars) in the first half of the year. Moreover, from 2022 up to now, 12 percent of the total amount of bank mortgage loans in China are being repaid ahead of schedule. All of these are due to the suppression of consumption caused by the sluggish real estate market.

To unleash the spending capacity of citizens, measures should be taken to relax restrictions on the demand side of the housing market by removing home purchase limits, imposing higher taxes to deter short-term speculation, and permitting long-term property holdings.

What needs to be restrained is property developers relying on high leverage for over-development. What should be encouraged is holding real estate for long-term investment purposes. A clear distinction should be made between speculation and long-term holdings. When ordinary citizens across the nation purchase multiple properties for long-term purposes, whether for vacations or rentals, it benefits the economy, and this is so anywhere in the world.

Nowadays, Chinese citizens can purchase properties anywhere in the world. In the first half of this year, the amount spent by Chinese individuals on purchasing properties in the United States doubled from the previous year, and Chinese buyers are seen in property transactions in all major cities around the world. Yet, they are not allowed to purchase residential properties without being a resident of that specific city. And even for local residents, they can only buy a primary home in their own city. Foreigners are generally not permitted to buy properties in China. This situation has led to depressed property prices, severely impacting consumer purchasing power, and consequently, dragging down the overall economy.

The primary challenge in the Chinese economy, as assessed by the central government, is inadequate domestic demand. Further relaxing restrictions on the demand side of the property market is an imperative. The policy tool in this regard does not even require any resources: it just needs a decree to remove restrictions on home purchases.

• A Stable Financial System

In fact, even if property prices in China were to experience a significant drop, it would not lead to a financial crisis. This is one of the unique strengths of China and a cornerstone of its economy. Why?

Firstly, China's average loan-to-value ratios (LTV) for mortgages, the proportion of the home loan amount to the property's value, is quite low. In the second quarter of 2023, the average LTV in first-tier cities was 44.5 percent, and in second-tier cities, it was 60.2 percent. These figures indicate that it is nearly impossible for China to experience widespread "negative equity" (where property prices are lower than the mortgage value), thereby endangering loan security and banking stability. As is well-known, the 2008 financial crisis in the United States was caused by widespread negative equity.

Secondly, in the United States and many developed countries, mortgage loans collateralized by homes are limited liabilities for borrowers. That means, if the property value falls below the mortgage amount, borrowers can simply relinquish the property and walk away. However, in Hong Kong and the Chinese mainland, mortgage loans are unlimited personal liabilities, meaning borrowers cannot just walk away from their properties; as long as the borrower is not in personal bankruptcy, his payment obligations continues. This is the reason why, during the 1997 Asian Financial Crisis, Hong Kong's property market experienced significant amount of negative equity, but there were very few instances of mortgage defaults, and no banks went bankrupt.

For these reasons, even if a housing crisis were to occur, it would not pose a systemic risk to the banking system, let alone trigger a financial or economic crisis.

• Using Policy Space

For any country, the greatest safeguard for national security is its economy. This is especially true for China. Only by rapidly growing its economy can it reduce geopolitical risks.

China possesses significant policy space, but so far, the measures used to stimulate the economy have been quite limited, with more talk than action.

China's economy does exhibit resilience, as seen in its third-quarter performance outpacing the second quarter. However, the downward trend in China's economic growth rate has not been reversed, and there is a general lack of confidence among both businesses and consumers. This is a critical time to employ policy measures to tap the potential for economic growth in China.

Preventing a crisis is easier than trying to recover from one once it occurs. It's like steering a ship away from a looming tempest; it's challenging when the ship is already in the midst of a storm. At this juncture, the use of policy measures can be highly effective. Any delay in action may result in reduced effectiveness. China's policy space should be put to good use, and now might be the right moment.

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