Ample room for fiscal policy manoeuvring
By Zhang Dingmin (China Daily)
Updated: 2004-06-08 08:26

Editor's note: This is the second in a series of analytical reports on the Chinese economy focusing on financial and fiscal policies.

Worries that China's economy is overheating have grown this year with the continued extensive growth in the nation's fixed investment and bank lending.

Fears have increased in some quarters that the central government's recent steps to cool down economic growth, especially its controversial use of some administrative measures, show that it is running out of policy options to orchestrate a "soft-landing" for one of the world's best performing economies.

But these fears are dismissed by senior Chinese experts who argue that the authorities still have much room for manoeuvre in the nation's increasingly market-oriented economy, even if they steer clear of administrative measures.

Ample opportunity remains for monetary policy measures, which have taken a pre-eminent position in the ongoing round of macroeconomic manoeuvring, but the nation's fiscal authorities have a supporting role to play in structural adjustment, they say.

"There is plenty of room for (monetary) policy manoeuvrings. You just need to take into account their influence on economic activity and market conditions," said Qin Chijiang, a senior adviser to the People's Bank of China (PBOC), the central bank.

"You don't use one single instrument, it's a comprehensive deployment of many tools - the interest rate, discount rate, reserve requirements, open market operations and bank supervision...," added Qin, who is also deputy secretary-general of the China Society of Finance.

China's fixed investment soared by 42.8 per cent in the first four months of this year, coming hot on the heels of even faster growth in 2003. The list of industries showing signs of excessive investment is growing, with the steel, cement and aluminium sectors being the most obvious.

Bank loans are believed to have refuelled that investment frenzy, with the growth in broad money supply, mainly driven by loan increases, hovering near a high 20 per cent level for months.

Surging investment and new loans have significantly increased industrial prices.

Many worry that these inflationary pressures will impact on to consumer prices, which may disturb social stability.

But the central bank has acted to prevent this scenario from materializing, announcing two increases in bank reserve requirements - effective in April - and increasing rates on central bank lending, both aimed at reducing the banks' lending capacities.

However, this has not yet slowed down the pace of loans in recent months, increasing calls for an interest rate rise, regarded as a last resort.

Central bank officials have themselves mentioned the possibility of an interest rate rise on the condition that consumer price index (CPI) growth surpasses the one-year lending rate - currently standing at 5.31 per cent.

But experts say the central bank can do more than this. "The bank reserve requirements can be raised still higher, and the discount rate can be raised," Qin said. "No single instrument can work too much in isolation, the key is the synergy of different instruments."

Qin agreed an interest rate rise is necessary should CPI growth climb to the 5-6 per cent range, which he said may prompt depositors to divert their savings from banks and therefore frustrate bank liquidity.

Goldman Sachs (Asia) Managing Director Fred Hu said China needs to raise interest rates by 200-300 basis points in the coming eight to 12 months to curb the investment surge. But Qin said the final approach can be more flexible.

"There are quite a few variations (in interest rate adjustments). The central bank is quite experienced in that and knows what they can do," he said, citing the policy of granting fiscal subsidies on depositors' bank interest to offset the impact of price increases, which the State adopted during a period of rampant inflation in the late 1980s.

Qin also dismissed worries higher interest rates may prompt significantly greater inflows of US dollars by widening the interest rate differentials with foreign markets. Hefty dollar inflows have pushed up growth in domestic money supply as the authorities use local currency to lessen their impact on the renminbi exchange rate.

"There will not be huge room left for the simultaneous buying and selling or assets in different markets," he said. "Outsiders may naturally be worried, but that's because they cannot see the whole picture."

There are also doubts about the effectiveness of an interest rate rise. Some analysts are sceptical as to whether this can work as expected, arguing that soaring prices in overheated sectors can easily absorb the increases in the businesses' borrowing costs.

"It's only people who use bank loans to buy homes and cars that will be affected," said Li Hui, head of China Research at CLSA, a leading investment bank.

Many economists are worried that monetary policy is, theoretically, hardly capable of addressing structural problems. The Chinese economy is believed to be only partly overheating, with many sectors still thirsty for new investment.

But fiscal policy can be more effective in structural adjustment, experts say, although it has largely been quiet on the fiscal policy front in this round of macroeconomic management.

A "proactive" fiscal policy played a dominant role in kickstarting domestic demand in the years following the 1997 Asian financial crisis, with increased government spending on infrastructure.

The finance ministry has reduced this year's target of special bonds issuance for infrastructure projects from recent year's high levels - the essence of the so-called "proactive" fiscal policy - but has not yet staged other concrete policy initiatives.

Finance Minister Jin Renqing said recently that the nation's fiscal policy is shifting from a proactive stance to "neutral," but stopped short of elaborating on what this meant.

"The fiscal policy still has an important role to play," said He Zhenyi, a senior fiscal expert at the Chinese Academy of Social Sciences. "If monetary policy is more effective in quantitative management, fiscal policy has the advantage in structural adjustment."

Although measures such as raising tax rates on the over-invested industries are unlikely due to the inflexibility of tax laws, experts say there is some room for manoeuvre.

An experimental value-added tax reform that encourages fixed investment in other industries is one of the measures the fiscal authority could take to contain the surge in overheated industries. But the finance ministry has reportedly postponed this long-anticipated reform, fearing further increases in fixed investment.

The expert also proposes cutting or suspending a levy on bank deposit interest to stimulate private consumption and offset the impact of accelerating prices, which he said circumvents a key drawback to an interest rate rise - further dampening private spending.

Hu from Goldman Sachs also highlighted the role of fiscal policy, recommending cutting "unnecessary" government spending, which he said could also lead to slower loan growth. "This tool is very effective."

Experts also urged speedier fiscal reform to bring local governments' out-of-budget incomes into the State budget, as well as adjustments to current land-management practices, which they say can restrict local governments' investment capacity.

Many local governments, with various out-of-budget incomes the State cannot control and proceeds from sale of land use rights, are believed to have been a major force behind the fixed investment frenzy, as local officials pursue political credit with economic "achievements."

"The fiscal reform, especially the budget system reform, needs to be deepened in order to enhance the macroeconomic management capacity (of fiscal policy)," He said.