Can big local projects effectively drive growth?

A1

The central issue is that investment is already unprecedentedly high at about 49 percent of China's GDP and the investment appears to be less productive than in other comparable large emerging market economies. This is the reality behind all the talk about China "rebalancing" toward a more consumption-led growth model.

The Chinese authorities are responding to the deterioration in the outlook for the global economy and China's exports with a smaller version of the 2009 stimulus. It is inevitable this will be investment-led because that is the easiest way to get growth quickly.

China has the fiscal and financial resources to ensure a so-called soft landing for the economy in 2012, but only at the cost of postponing the resolution of the economy's structural imbalance toward investment.

That imbalance is a structural weakness that contributes to the negative outlook on Fitch's AA- local currency rating for China. Meanwhile, the foreign currency rating of A+ remains well supported with a stable outlook by China's exceptionally strong foreign currency sovereign balance sheet, underpinned by $3.2 trillion of foreign exchange reserves.

A2

It is unlikely that there will be 7 trillion yuan ($1.1 trillion) of new projects as part of the current stimulus - this is about 13 percent of 2012 GDP, which is a vast sum. We speculate local authorities may be "re-labeling" spending that would have happened anyway.

The key issue for the authorities is likely to be maintaining employment, rather than the technical efficiency of the projects.

Headline urban unemployment remains modest at just 4.1 percent in the second quarter of 2012, and the Ministry of Labor and Human Resources continues to report a surplus of vacancies over job seekers, in stark contrast to 2009.

However, the real picture for the labor market is probably less good - higher-frequency data show a decline in employment growth and a fall in migrant labor movement through July, while there is anecdotal evidence of exporting firms in provinces like Guangdong laying off workers.

A3

Given the imperative to maintain employment levels, we think the bottom line is the financial resources will be found one way or another.

Still, we believe the authorities are already concerned about the buildup of local government indebtedness since the 2009 stimulus, and the prospects for some of that lending to turn bad, impacting the banking system.

National Audit Office data show local government debt rose to about 27 percent of GDP by the end of 2010 from 18 percent at the end of 2008. The prospect that bank asset quality will deteriorate, potentially leading to a requirement for support from the sovereign, is one of the issues contributing to the negative outlook on the local currency rating.

This means China's public finances are less strong than is often supposed - we think a debt measure comparable to other countries will be about 49 percent of GDP by the end of 2012, which is about equal to the median for China's peers in the "A" rating range - not a weakness, but not a strength either.

It may be more likely for financing for any new stimulus this year and next to be raised via local government financing vehicles with more or less informal local government guarantees.

A4

It is not for Fitch, as a ratings agency, to provide policy advice. But it is simple arithmetic that if investment is to grow less quickly than headline GDP, something else has to grow faster.

This is unlikely to be exports given the outlook for the global economy, so that leaves the government and households. Experience with some higher-income economies in the West shows that it is unsustainable for government spending - and so deficits - to grow faster than the economy, so that just leaves households.

This comes back to the point we started with about "rebalancing" toward consumption. One possibility is that financial liberalization may lead to higher interest rates for households on their deposits, which might make it possible for households to achieve their savings goals with less saving, leaving more over for consumption. However it is achieved, rebalancing implies deep and wide-ranging reform of China's economic structure - and it might be a bumpy process.

Still, it has to be faced at some point because investment cannot go on rising forever as a share of GDP. Uncertainty over when and how rebalancing occurs and what the costs might be is one factor that contributes to China's rating of A+ - still a high rating, but below some higher-income countries - despite the strength of the sovereign balance sheet.

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