The economy is in the clutches of a debt-deflation spiral that will necessitate a weaker yuan to cushion the adjustment.

Beijing is struggling to come up with a successful stimulus plan. It is unlikely to go for a big bang monetary boost as we wrote in "China's Debt Deflation Dilemma" but we expect more supportive measures to be rolled out soon. The problem is that while policymakers want and need to boost consumer spending, they are incapable of doing so.   

We have discussed what's holding consumer spending back, why 'animal spirits' have been crushed and why Beijing has opted for government transfers to households, in both the report above and in a recent note "China's Lackluster Household Income and Mystery Government Transfers Bode Ill for Consumption".

Importantly, the Party-state will have to rely on government transfers to households that are funded centrally, rather than through local governments. 

Cash-strapped local governments are struggling with Beijing's directives, split between the conflicting tasks of being prudent and stimulating consumer spending.  In the same way as banks are at a loss as to how to boost credit to small and medium-term enterprises, while ensuring they lend responsibly. One Chinese brokerage estimates that the size of local consumption coupons, one of the main measures employed by local governments, totalled Rmb760mn in the year to June 2023, down 40% on the same period last year. 

China is likely to resort to a currency depreciation to smooth its otherwise difficult retrenchment, despite having spent decades trying not to resort to a devaluation in the face of crises. 

In a recent speech, the PBoC governor Yi Gang noted that, "... [China needs to] use the exchange rate as an automatic stabilizer for regulating the macro economy and the balance of payments better."

We do not take this as a strong signal of imminent action not least because it is now Pan Gongsheng, the PBoC's new Party chief, who will be in charge of the central bank. Importantly, none of the senior management team of the PBoC was included among the full members or alternates of the Party's Central Committee, the key decision-making body of the CCP, suggesting that the central bank has been relegated even more to the role of the executor than the before. Even so, Yi's views carry importance in shaping the advice available to the Party's top economic leadership. 

Conclusion

China will ultimately have to pay a price for years of debt-fuelled overinvestment -- all that remains to be seen is what form the necessary retrenchment will take. Xi Jinping often talks about the 'struggle' that the Chinese face on the road to national rejuvenation, but he has never defined what it entails. 

It is fair to say that the Party's survival will trump any other consideration, but under Xi the overarching focus has been on national security at the expense of the economy, so it is difficult to see the economic adjustment route he would prefer. But if left to market forces, a significant depreciation is on the cards.