by LIU Qiao, Dean of the Guanghua School of Management, Peking University

Report Summary (English)

China’s GDP grew by 6.8% in the first half of 2018, 0.1 percentage points lower than the same period last year, and the actual growth was stable. However, the GDP deflator has fallen sharply, and nominal GDP growth fell to 9.8%-- the first time in six quarters that it has fallen below 10%.

Consumption growth fell between June and July. Overall consumption from January through July grew by just 9.3%, lower than growth over the same period last year and representing a return to single-digit growth. May’s 8.5% growth in consumption was not only the slowest increase across this seven-month period but was also the slowest increase in the last 15 years.Investment growth continued to decline, with fixed-asset investment growth of 5.5% from January through July, down 0.5% from the 6% growth that occurred if only taking into account the period from January through June. This is the slowest level of growth since this data was first made available. The reduction in investment is primarily a result of limited capital available to local governments and state-owned enterprises as they deleverage.

Another worrying change is the urban unemployment rate for July, which increased to 5.1% from 4.8% in June. The increase in unemployment reflects a lack of vitality in the real economy.

The downward trends in the real economy are, to some extent, related to rapid deleveraging in the financial sector. In July, newly added social financing (financing from non-bank and non-government sources) amounted to RMB 1.04 trillion, a decrease of RMB 124.2 billion compared with the same period last year. Social financing from January to July grew by only 10.3%, well below expectations.

Money supply (M2) grew by 8.5% in July, which was slightly higher than growth in June but still 0.4 percentage points lower than growth over the same period in 2017. Overall, the monetary base has maintained steady growth and interbank liquidity is relatively abundant, but strict oversight and tight credit has caused tight liquidity in the real economy, especially for SMEs.

Efforts to reduce leverage in the financial system, increased trade tensions with the United States, and expectations of deteriorating conditions in the real economy have caused investors to become anxious and has resulted in volatility in the financial market. Stocks listed on the Shanghai Stock Exchange lost RMB 3 trillion in value, with A shares sliding 14.4%.June and July also saw significant devaluations of the RMB against the US Dollar. The volatility of financial markets is largely a reflection of market pessimism.

Government revenue growth was healthy from January through June as a result of increased revenue from taxes and increased revenue from the sale of government-owned land compared to the same period last year. However, the efficiency of fiscal expenditures needs to be improved. This can be achieved by providing effective public services (in areas such as medicine, education, urban public utilities systems, etc.) as a way to increase rates of investment and address unequal consumption.

Analysis and Policy Suggestions

The economic challenges described above have exposed a structural problem in China’s economy and constraints in implementing macroeconomic policy. During periods of high growth, the Chinese economy relied heavily on investment, but the Return on Invested Capital (ROIC) has fallen. When ROIC falls, the only way to achieve a higher targeted growth rate is to increase the rate of investment. In recent years, real estate investment and infrastructure investment have become an important source of steady growth in China. However, this has caused China to become more and more economically dependent on financing, and the marginal effect of macro-economic policy on economic growth is becoming weaker.When a large amount of capital flows to industries or enterprises with low ROIC, the development of the financial sector is reflected only in an increase in the leverage ratio, rather than an increase in real economic support.

At the present stage, the macro-policy objective is to maintain stable growth while preventing systemic financial risks and limiting financial leveraging. When ROIC is not high, it is difficult to balance all of these policy objectives.

The key point of transitioning China's economy from high-speed growth to high-quality development therefore lies in re-shaping the micro-foundation of China's economy, to enhance the ROIC of companies, to improve the efficiency of capital utilization across the entire Chinese economy, and ultimately reduce reliance on financial leveraging in the development process.

Policy Suggestions

Reduce taxes and other government-imposed fees. This will increase consumer willingness and eagerness to invest, boosting corporate profitability (ROIC).

Greatly increase the salaries of civil servants, scientific and technical personnel and health care workers. Increased levels of household debt and increased housing prices are not conducive to increasing levels of consumer spending. The best way to encourage consumers to spend is to increase income levels.

Increase expenditures on research and development (R&D) as a share of GDP. R&D expenditures in the US and Japan have already reached 3% as a proportion of GDP and have reached 4% in Israel. Decision makers in China should explore raising our R&D expenditures to similar levels.

Introduce standardized Real Estate Investment Trusts (REITs). High housing prices is a major cause of systemic financial risk accumulation. Nearly half of current total debt is related to the real estate market. Developing the rental housing market and forming a market-oriented rental price that reflects the relationship between supply and demand can help establish a rational pricing level for the real estate market. The conditions are ripe for the rollout of REITs, and this move is in line with the spirit of the guidelines put forward by the Central Economic Work Conference last year.

Launch an IPO registration system and re-double commitments to implementing a market-oriented delisting system. The biggest problem with China’s capital markets is the lack of high-quality listed companies, with the average return for investors in Chinas A-share market sitting between 3-4% between 1998 and 2017. These two improvements will help improve the quality of listed companies.

Establish a financial system for local governments. One important characteristic in China’s economic model is the important role played by local governments, but this has also resulted in significant debt held by local governments. First, we need to establish a market-based financial system to improve the efficiency of local government investment. In the future, local governments will prepare complete balance sheets and income statements, introduce market mechanisms into their decision-making, establish a government credit rating system, and price local government debt based on the credit rating system.