As the global economy contracted sharply in late 2008, the PRC government’s massive response helped China remain one of the few relatively bright spots in a bleak economic landscape. Boosted by the ¥4 trillion ($585 billion) stimulus package and other measures, such as greater social spending, China may be able to recover more rapidly than other countries. CBR Editor Virginia Hulme and CBR Assistant Editors Arie Eernisse and Daniel Strouhal interviewed six prominent China economists in late March and early April (see Box).

CBR: In recent weeks, several economists have been quite optimistic about China’s recovery. What is this optimism based on? What key indicators should we look for as signs that China’s economy is recovering?

Bottelier: China’s recession may have bottomed out sooner than we had expected. The Purchasing Managers’ Index (PMI) is improving, and recently we’ve seen a relatively sharp upturn in total construction activity. It is obvious that China has been hit hard by the crisis, but we should not forget that in China’s case, the situation is a bit more complicated. The economic downturn started in 2007, well before exports began to tank. The decline in 2007 was due to deliberate government efforts to deflate the real estate bubble and cool down the economy more generally. If the construction sector can be revived, that could go a long way to compensate for the decline of exports in terms of total domestic demand. The other sign is the sharp upturn in new bank lending, even though much of that is bill discounting. Demand for raw materials has revived, so restocking has gone up.

Dollar: The optimistic forecasts are focusing on some recent good news: real retail sales have held up well, and the government’s fixed-asset investment is rising rapidly. However, exports are likely to decline for the year, and a lot of related investment will be dampened. The best “bottom line” summary of what is going on is growth of real industrial value added: for January-February this was up 3.8 percent over the year before. It is hard to be too optimistic when half the economy starts the year with that kind of growth rate.

Keidel: Recent optimism has come from some initial construction activity in the downstream real estate sector that looks like the real thing, as well as a survey of purchasing managers in March that showed their expectations shifting into the expansion range of the index value, which is a big change from just a few months ago. Economists are also encouraged by the scale of the credit expansion, what looks like strong retail sales growth, reported healthy investment growth, and the continued flow of government announcements about expansions in and adjustments to the stimulus package.

Lardy: First, I’d follow closely what’s happening in the housing sector. Are transactions picking up? Is the inventory of unsold property declining? Are new starts beginning to pick up? The property sector is important. China’s property correction has been a big contributor to the slowdown.

Another thing to watch is how well private consumption holds up. Typically in previous downturns, employment growth slows, unemployment rises, and wage growth is much less rapid, so disposable income tends to rise relatively slowly. It’s hard to get buoyant consumption growth in a downturn.

Rothman: I am optimistic, in part because many key indicators have begun to strengthen earlier than I had expected. CLSA’s PMI—our survey of purchasing managers at more than 400 manufacturing firms across China—rose for three consecutive months before slipping slightly in March. Fixed-asset investment has held steady at a strong pace, due to heavy government spending. Production of steel, cement, and electricity has begun to pick up, and retail sales growth remains healthy. And housing sales have begun to pick up, as both prices and financing costs have come down.

Wang: Our 7.0-7.5 percent growth estimate for this year incorporates a rebound in growth. In the fourth quarter of last year, quarter-on-quarter annualized growth was close to 2.5 percent, so to reach 7.0 percent the economy obviously needs a rebound. We believe that rebound will not come from external situations improving but from the government’s stimulus package, in terms of fiscal and credit (bank lending). The policy was announced in November, and the money has been disbursed quite rapidly. We think that it will come through in the economy starting in the second quarter of this year, especially in infrastructure-related investment, and will help to cushion the negative impact from the external shock and domestic housing downturn. We will therefore see a sequential rebound in growth momentum beginning early in the second quarter that will help to bring China’s economy into a recovery process. But that does not mean that China will go back to the kind of growth it saw in the last few years; it just means recovery from the trough of the fourth quarter of last year.

CBR: How much will the global drop in demand affect China’s economy? Will the stimulus package be able to offset that effect?

Bottelier: The sharp decline in exports, in absolute terms even, which is really unprecedented, is of course very serious. But we should not forget that many of China’s exports are of a processing nature and that the domestic value-added on that portion of their exports is rather limited. So the GDP [gross domestic product] effects are not as great as the gross export numbers might lead one to expect. The stimulus package is really quite enormous. The ¥4 trillion [$585 billion] investment plan is largely aimed at infrastructure—capital formation. That is significant because there are still many bottlenecks in China’s infrastructure that can be corrected as a result of this program. The extent to which China is now increasing spending on the social sector is often underestimated. The harmonious society objectives are being taken seriously by the government. In recent years, we’ve seen substantial increases in government spending for healthcare and education, and the rolling out of social safety nets. Just a few months ago, the central government increased the pension payments for all people covered by the official pension program by ¥10 [$16] a month. I understand that a similar increase is planned for next year. These are significant amounts; 55 million people are reported to be covered by that pension scheme.

Dollar: The drop in global demand is seriously affecting China’s economy. China’s exports have dropped by about one-third from their peak last fall. We expect exports to stabilize and slowly increase over the year, but for the whole year we forecast a 6 percent decline for China’s exports. The stimulus package is limiting the decline but does not fully offset the shock, which is why industrial growth in the first two months is positive but low.

Keidel: The global drop in demand is clearly having a dramatic impact. Whether the stimulus can counterbalance it is the trillion-dollar question. If the drop in China’s trade surplus (a surplus that was close to 10 percent of GDP last year) is limited to a 50 percent decline, and if investment and consumption growth are in the 10 to 15 percent range, then yes, the stimulus can counter the trade decline and deliver close to 8 percent growth—but these are all big “ifs.”

Lardy: The decline in global demand in 2008 compared to 2007 took off about 1.5 percentage points of economic growth. But the external sector was still contributing to economic growth in 2008. There could be a further softening in the external side, which the stimulus would also have to partly offset if growth were not to fall further. The stimulus package is certainly sufficient to offset the decline we saw in 2008 compared to 2007, but whether it’s sufficient to offset the decline we’ve seen in 2009 compared to 2008 remains to be seen.

Rothman: The global recession is having an impact on China but not as much of an impact as many think. China is not an export-led economy; it is a continental economy driven primarily by domestic investment and consumption. During a global slowdown, China cannot grow at the double-digit pace of recent years, but it can grow at 6-8 percent.

Wang: The drop in global demand will obviously affect China greatly, even though we think that China’s economy is structurally not as export dependent as most people think. Cyclically, in the last few years, China’s exports have been growing rapidly, and investment and job growth have been affected by the positive pull from global demand. So in this downturn, when global demand is falling, the immediate impact on China’s economy is quite large—not just slowing exports but also affecting manufacturing investment and leading to increasing unemployment and therefore weaker consumption and so on. The stimulus package can do little to boost external demand, and we expect exports to be weak and manufacturing investment to decline. What the stimulus can do is create domestic investment demand that offsets part of the manufacturing investment decline. If you just look at the government target of 8 percent, it’s clear that the government is not aiming to completely offset the impact but rather to cushion the impact.

CBR: How effective will China’s stimulus package be? What early signs, if any, are there that it is beginning to work?

Bottelier: It is still early, but we are beginning to see some effects already, for example in construction. But not all of the pick-up in construction is the result of stimulus spending. There have also been policy changes aimed at stimulating demand for housing, such as a relaxation of mortgage terms (from a 30 percent to 20 percent down payment). The PRC Natural Bureau of Statistics’ PMI number for March for manufacturing—52 (above 50 for the first time since September last year)—is another important indicator that some parts of the economy are picking up. [A PMI above 50 generally indicates an expanding economy, while a number below 50 could indicate contraction.]

Dollar: The stimulus package is definitely working. Steel production has stabilized at about the level of early last year, and cement production is up 17 percent from a year ago. Some specific components of investment, such as railway investment, show increases of more than 100 percent over a year ago. So, we know that activities have started, and we think that they are the reason that China’s growth remains well above the rates of other major economies.

Keidel: The earliest signs include the “input” signs—has credit expanded? Yes, it has expanded enormously, even if one corrects for the large part of it that went into the purchase of corporate paper. Have government budgets expanded? Yes, by all accounts, strongly. Has the trade surplus decline been moderate? In fact, in January-February, the surplus increased because of the sharp decline in imports. Are there signs that investment and consumption are responding to the stimulus? Yes, but only in terms of retail sales, which is always a questionably useful statistic. Has the real estate sector begun to come out of its slump? A bit, according to early data on downstream development and construction activity and sales of cement. Are inventories building again after their sharp declines late last year? It is a bit early to know. In truth, the best signs will be GDP growth figures for the first two quarters along with a whole set of statistics on things like electric power consumption that point to an accurate and consistent growth figure. So we won’t really have credible signs until first-half data come out in July.

Lardy: It will be effective. I think the early signs are that the banks are increasing their lending quite significantly in response to the easing that began in September, which took the form of lowering interest rates, lowering down-payment requirements on mortgages, and reducing quantitative restrictions on lending. Even as early as November, we began to see much more rapid credit growth.

Some people look at the PMI, which has been in decline but has turned up a little. I’m not sure how much significance I attach to that but it’s certainly a good sign that it’s not dropping further; it’s coming back up.

Rothman: There are three parts to China’s stimulus package. The first was the November removal of the brakes on growth that Beijing put in place in 2007, when the government was worried about overheating. The second stimulus was the huge flood of credit and liquidity that began in December, when new lending rose by over 1,000 percent year on year. The third part is the massive infrastructure spending program that is just getting under way. We can see signs of the early impact of these programs in the improvement of the PMI index, strong investment growth, rising sales of excavators, and other indicators that construction is picking up. Most important, Chinese consumers have shown confidence in these stimulus programs, which is why retail sales are holding up and housing sales have begun to increase.

Wang: One thing to remember is that the stimulus package is not all fiscal; a huge portion of the stimulus is going to be financed by bank lending. Second, in addition to investment, the fiscal stimulus also includes various tax cuts and transfer payments. Because China’s economy is still in transition from a command economy to a market economy the government has, compared to a lot of other countries, relatively good organization in terms of disbursing the funds. It already has a lot of projects lined up and medium-term plans in place so it can disburse the funds pretty quickly.

In terms of signs, fiscal funds were disbursed quickly and bank lending went out quickly as well. That boosted confidence, and metals traders especially started to restock materials in December and January, anticipating demand, which helped to bring back some production. Production cuts were quite severe in October and November, and production recovered in subsequent months. One can argue whether that is sustainable, and we think that sectors will be cautious in the next couple of months until final demand really shows up. But in terms of delivering liquidity to the system to keep the economy going and to help boost confidence, certainly there have been signs of that.

CBR: What actions or policies does China need to take to become more consumption driven? How likely is it that rural consumption will become a major driver of domestic demand?

Bottelier: I’m quite frankly impressed by what the government is doing to stimulate household disposable incomes, which is not the same as household consumption, of course, because people have to decide what to do with their money. There is a savings culture in China that will not fundamentally change anytime soon, so even if disposable household incomes rise, it’s possible that the savings ratio will remain the same, or even increase temporarily. If the government can maintain the improvements in social safety nets that are now being made for two or three years, you will probably begin to see a change in savings behavior. I don’t expect household savings to change significantly in the short-run.

But corporations are the largest single source of savings at the national level, not households or government. There, we also see some initial movement in the right direction by requiring profitable state-owned enterprises (SOEs) to begin paying dividends. That’s new because they hadn’t paid dividends since 1993. The initial levels have been set at either 5 or 10 percent of after-tax profits, which is a good start but much too low to make a difference. Changing the dividend culture for profitable SOEs and private enterprises would be significant.

It would also help address macroeconomic imbalances due to overinvestment, particularly in manufacturing. China created too much capacity in manufacturing, which contributed to the trade surplus. The trade surplus went through the roof from the second half of 2004. Tremendous productivity growth in the manufacturing sector and associated profitability growth allowed Chinese exporters to maintain lower prices on international markets and gain market share while increasing profits and raising real wages, an unusual combination of achievements. Furthermore, much of this excess manufacturing capacity resulted in import substitution, which was more important than export growth in explaining the exploding trade surplus.

But now, there are all sorts of new initiatives to promote consumption growth. In the finance minister’s March 5 budget speech, we see new subsidies aimed at promoting rural consumption growth. People can get 13 percent price discounts on a range of consumer items, from televisions to motorcycles. There has been a significant increase in social spending in recent years. I believe that the government is serious about promoting household consumption.

Dollar: To continue to grow well in the next period, China will need more demand from consumption. But it is hard to change spending habits overnight. The best measure in the short run is to increase public spending on health, education, and the social safety net. Social services are recorded as consumption in the national accounts, and they are one item that the government controls directly. More social spending will also reduce household vulnerability and gradually lead to more private consumption spending. Right now, rural consumption is only 9 percent of GDP, so it cannot be a major macroeconomic source of demand in the near future, but efforts to raise rural consumption will be good for people now and help make the necessary adjustment to a more consumption-driven economy in the future.

Keidel: The key to more consumption growth is more and better-paying jobs. Hence, paradoxically, investment growth is one of the key ingredients in stronger consumption growth. An additional factor is the status of rural income and consumption spending. The increase in food prices that erupted in 2007, while looking like inflation, was also an improvement in rural-urban terms of trade and was accompanied by a rapid expansion in rural household consumption. This has been severely compromised by the absolute decline (5 percent) in rural income in the fourth quarter of 2008 because of the slump in migrant incomes and remittances. Government vouchers and other programs to subsidize household purchase of consumer appliances and other durable products might help temporarily, but ultimately it is rapid growth of jobs—which means continued high rates of investment—that will strengthen consumer demand. Rural household consumption has fallen to roughly one-third of total household consumption, as rural-urban migration has increased China’s urban population in the last decade and as urban jobs have become more productive and more remunerative than rural employment. Hence, another major process that promises stronger consumption growth is continued permanent migration from rural to urban areas (see Off to the City).

Lardy: I think four sets of changes are required to put China on a more consumption-driven growth path. First, the government needs to build up the social safety net so individuals will not feel that they have to fully finance their education, healthcare, pensions, and so forth. On the tax side, China’s manufacturing sector is too lightly taxed. Profits in the manufacturing sector have risen dramatically over the last seven or eight years. Most enterprises are not paying dividends to their owners; even those that are paying are paying an absolute pittance. As a result, businesses have a lot of retained earnings, all of which are reinvested. Some of that should be taxed away to reduce the rate of investment, which is an important part of rebalancing.

The second set of policies concerns interest rates. First, deposit rates should be higher, and there should be competition for deposits instead of central bank setting a ceiling on deposit rates. Household interest income is low relative to bank savings, because the returns on those savings have been declining in real terms over the last five or six years. Interest income has declined by more than half as a share of GDP over that period, because nominal interest rates are low, and in periods of inflation, real interest rates are frequently negative. Declining interest income has contributed to slower personal income growth over the last five years, which in turn leads households to spend less. Second, lending rates should be higher. Manufacturers and other borrowers generally pay low interest rates. Again, in many periods the interest rates are negative in real terms, and that contributes to an excess demand for capital and over investment.

The third set of changes is on the exchange rate. China has the world’s biggest current account surplus at $440 billion last year, compared to $17 billion in 2001. The currency needs to appreciate more to slow down the growth rate of the surplus and eventually bring it down to a more sustainable level. This also would help on the interest rate side, because an undervalued exchange rate is usually accompanied by interest rates that are too low. If you allow the exchange rate to appreciate more rapidly, you have more flexibility on interest rate policy.

The fourth and final set of changes is price reform. Inputs that are used intensively in manufacturing—land, water, electric power, and until quite recently, gasoline and diesel—were underpriced in China. That constitutes a subsidy to the manufacturing sector, which has driven up the share of investment going to manufacturing, which has expanded the export sector to an overly large size. It has meant that the amount of investment as a share of the total going into services has declined significantly. Many people don’t recognize that in China most of the electric power, and most of the gasoline and diesel fuel, is not used by households but by manufacturers. So the under pricing of certain inputs has tilted investment into manufacturing.

Rural consumption has grown significantly in recent years, and rural real incomes are rising but not as fast as the overall economy, so rural income as a share of GDP has been shrinking slightly. To move toward more rural consumption, rural incomes must grow more rapidly. There are a number of things which could be done, some of which the government has already done. For example reducing agricultural taxes tends to increase agricultural income, although that’s not a big factor. China could accelerate rural land reform, so that land was an asset against which households could borrow, which would be a mechanism for increasing rural consumption expenditures and rural expenditures more generally. But the best thing is the rapid liberalization of migration, which allows rural people to move to the modern sector and earn much higher incomes. In other words, the long-term solution clearly has to be a continuation of the path of the last 25 years, the transformation of the labor force. As long as you have a large portion of the labor force bottled up in agriculture, it’s difficult to raise farm incomes dramatically.

Rothman: The answer is both simple and complex. Chinese households have been taxing themselves with a high savings rate to compensate for the absence of a formal social safety net. They save to ensure they have funds for education, healthcare, and retirement. Beijing has begun to work on creating the financial infrastructure to enable people to save a bit less, but it will take many years to establish a system that is well funded and trusted. At the same time, it is important to note that Chinese are consuming; the consumption share of GDP [ratio] just looks low because investment is growing at an even faster pace.

Wang: China’s consumption as a share of GDP is relatively small. That is a structural issue for several reasons. One is that households tend to save a lot, because China does not have a good social safety net. Second, the credit market is not well established, so people save for large-item purchases, including houses. To address that issue China needs to build a better social safety net, which it has started to do with healthcare reform. The same is true with developing the credit market. These are medium-term policies that will take a while to bear fruit, especially in an economic downturn.

Another big reason why China’s consumption is relatively weak is that corporate savings is very high. It is as large as household savings as a share of GDP. That means corporate profits are plowed right back into investments rather than distributed to households. It also means that China’s growth has not been employment-driven, but more investment-driven. To change that, state-owned companies probably need to pay more dividends to help set up the social safety net system and corporate growth needs to be more employment-driven, focusing on services and labor-intensive industry rather than capital-intensive industry. To change all that you need to change the incentive structure. Even though China is trying to address this issue, to do so will take years.

Rural consumption has a lot of potential because it is relatively low, but the biggest growth will have to come from job creation and a social safety net for the rural area. Again, that will be difficult to achieve right now, so it’s more of a medium-term goal.

CBR: Are there any positives (or silver linings) that will come out of this economic crisis? For instance, will the crisis accelerate the rebalancing of China’s economy?

Bottelier: The big risk I see is that the measures taken to fight the recession will not rebalance China’s economy. If the tremendous additional spending from the budget and through the banking system ends up in the wrong place, we could even see deterioration in overall macro-balances. But government economists I met in Beijing recently seem to be keenly aware of that and are doing everything possible to avoid that. If they do the right things, China could come out of this crisis stronger than when it entered it, with a more balanced economy, a lower external surplus, a higher proportion of GDP dependent on consumer spending, and lower overall investment and savings rates. That would be good for China and the rest of the world.

Dollar: The crisis does have a silver lining in that China will have to aggressively pursue a rebalancing agenda that is necessary for the long term. We can anticipate that US consumption and imports will grow slowly for years, so China needs a new growth model based less on exports and investment and more on consumption and quality of life. China can stimulate its economy in the short term and prepare for the long term through increased expenditure on education, health, passenger rail, urban public transport, energy efficiency, and environmental clean-up.

Keidel: I am not so concerned about the “rebalancing” issue. China’s trade surplus interpreted as excess savings is not really an accurate analysis in my mind. What happened was that China’s investment levels dropped below domestic savings levels at a time when extraordinary export demand from the United States and Europe contributed to overheating of China’s economy. Consumption growth has actually been pretty good in recent years. As for a silver lining, I see restructuring of industry and China’s labor force in the direction of more productive jobs and hence higher earnings as benefits. A considerable share of the stimulus package is going to investments that will benefit Chinese productivity in the next economic acceleration. I am thinking of railroads and light rail, which will help reduce dependence on automobiles, pump-priming of China’s evolving national health insurance program, increased spending on education and pollution abatement, an emphasis on affordable housing, and strengthening of rural infrastructure and quality-of-life features that should facilitate migration of rural family members to more productive and better-paying urban jobs.

Lardy: It has got the potential to accelerate rebalancing. We’ve already seen the dramatic expansion of health insurance programs—China plans to cover an additional 400 million people in the next two and a half years. There’s been a big increase in transfer payments to low income people under various schemes. That will help boost private consumption. What we’re seeing is an increase in government consumption as a share of GDP, and that is an important turnaround, since government consumption as a share of GDP has been falling fairly continuously since 2001. As the government begins to provide more of these services, household precautionary savings will eventually come down, which means that people will spend a larger share of their disposable income. That will add to aggregate demand, but it will be of domestic origin and lead to much less dependence on exports. I believe that we will see, if not this year then next year, not just a plateauing of China’s large external balance but even shrinkage, which would be the first time in eight or nine years.

Rothman: I expect Beijing to accelerate its investments in soft infrastructure begun in recent years under the “harmonious society” campaign.This means more money for healthcare and education.

Wang: Right now, we think there are two imbalances in the Chinese economy. One, of course, is that exports have been a significant driver. Second is the focus on investment rather than consumption. In the short term, export demand has collapsed, and China has had to resort to domestic demand; this year, all growth will come from domestic demand, and external demand will contribute negatively. Next year won’t be much better. So in the short term, there is a forced rebalancing. China can put itself on a better footing for sustainable growth. One thing, of course, is to build a better social safety net. The government is moving ahead with healthcare reform and has announced plans to extend the coverage of minimum allowance for the poor. Second is to address some of the distortions in the economy. Certain prices may not be right and they can correct that by, for example, raising the prices of previously controlled products—of energy, grain, and so on—so that when growth picks up, resources are allocated more efficiently.

CBR: Once China’s economy begins to recover, what types of growth rates can we expect? Will it return to double-digit growth?

Bottelier: It’s unlikely that China will go back to the turbo growth rates of recent years, because it has a fairly significant overhang in the property sector. Commercial real estate and high-end residential housing are significantly overbuilt. That was the destination of a lot of investment activity. It will be awhile before that overhang has been worked off.

It’s possible, of course, that China will begin to focus more seriously on subsidized low-cost housing. In the past, low-cost housing programs, though mandated by the central government, were always the financial responsibility of local government. Now, China is beginning to put money into the central government budget for low-cost housing. It will take awhile to figure out the best way to do that without distorting markets. But that has the potential to be an enormous growth engine. Although China’s population will peak in the next few decades and the labor force will peak in the next five or six years, urbanization will continue for decades and that’s why the need for residential housing, including low-cost housing, will remain very large for a long time to come. The commercial markets have taken good care of the higher end of the market, but typically—and China isn’t alone in this—the lower end of the market doesn’t get adequately supplied because it’s less profitable. A scheme to use the central government budget to boost the market for low-cost housing has significant potential for sustaining high growth.

If China can institute a policy with subsidies—but on market-based principles—that would supply adequate minimum standard housing to all the migrants in the next 30 years, that will be a significant achievement, both socially and economically.

Dollar: Even without the crisis it was unlikely that China could continue double-digit growth now that it is a middle-income country. Other fast-growing economies of the past have usually slowed down to growth in the 7 percent range at this stage of development. With the right policies and investments China has the potential to grow at this kind of healthy rate for years to come.

Keidel: I expect that growth rates will fluctuate in the 8-11 percent range from 2010-15. Anything faster risks inflation—which is not to say China will avoid inflationary pressures. It may not. With China’s revision of 2007 GDP growth to 13 percent, China will now easily reach the 2010 GDP output level I predicted last summer ($4 trillion in constant 2005 dollars), even if GDP performance in 2009-10 is below pessimistic expectations.

Lardy: Economic policy should be geared toward an evaluation of China’s long-term potential growth. We were in a supercharged period of economic growth in 2005-07, but that was because the growth of the external surplus was so large, and there was huge additional demand coming from the growing trade surplus that added 2-2.5 percentage points to the growth rate. I don’t think that’s sustainable on a long-term basis. I think a more balanced growth pattern that relies more on domestic demand, particularly consumption demand, would result in growth of about 9-10 percent, rather than the 11, 12, or even 13 percent that we saw on an annual basis in recent years.

Rothman: A return to double-digit growth is highly unlikely, as that was driven by very high net export growth. With more of a focus on domestic consumption and investment, China can grow at a 6-8 percent rate over the coming five years.

Wang: We think it will be really difficult to get to double-digit growth without the United States and the other major economies recovering very strongly. In the past five years or so when China had double-digit growth, it coincided with a period of global economic growth that was faster than at any time since the late 1960s. The domestic economy, even in those best circumstances, was growing more like 8-9 percent, so we’re not looking for double-digit trend growth. I think the last few years were not really a trend, but more of an exception.

CBR: In recent years, small and medium-sized enterprises (SMEs) and private sector companies have created millions of jobs in China, yet they still have difficulty accessing credit. Will the government’s focus on boosting employment during this downturn improve their access to credit?

Bottelier: SMEs have usually had access to credit, but it was the curb markets; unofficial financial intermediation remains quite significant, but this is by definition hard to measure. Underground financial markets in China, which are believed to be large, are pushed by low deposit rates. That’s where the SMEs get most of their money, plus of course their own equity money.

Will they be given more access to official channels? The indications are somewhat mixed. One source indicated that the share of SMEs in the official new bank lending from December onward has been unusually large, which would seem to suggest that the government is putting its money where its mouth is. That would be good, because many SMEs only had access to expensive money in the curb markets. It would promote faster growth for the SMEs which would be good for job creation.

Dollar: China has eliminated the quantitative lending restrictions that had been in place to control inflation in recent years. Those restrictions made it especially difficult for SMEs to get loans. The end of restrictions and lowering of interest rates has led to a lending boom, which has improved SME access to finance. Of course, some SMEs are involved in exporting, and demand for their products has dropped sharply. Ease of credit is not going to solve their problems. But SMEs oriented to the domestic market are facing a relatively favorable environment.

Keidel: I doubt it. There is probably a good reason that SMEs and the private sector have had difficulty getting bank credit from major commercial banks, such as lack of transparency in company accounting, business plan, market prospects, and management quality. I have heard that the indigenous private sector is the least transparent in these regards. In these circumstances, local equity, personal loans, and retained earnings are likely to remain the most important sources of funding for private firms and SMEs—since in these funding dimensions, private investors can maintain closer scrutiny over their investments. Given the large demand for public investments, like infrastructure, and given the limited traditional revenues from taxation, China’s strategy of using bank deposits to supplement public investment resources is probably preferable to pushing bank loans to SMEs and private companies. It is interesting that in January and February, while state-owned and state-controlled manufacturing firms registered negative growth (of 1 percent), private-sector manufacturing growth was more than 15 percent.

Lardy: The government has given a lot of window guidance to the banks, urging them to extend more credit to SMEs. Whether that will actually happen we’ll have to wait and see. It’s more expensive, and banks sometimes consider it riskier to lend to SMEs. SMEs nonetheless have grown rapidly, mostly on retained earnings. Remember, most SMEs are in the services sector or light manufacturing, so their need for capital is not as immense as capital-intensive manufacturing. They’ve grown remarkably well given the restrictions on their access to credit.

Rothman: Providing SMEs with access to formal lines of credit is a long-term process, but private firms have done well in the recent past without bank lending. We’ve noted that the flood of credit and liquidity has led to a steep fall in interest rates in China’s curb market, where SMEs have traditionally sought short-term financing.

Wang: The government is calling for banks to increase their lending to SMEs. However, SMEs and the private sector tend to have difficulty accessing credit during good times, and now a lot of orders are gone, especially in the export-related sectors where a lot of SMEs are. So they face a worse economic situation, demand is falling, and banks remain reluctant to lend. So, the credit situation has not improved for SMEs, and it’s rational for banks not to want to lend to what they perceive as risky businesses. What the government has been trying to do, and what may work at the margins, is to establish loan-guarantee funds for SMEs, whereby the government shares credit risks with the banks. And secondly, the government removed the overall credit constraints on the system. When credit is more available in the system, it will also help SMEs to some extent—probably not directly from banks, but from their suppliers and customers.

CBR: A large portion of the stimulus package will be funded by bank loans and local government. What is the risk of a sharp increase in non-performing loans (NPLs) in China’s banking system? How will local governments fund these initiatives? Is there a risk that much of the plan will not be implemented?

Bottelier: The plan is still being formulated. The total initial stimulus program announced was ¥4 trillion [$585 billion]. When I was in Beijing in March, I was told that the total of investment projects proposed by local governments was in excess of ¥18 trillion [$2.6 trillion]. So there’s plenty of capacity to do things if they want to.

Financing is a more troublesome question. For many local governments, we know the rough breakdown between government budget, local government budget, and bank lending—a large part will come from bank lending. I am concerned that some of this extra lending may end up in the manufacturing sector, where there is a lot of excess capacity already. If that occurs, I would be worried about new NPL accumulation. Beijing appears to be aware of these problems and is trying to make sure that funds will not end up in the wrong sectors, but you never know. I think it would be realistic to expect an uptick in NPL ratios in the years ahead. Whether that will be a real problem or a manageable one is hard to say at this point. I am inclined to think that we are talking about a manageable problem, because current NPL ratios are quite low and banks are well capitalized. In one of the meetings I had in Beijing in March, I was informed that the average capital adequacy ratio was 15 percent, almost double the required ratio of 8 percent.

How will local governments fund these initiatives? Here, I think we can adopt a more positive tone. One of the new initiatives is to allow selected local governments to issue bonds in their own name. That is a significant new development. For the first time, China has allocated certain amounts for bond issues by local governments—the first local governments selected for this program are Xinjiang and Anhui—but still under the tutelage of the central government. The bonds are sold by the Ministry of Finance on behalf of “eligible” local governments.

Dollar: A key funding source of the stimulus is a fiscal deficit of ¥950 billion (3 percent of GDP) programmed for 2009. This is a large fiscal stimulus, well above the 2 percent that the International Monetary Fund is recommending as a minimum. Much of the rest of the stimulus program will be funded by lending from Chinese banks. These banks entered the crisis in strong financial condition, well capitalized with low NPLs. A modest increase in NPLs is likely as China goes through this difficult structural adjustment, but we are not worried about the financial health of the Chinese banking system.

Keidel: There is a clear risk of increases in NPLs, but how serious it will be is another matter. This has to be held up against the prospect of a severe economic slump and what that might mean for NPLs—quite likely a sharp increase. So is it “damned if you do and damned if you don’t?” I would come down more strongly on the “damned if you don’t” side. Some increase in NPLs is inevitable, but if the stimulus works, corporate profits will be more robust, as will government revenues at all levels, and the quality of bank and local government balance sheets will benefit accordingly. Local governments will likely fund these projects with development loans from the China Development Bank, commercial banks lending based on suggestions from local offices of the National Development and Reform Commission and their party secretaries, project office borrowings with some kind of local government or other “guarantee,” and in some cases local government bonds. The only risk is that Beijing and local governments won’t follow through with the program as outlined if it is successful quickly and seems to threaten inflationary pressures. That would be a good problem to have.

Lardy: NPLs will rise as we go through 2009. It’s almost inevitable in a slowdown that NPLs go up. But the loans that will be going bad are the loans that were made in the boom years from 2005 through early 2008. The banks have enough reserves and high enough earnings to write off most of these loans on their own. I don’t expect the government will have to inject capital into the banking system or guarantee any bank liabilities.

Another thing to keep in mind is that not much of the lending these days is going to traditional manufacturing activities. Even in 2008, about two-thirds of medium- and long-term lending was going to infrastructure projects, and only about a sixth of it was going to manufacturing. So the manufacturing sector was not getting a lot of medium- and long-term credit in 2008.

Local governments are obviously cash-strapped because of the slowdown in property—they get a lot of their income from the sale or leasing of land. The central government is trying to help a little bit by allowing the Ministry of Finance to issue some bonds on their behalf, I believe it’s ¥200 billion, but that’s a pretty small amount. The reality is that most of the stimulus spending will be financed through an expansion of bank credit. The second most important source is the ¥1.18 trillion the central government has indicated that it will put into the program. The balance would come from local governments.

Rothman: I’m not worried about funding or about NPLs. The Chinese Communist Party (CCP) controls all of China’s banks, so they are lending to support the stimulus programs. And because they are lending primarily to other government agencies—local government infrastructure projects and state-owned industrial firms—the risk of bad loans is not great. At the same time, banks will have their net interest margins and earnings growth slashed by Beijing as their contributions to getting the economy rolling again.

Wang: A large portion of the loans will be funded by bank loans because local government does not have the money. So indeed there is a risk for the banking system at this moment. However, the Chinese banking system is in a uniquely good position compared to the rest of the world in that the banks have been recapitalized, cleaned up, have clean balance sheets, and did not have a credit bubble and a credit boom in the last few years. Households and corporations also have not increased their debt in the last few years, so overall they entered into the downturn in good shape. During an economic downturn, I would expect NPLs to rise, and that will affect Chinese banks. Right now, with a lot of projects, you will wonder whether debt will increase NPLs in the long run. By design, a lot of the projects are infrastructure-related and government guaranteed, so bank loans are relatively safe. Of course, in execution, local governments could persuade local banks to try to increase lending to sectors that already have overcapacity. In this case, I would worry more about NPLs rising disproportionately.

CBR: What consequences will rising unemployment have for China’s social stability? How high could real, total unemployment go?

Bottelier: Employment is the key issue. There’s no question in my mind that the current crisis has provoked a serious overall employment problem, particularly for migrant workers, many of whom were laid off, not only in the export sector but also in the construction sector and by SMEs that supply the big construction materials SOEs [state-owned enterprises]. So you have a serious migrant employment problem, partly because these people—if they don’t have a permanent hukou [household registration] in the areas where they work—cannot even register for unemployment benefits. They’re on their own. If they’re lucky, their old farms still exist. But many farms, particularly in the urban fringe areas, have been converted into urban land. Even when the farms still do exist, many of these migrants haven’t worked there for 10 years or so. They’re not keen to go back to farming. They’d rather hang around in the city and see if they can get another job.

Total unemployment, especially of migrants, will probably remain high in China for some time to come, even if the economy starts growing again at a reasonable rate. There is also a rather serious problem now of university graduates who can’t find jobs. The total number of job seekers in 2009 will far exceed the total number of jobs available. I wouldn’t be surprised if we end 2009 with some 30-40 million unemployed people (6-8 percent of the non-agricultural labor force), including more than 20 million migrants who are typically not included in the government’s official unemployment statistics.

Dollar: The government estimates that 20 million migrant workers have lost their jobs since the downturn began. Most of them returned to their villages for Chinese New Year, as usual. Anecdotal press reports suggest that 80 percent of them have returned to cities to look for jobs. I find that believable. There is little extra work in the countryside, and the safety net is much better in the cities. China has the resources to cover all of these unemployed workers with the minimum income support program. Some coastal cities have taken the initiative to start training programs for laid-off workers to help them develop new skills. There is no reason why unemployment should lead to social instability in China as long as the government uses its ample fiscal resources to help people through the difficult adjustment.

Keidel: I agree that the rural unemployed represent less of a political threat. The reported 20 million rural migrant unemployed represent about 3-4 percent of China’s economically active population. If the figure is actually twice as large as some estimate, it is a big number but still manageable for healthy business-cycle processes. I don’t think we have a reliable way to talk statistically about the degree of unemployment in China, given the high levels of underemployment and the reporting lacunae with regard to migrants and rural workers. To the degree that bouts of unemployment represent reallocation of labor from less productive activities to more productive (and hence legitimately more remunerative) activities, it represents progress in lifting living standards—including living standards of the poor. What is important is that investments in education, transport, and communications continue at high rates of growth to enable this restructuring.

I would also point out that as early as the first half of 2007, Beijing was implementing a program to close small-scale and polluting export-oriented manufacturing plants in southern China as a way of upgrading the sophistication and competitiveness of China’s manufacturing establishment. In some ways, the economic crisis is helping implement this program, which drew criticism from the governor of Guangdong in early 2007 because of its unemployment implications.

Lardy: It’s difficult to say. Chinese unemployment figures are the least realistic of any data that the Chinese government publishes, because the concept of unemployment that they measure is not really what we’d like to know. Unemployment has obviously risen. The government has acknowledged that 20 million rural migrants have lost their jobs over the last couple of quarters. That number is sure to rise before it falls again. So unemployment is higher than China has experienced at any time in the last decade. Having said that, I believe that this is not going to lead to extreme social instability. Most of the workers who have lost their jobs have gone back to the countryside and have not returned to the cities to look for work because they know that the prospects are rather bleak at the moment. They’ll stay in their villages for a year or maybe longer. When economic growth becomes more robust, and they learn that jobs are available in the coastal cities, they will return. So it is a kind of an automatic buffer, a shock absorber. You don’t have tens of millions of people bottled up in cities who have no jobs, in some cases no housing, or no access to healthcare. There are large numbers, but they’re dispersed over thousands of villages, and I don’t think they’ll contribute to massive social unrest in China—in part because they understand the slowdown is of external origin. This slowdown is not happening because the Chinese government made a series of economic policy errors; China is being affected by the global slowdown. As a result, the potential for social unrest is less than it would be if the perception was that the slowdown was of domestic origin.

Rothman: As long as the CCP follows through on its pledges to take care of the basic needs of the newly unemployed and their families—assistance with education, healthcare, putting food on the table, and retraining—I do not expect rising unemployment to become a serious social stability problem.

Wang: Indeed, we expect the number of new unemployed people this year to rise by more than 20 million. Of course, the official statistic does not include all unemployed because it is the urban registered unemployment rate. There are a lot of people unregistered, such as migrant workers, who are excluded from the data. We think that the unemployment rate until recently has been low, probably close to 4 percent, but 4 percent of non-farming employment is probably about 18 million people, and then another rise of 20 million, so we could easily see true unemployment double this year.

I’m not too concerned about large-scale social unrest, even though the pressure on social stability will rise. Most of the people losing their jobs are migrant workers, and there are two issues related to them. First, they are not covered by formal social safety nets, do not have formal channels of complaint, and are often owed back pay for months or a year. So when they lose their jobs they often resort to demonstrations, because there is no other way for them to get fairly compensated or have their voice heard. Therefore, small-scale unrest could rise. However, because they’re migrant workers, they are often not well organized. Second, they do have a final safety net in the form of their family home, which usually has a small plot of land. They will probably not be absorbed back into agriculture effectively, but their family will provide for them, at least for awhile. Third, the government has resources and has also announced plans to increase spending in the rural areas and for the poor to help stabilize income and consumption. So, I think the chance of large-scale unrest is relatively small.

Posted by Virginia Hulme, Arie Eernisse and Daniel Strouhal