Debate on Countercyclical Measures vs. Structural Transformation

The issues facing the Chinese economy have sparked two differing viewpoints. One camp argues that the key to addressing economic downward pressure lies in enhancing counter-cyclical policy stimulation, while the other believes that the fundamental cause of the economic downturn lies in structural problems and that stimulus policies cannot resolve these issues but should focus on structural reform.

Indeed, intensifying counter-cyclical policies is an urgent necessity. Since the end of 2020, China's economy has exhibited a "dual-track model" characterized by strong external demand and weak internal demand. If one only looks at the overall GDP growth rate, the risks posed by weak internal demand may be underestimated. Simultaneously, the pressure of structural slowdown is evident, especially since the fiscal reform dividends that began in the 1990s have nearly been exhausted. To unleash new growth momentum, a new round of fiscal reform is essential.

The "dual-track model" of strong external demand and weak internal demand

At the end of 2020, exports experienced an unprecedented strong rebound, while the new energy sector entered a phase of rapid development. The strengthening of external demand and manufacturing provided a rare policy window to tighten the real estate market. Policies such as the "three red lines" were subsequently introduced, leading to a swift adjustment in the real estate industry. With a substantial decline in housing prices and land transfer revenues, the pressures on consumer spending and local finances continued to mount. Since then, the Chinese economy has entered a "dual-track model" of strong external demand and weak internal demand.

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A significant characteristic of the "dual-track model" is its self-perpetuating nature. First, weak internal demand suppresses the rise of labor and capital costs, while also exerting depreciation pressure on the currency, all of which favor exports and manufacturing. Second, the decline in export prices stemming from weak internal demand, and its negative impact on commodity prices, help alleviate inflation pressure in developed countries, allowing them to maintain loose policies in the long term, further supporting China's external demand. Third, strong external demand partially offsets weak internal demand, reducing the necessity and intensity of counter-cyclical policies, which in turn leads to sustained weakness in internal demand.

Recent policy adjustments originate from weak internal demand

The advantage of the "dual-track model" lies in its reliance on the robust development of exports and manufacturing, successfully achieving a decoupling from real estate in the Chinese economy. Compared to 2020, manufacturing investment this year is expected to rise from 21 trillion yuan to 31 trillion yuan, while real estate investment is projected to decrease from 14 trillion yuan to 11 trillion yuan, with the scale of manufacturing investment nearing three times that of real estate investment.

However, persistent weakness in internal demand, coupled with increasing pressures on local governments and the job market, ultimately triggered a notable policy adjustment at the end of September this year. Nevertheless, as external demand and manufacturing remain robust, achieving this year's GDP target does not require extensive incremental policies. Therefore, the focus of this policy shift remains on stabilizing internal demand, rather than altering the existing "dual-track model." Looking ahead, internal demand still faces significant pressures in the short term.

External demand is key to switching growth models

The sustainability of the "dual-track model" primarily hinges on changes in external demand. If external demand significantly slows down, the support for internal demand will undoubtedly increase due to the counter-cyclical policy aimed at anchoring GDP growth. This might even lead to a new round of changes in the growth model.

Since the beginning of this century, the growth model has undergone three significant changes, each driven primarily by external demand. The first was after joining the WTO in 2001, when exports accelerated sharply, shifting growth to be export-driven; the second occurred after the financial crisis in 2008, when exports noticeably slowed, leading to an economy dominated by internal demand. The third change took place after the outbreak of the pandemic in 2020, with exports accelerating again, shifting growth back to external demand-driven. The fourth switch in the growth model is likely to be triggered by a slowdown in external demand as well.

Expanding internal demand requires strengthening counter-cyclical policies

Economic operations exhibit strong inertia, so changing the growth model requires policy impetus. Although household deposits are nearing 150 trillion yuan, consumption capacity does not necessarily translate into actual consumption. In the past two years, China's economy has typically exceeded expectations at the beginning of the year, experienced a noticeable slowdown by the second quarter, had counter-cyclical policies ramped up in the third quarter, and began stabilizing in the fourth quarter. This recurring cycle stems from long-term weak expectations and demand, resulting in an unstable foundation for recovery. Hence, counter-cyclical policies need to be substantial enough to change consumer confidence and establish a self-reinforcing positive cycle of expectations and demand.

The current inadequacy of internal demand in the Chinese economy cannot solely be attributed to structural issues, nor can it be concluded that counter-cyclical policies are ineffective as a result. In the pre-pandemic United States, there was a long-standing issue of "three lows"—low inflation, low growth, and low interest rates. Many saw this as a structural problem; for instance, former Treasury Secretary Summers argued that demographic changes and technological transformations would lead the U.S. economy into a "secular stagnation." However, following the strong stimulus policies during the pandemic, the U.S. economy broke away from the "three lows," and Summers himself stopped referring to "secular stagnation."

A new round of fiscal reform to unleash growth momentum

The structural camp's viewpoint also possesses its rationale; dependency on cyclical policies to address structural issues is not sustainable. From a long-term perspective, structural reforms are essential to release new growth momentum, with fiscal system reform as the most crucial component.

The current fiscal framework originates from the tax-sharing reform of the early 1990s. Following this, local governments developed land finance (through land sales) and land financial mechanisms (by financing platforms) to increase revenues. This framework incentivized local governments to attract investment and invest in infrastructure, providing immense momentum for rapid development over the past three decades.

However, this system has also led to numerous problems: income distribution has favored the public sector over residents, economic structure has leaned towards production rather than consumption, local government debt risks have increased, and housing prices in large cities have surged while smaller cities face an oversupply of properties. In the long run, leveraging real estate as an engine for economic growth is becoming increasingly unsustainable. Coupled with stringent regulations on local government debt, the existing development model requires not just patching but a fundamental transformation.

This necessitates a new round of fiscal system reform. First, the sources of fiscal revenue should gradually shift from production and land to wealth and property income. Second, fiscal expenditures should lean towards social welfare rather than infrastructure investment. Third, the proportion of central government fiscal expenditures should increase as central-local relations transition from administrative decentralization to economic decentralization. For instance, land resource allocation should be more based on population movement rather than administrative divisions. Finally, further relax the household registration system to accelerate population influx into large cities, thereby creating new real estate and consumption demand.

Conclusion

Counter-cyclical policies and structural reforms are not mutually exclusive. In facing the current challenges of the Chinese economy, both are equally important. Counter-cyclical policies can create a stable environment for structural reforms, while structural reforms help reduce future reliance on counter-cyclical policies. Although there are concerns that counter-cyclical policies may diminish the urgency for structural reforms, in reality, economic weakness often makes structural reforms more challenging, such as the difficulty of implementing property taxes during a downturn in real estate. In the short term, it is crucial to recognize that under the "dual-track model," strong external demand can easily lead to an underestimation of weak internal demand. In addition to GDP growth, inflation should also be a significant basis for formulating counter-cyclical policies.