China needs more momentum in its economic recovery

China's economy is still in a post-pandemic recovery stage, with production indicators in January and February showing positive trends. The recovery phase indicates that severely impacted areas are gradually recovering, while areas less affected by the COVID-19 pandemic are recovering more slowly, leading to a significant divergence across economic sectors.

Analyzing this year's economic situation, it can be concluded that China's economy has entered a stable growth phase, albeit at a low momentum, characterized by low prices and deflationary pressure.

First, economic stability mainly relies on manufacturing investment and exports. From January to April, China's exports grew 11.4 percent year-on-year, and manufacturing investment maintained a rapid growth rate. Driven by exports and manufacturing investment, industrial production recovered relatively well, with a growth rate of 6 percent from January to May.

After a rapid recovery in the services sector last year, the growth rate slowed to less than 5 percent from March onwards. Comparing monthly data over the past four years affected by the pandemic, the services sector has roughly recovered to average recent levels.

Driven by exports, industrial production growth from January to May this year was faster than in the past four years. Maintaining a high export growth rate is crucial. If export growth slows, industrial production may decline, manufacturing investment may decelerate and the economy could see further downturns.

Second, from March to May, economic data remained stable but at a low level, mainly reflected in prices. Price increases were not significant, especially the producer price index, which had been negative for the past 20 consecutive months leading up to May. Although there was a slight month-on-month increase in May, it was influenced by international market-driven inflation.

From January to April, import prices rose continuously, especially in April. Although specific data for May is not yet available, the increase is expected to be greater, linked to rising copper and oil prices in the global market. Excluding these factors, domestic price levels are relatively low, especially the PPI. The consumer price index is also at a low level, both in terms of core inflation and month-on-month growth.

Thus, although China's economy remained stable from March to May, it has not rebounded to a high level, and price declines reflect an unresolved supply-demand gap. It is estimated that China's current potential growth rate over the period should be between 5.2 percent and 5.3 percent, with the supply-demand gap accumulated after the pandemic still not being fully addressed.

Key challenges

The current Chinese economy faces three main challenges. To start with, there is insufficient effective demand. Consumption demand is insufficient, with the growth rate of total retail sales of consumer goods stuck at around 4 percent in recent years.

Services consumption, heavily affected by the pandemic, fluctuated greatly but recovered to a 5 percent growth rate post-pandemic recovery. This level is significantly lower than the nearly 8 percent growth rate before 2019 and the real consumption growth rate of 6 percent after adjusting for prices.

Meanwhile, the real estate market remains sluggish, making it difficult to reduce dependency on the property. Despite a series of stimulus policies this year, their effectiveness has been insufficient, and real estate investment growth may continue to decline in the second half and into next year.

Export growth in the second half might slightly increase compared to January-May, but import growth may also rise. Actual export growth may not reach the nearly 11 percent level of January-May, reducing its pull on the economy as trade frictions persist.

Second, there is a risk of deflation. China faces structural and institutional overcapacity in some sectors, leading to persistent deflationary pressure. The 10-year government bond yield has fallen to 2.25 to 2.3 percent, while the one-year medium-term lending facility, or MLF, rate remains at 2.5 percent. This inverted yield curve reflects market concerns about future economic and deflationary risks.

The PPI has been declining for 20 consecutive months, and the CPI is only 0.1 percent. During the initial four years of supply-side structural reforms from 2012-15, the CPI remained at around 2 percent, and the PPI experienced over 50 months of negative growth. This time, the CPI is not high, the PPI is still falling and some industries face overcapacity issues.

Price expectations of no increase or even declines will significantly impact industrial and enterprise production, discouraging inventory stocking and large-scale investment. While current policies, including large-scale equipment renewal and replacement, provide some support, maintaining high growth in manufacturing investment is challenging.

Third, trade frictions persist. The scale of trade frictions might not be large, but unresolved issues between countries could lead to conflicts, significantly impacting business. Marginal effects suggest that exports' contributions to economic growth may slow in the second half.

The complexity, severity and uncertainty of the global economy are rising, affecting China's economy through exchange rates, prices, capital flows, foreign trade and overseas asset security. The global economic environment in the second half is expected to be more challenging for China than in the first half.

The Chinese economy might hover at the bottom in the second half or even be lower than in the first half. The second-quarter growth rate is expected to be around 5.1 percent, with the overall growth rate in the first half at about 5.2 percent. The third and fourth quarter growth rates might be below 5 percent, with the annual growth rate around 5 percent.

Specifically, the consumer market remains stable, manufacturing investment remains relatively high but may slow, and infrastructure construction investment is weaker than expected despite substantial government funding, including special bonds.

Short-term recovery to stability in the real estate market is unlikely, and it is expected to continue its downward trend. The marginal effect of exports may weaken, with less pull on economic growth. Despite strong resilience in the US and European economies this year, their growth is expected to slow in the next one to two years, impacting China's exports.

Policy recommendations

China's economy remains in a recovery phase, now stabilizing but with potential slight deceleration and continued deflationary pressure. In this context, three economic principles are proposed.

First, economic development is more important than risk prevention. Actions should not be taken solely to prevent risk but to promote development. Last year's Central Economic Work Conference and this year's two sessions — the nation's legislative and political advisory meeting — emphasized consolidating and enhancing the momentum of economic recovery, while avoiding economic decline due to excessive risk prevention, which could lead to even greater economic risks.

Second, internal economic balance is more important than external balance. Fiscal and monetary policies should closely monitor price levels to ensure stability, focusing on money supply and exchange rate stability.

Third, there is a need to develop new economic drivers while stabilizing traditional ones. Efforts should be made to avoid blind pursuit of new drivers which could lead to overcapacity and over-competition.

We look forward to the upcoming third plenary session of the 20th Communist Party of China Central Committee, a vital reform meeting scheduled for July, to provide guidance for long-term policies. For short-term policies, including fiscal policy, monetary policy and policies targeting the real estate market, the following recommendations are advisable.

To start with, proactive fiscal policies should be properly strengthened. This year's two sessions proposed a 0.1 percent growth in the fund budget, namely an expected increase of 0.1 percent in land transfer fees. However, land transfer fees from January to May declined by over 10 percent, implying a reduction in fund budget revenue. This funding gap needs urgent resolution so that local governments can ensure fund security in three areas — basic livelihoods, salaries and operational expenditures.

Second, prudent monetary policy needs to be flexible, targeted and effective. It should maintain reasonable liquidity, aligning social financing and money supply with economic growth and price targets. Lowering interest rates and reserve requirement ratios, and prioritizing development over risk prevention should be considered. Emerging bank risks can be addressed through fiscal special bond issuances.

Third, more efforts are needed to expand demand. Boosting consumption requires increased urban and rural incomes through smooth economic circulation and development. We anticipate reforms in July to progress in income distribution and social security. Strengthening the social security system can stimulate consumption by addressing issues like migrant workers' retirement stability and encouraging childbirth policies.

For investment, there is a need to relax restrictions in certain areas and encourage mergers and restructuring in sectors displaying overcapacity, including real estate. Local governments should reduce large-scale investment funds to avoid herd-like behavior. When encouraging the development of new quality productive forces, it is important to avoid excessive investment and inappropriate use of structural monetary policy tools.

As for exports, it is crucial to address trade frictions properly. When exporting Chinese electric vehicles, EV batteries and photovoltaic products, a possible solution is implementing a quota system, drawing from the 1990s US-Japan trade dispute experience. This system would specify the quantity supplied to a specific market each year, on the condition that the other party must encourage our enterprises to invest in their country by utilizing comparative advantages. Quotas can be auctioned domestically, generating fiscal revenue and incentivizing higher value-added exports. Meanwhile, due to the quota restrictions, domestic enterprises can determine production volumes based on these quotas and domestic demand, thereby avoiding blind large-scale investments.

In the property sector, first and foremost, the task of ensuring the completion of presold properties must be effectively completed. Enterprises on the white list should be exempt from accountability for bad loans related to development loans and housing acquisition loans, which is an important reflection of policy coordination and consistency. Second, policies to assist real estate enterprises should be studied, including mergers and acquisitions of real estate companies and the revitalization of existing housing stocks, such as policy-oriented housing financial instruments. Finally, further research can be conducted into including mortgage interest in the deduction of personal income taxes to encourage real estate demand.

On the supply side, current support policies for new economic drivers are correct. Encouraging mergers and restructuring in industries with overcapacity is advisable. Meanwhile, more specific policies surrounding the construction of a unified large national market could be planned at the upcoming third plenary session of the 20th CPC Central Committee this month to address supply-side issues.

The writer is former chief economist of the State Information Center.

The views don't necessarily reflect those of China Daily.