Xi Jinping's new economic team is at a loss as to how to revive the sputtering economy and prevent China from plunging into a Japan-style deflation. We expect to see a number of measures trialed -- with limited results -- as policymakers attempt to avoid deflating their way out of a debt hangover.

With external demand faltering and decoupling well underway, Beijing needs domestic demand to carry the day. But after years of pump-priming China is now under a mountain of debt, while the Covid lockdowns and Xi's statist policies and assault on the real estate sector have sapped its "animal spirits". 

As this week's half-hearted interest rate cut shows, there's no easy way out. A broader stimulus plan is in the works, but we do not expect a 2009-style monetary splurge. 

Instead, Beijing is likely to lean on government transfers and mortgage borrowing incentives to underpin consumer spending, subsidies and preferential loans to boost SMEs and financial engineering to lessen the local government debt burden. Simultaneously, they will continue to push China's supply-side transformation in the hope it bears fruit sooner rather than later. 

The jury is out on whether they'll succeed, but as we have said over the past couple of years, China faces the sternest test of its economic model since reform and opening up began 40 years ago. 

The CCP will struggle to achieve the economic stability it craves in coming years.

The Party won't inflate the debt away

China has an acute debt problem. Our estimates show credit losses at between 26% and 31% of GDP in 2021. They is likely to have gone up sharply in 2022. 

But throwing money at it in a 2009-style stimulus -- when annual broad money growth averaged 27% a year -- carries a serious inflation risk unless China's supply-side transformation starts to bear fruit imminently, which is unlikely.

Beijing began opening up the monetary taps last year and broad money growth has accelerated to its fastest pace in six years. Running at 12% over the past twelve months nominal broad money growth should be consistent with the official GDP target of around 5% this year.

The Communist Party perceives runaway inflation as the one economic force that can upend its hold on power, so it is unlikely to throw caution to the wind.

The PBoC has been cutting bank funding rates to spur bank lending to both firms and households, but household demand for credit has been muted while banks have been unwilling to lend to the private corporate sector. Corporate borrowing growth has picked up speed since last summer, but SoEs could well be hoarding cash. Our investigations have uncovered private firms complaining of delayed payments from their SoE clients. 

Because banks are unwilling to lend to the private SME sector, real private borrowing costs have shot up, and private sector post-Covid confidence is down in the dumps. The authorities have been struggling with unclogging this blockage in the transmission mechanism of monetary policy for some time, as they consider this to be more effective than lowering interest rates sharply, which would put further downward pressure on the currency. 

In early May we expected one or two MLF cuts this year (and LPR declines as the benchmark rate is priced off the 1-year MLF rate) as well as one or two more cuts in the required reserves ratio (RRR) in order to help banks deal with mounting credit losses; together with the authorities focusing on giving preferential loans to SMEs and consider providing banks with guarantees. We keep our forecast unchanged.  

Beijing wants consumer spending to drive growth

The authorities have known for quite some time that China's economy needs to become consumer-led, but they are still focused on investment-led growth as well as enticing foreign firms back to China. 

As their pump-priming efforts and charm offensive abroad have not yielded the expected result, Beijing is scrambling for ideas on how to entice consumers to spend more and kick-start a virtuous growth rebound.  

But consumer sentiment is weak and the household savings rate has risen. 

The tech sector crackdown and the ordeal of SMEs under lockdown have battered employment; and Xi’s “common prosperity” push has hurt urban household income and wealth. The protracted lockdowns and the experience of everyday authoritarianism (for the first time, for urbanites under 40s) as well as the abrupt abandonment of zero-Covid have revived the deep-seated uncertainty that has contributed to Chinese abstemiousness over the decades. 

The assault on the housing market has also sapped mortgage borrowing growth as households remain in a wait-and-see mode despite lower mortgage borrowing costs. 

We have argued that China's households continue to earn very little income from their assets and wages have stopped their relative rise, holding back consumer spending. And with the Chinese being large net savers, policymakers guiding deposit rates lower may help bank margins but will only hurt household income further and lead to more precautionary saving. 

We expect to see government transfers as a share of income continue to increase, and more redistribution of income from the wealthy to the less wealthy. But this redistribution will only succeed, in economic terms, if the boost to income and spending of the poor outweighs the hit to income and spending of the rich. It's far from clear that it will.

A return to the "to get rich is glorious" days of Deng Xiaoping would most certainly inject the needed strong dose of "animal spirits", but this would be anathema to Xi Jinping. Instead, together with consumer handouts and redistribution efforts, Beijing is likely to be more proactive in boosting mortgage borrowing growth. 

Structurally, China has scope to increase the share of mortgage borrowing in GDP. While this is the only viable private sector borrowing growth route left, there's not a lot of mileage in it.

Beijing to use financial engineering to help with local government woes 

The appointment of Li Yunze as Party secretary of the newly created National Financial Regulatory Administration has rung alarm bells as it signals Beijing's serious worries about the state of local government finances. 

Yet the central government does not appear keen to come to the rescue. Its suggestion that "each household take care of its own children” implies that it will not backstop local government debt.

Some targeted support to reduce debt costs via refinancing for the most vulnerable regions, however, is likely. At the same time, the central authorities are also likely to tolerate more bankruptcies at the local level. 

 For example, the think tank of the Guizhou provincial government recently said that "debt reduction work is extremely difficult and cannot be effectively resolved by relying on one’s ability alone.” Also, the Guangxi government has issued guidance saying that “local governments are not responsible for repaying debts of LGFVs”. 

Interestingly, we've also learned that some local governments have asked civil servants (especially from the public security, procuratorial and court organs) not to buy any bonds or wealth management products from LGFVs. This suggests local governments are not expecting to repay these debts, and want to ensure that the civil servants responsible for keeping public order don't lose their own money. 

Demand deflation, defaults but what about devaluation 

The three Ds -- default, demand deflation and devaluation -- are the solution to an excess debt problem. Typically countries resort to a combination of all three. 

So far, China has mostly had to endure demand deflation and some defaults, but this route could well prove too painful if its supply-side reforms don't lead to a swift improvement in productivity. 

Beijing would loathe a sharp 20-25% devaluation of the yuan. It has been working long and hard to portray its currency as a stable alternative to the dollar for the benefit of its Asian neighbours and the Global South more generally. Moreover, with external demand weak and the geopolitically-motivated decoupling underway, it's not clear a weaker currency would have as much bang for its buck. 

But if all else fails this is China's last remaining economic pressure release valve. And it may not be within the authorities' capability to defend the yuan for very long, if the exodus of capital gathers speed. 

Conclusion 

A piece of news that caught our attention is that Shenzhen has allowed citizens to take part in "night market" style hawkering, called di-tan in Chinese. This means some streets are zoned off in the evening and people can sell whatever they have (or made, including cooked food) on those streets. The concept was first proposed by Li Keqiang about 2 years ago to solve unemployment -- and initially nixed by Xi Jinping. But given the state of joblessness, Xi's people last year revived Li's practical idea. 

The big question is: "If Shenzhen is China's most successful and industrialized city, how come folks there have to resort to one of the most primitive capitalistic practices of selling clothes or food items on the street?"

Beijing is clearly struggling with finding a viable and sustainable solution to years of over-investment and the build-up of excess debt, continuous household financial repression, the sapping of "animal spirits" induced by the severe lockdowns and Xi's assault on the private sector and the fast deteriorating international environment. 

We foresee neither a big bang monetary stimulus nor an abandonment of Xi's statist and Marxist-Leninist policies.

At best, the Party would manage to keep social stability amid feeble growth long enough for supply-side transformations, if successful, to start bearing fruit. At worst, it will have to convince China's people that "the struggle" is necessary -- for instance, by rallying the population behind the military solution to Xi's dream of Taiwan reunification.