BOFIT Viikkokatsaus / BOFIT Weekly 2019/37

The IMF last month released its annual Article IV consultation on trends in the Chinese economy. China’s public sector deficit and indebtedness continue to rise when borrowing by off-budget local governments and other debt is included (augmented debt). This year’s fiscal policy stimulus through tax cuts and investment by local governments in infrastructure projects will boost the augmented deficit by 1.5 percentage points to 13 % of GDP (11 % in 2018). Stimulus measures should support growth this year by 0.8 percentage point.

Both public debt and China’s total debt-to-GDP ratio are expected to rise until 2024. China’s augmented public sector debt should rise from 73 % last year to over 80 % this year (official public sector debt 38 % of GDP in 2018) and exceed 100 % of GDP in 2024. China’s overall debt-to-GDP ratio is expected to rise this year by nearly 10 percentage points to 266 %.

Rising public sector debt poses a threat to the sustainability of China’s indebtedness. To lower public sector debt, the IMF recommends limiting off-budget borrowing by local governments to finance infrastructure investment, as well as a shift to progressive and pro-rebalancing taxation that rewards structural adjustments (e.g. carbon tax). The credit growth of state-owned enterprises (SOEs) is of particular concern as debt ratios are rising, productivity remains generally weak and about a third of SOEs now operate at a loss. SOE debt represents as fast-growing share of total debt, highlighting how state firms are favoured by banks at the expense of private firms.

The state’s extensive involvement in the economy interferes with efficient allocation of resources. The situation will only worsen if China continues to pile on debt to hit official growth targets. Administration of an ever-more complex economy requires an overhaul of policy, improvements in governance and a shift to more market-based and transparent frameworks. Rather than focus on rigid growth targets, fiscal policy resources should be used to mitigate the problems arising from critical structural reforms.

At the time of the consultation, roughly half of US imports from China were subject to punitive tariffs. Under the adverse scenario proposed by the IMF, whereby the US applies a 25 % tariff to all remaining Chinese imports, China’s growth would slow by about 0.8 percentage point over the next 12 months relative to the baseline scenario. With the increased tensions in the trade war in August, the assumptions of the adverse scenario have largely come to pass.

The IMF recommended increasing fiscal stimulus to mitigate some of the impacts of the current trade war, noting that funding for such stimulus has to come from central government budget funds, that the stimulus must support structural reforms of the economy and be targeted at low-income households to amplify the impacts of stimulus as much as possible. These include hikes in pensions and unemployment benefits, as well as increased spending on education and health care. At the same time, however, public debt is rising faster than in the report’s baseline scenario. The IMF does not recommend monetary stimulus; monetary policy should be focused on inflation.

With regards to exchange rate policy, the IMF encouraged China to move to a freer exchange-rate formation regime as it would help soften the impacts of external shocks on the economy. China also should work to improve the quality of its statistical data and eliminate gaps in its data.