Will China's stimulus be enough to get its economy out of deflation?

China's current stimulus plan is still unfolding. The monetary easing announced by the People's Bank of China (PBOC) in late September has already been carried out, but the fiscal part of the plan still lacks details. While the Ministry of Finance has already unveiled how the upcoming fiscal package will be used, its size will not be known until China's top legislators meet and approve the plan in early November. Reportedly, Beijing is now considering announcing a RMB10 trillion fiscal package over multiple years at the upcoming legislature meeting. The actual size could be larger if Donald Trump, whose proposed tariff hikes on Chinese imports could inflict sizable damage on the Chinese economy if implemented, wins the US presidential election.

Despite the clear direction in China's macroeconomic policy, it is still unclear how Beijing defines success. Communist Party leaders clarified on September 26 that their immediate goal is to hit this year's GDP growth rate target of around 5 percent, which was reaffirmed by the vice finance minister more recently. But it would be a missed opportunity if they just stop there. What China urgently needs now is to reverse its deflation. China's GDP deflator, a measure of overall inflation in an economy, has been negative for six consecutive quarters now. The government still has to do much more than has been announced if it is to revive inflation.

It is noteworthy that the PBOC governor, Pan Gonsheng, stated at least twice in recent weeks that an important goal of the central bank is to restore inflation. By making those statements, Pan was trying to anchor inflation expectations. However, given the PBOC does not have operational independence, whether its governor's statements can credibly anchor expectations remains to be seen. Ultimately, it is the top leaders who decide on major economic policies in China. But so far, they have not made any explicit commitments about reviving inflation.

The central bank also faces multiple constraints in further loosening monetary policy, including concerns over bank profitability, capital outflows, and the RMB exchange rate. Moreover, there is a limit to what monetary policy alone can achieve. At a time of weak credit demand, the central bank could be pushing on a string even if borrowing costs keep declining.

Fiscal stimulus is therefore urgently needed. It can make the monetary easing efforts more effective and by itself play a critical role in combating deflation. The fiscal measures announced so far are important first steps towards cleaning up the balance sheets of local governments, banks, and real estate developers. But they will likely be insufficient to revive inflation. Local governments will likely be allowed to issue more special refinancing bonds to replace more of their off-balance-sheet debt that they owe through their financing vehicles with lower-interest government bonds. In this process, some modest amount of cash will be freed up from saved interest payments at local governments, which then can be used to repay contractors, provide public services, and make new capital investments.

For the large state-owned banks, a capital injection by the Ministry of Finance through special sovereign bond issuance will allow them to expand their loan books without sacrificing on their capital ratios. But banks will use part of their enhanced lending capacity to purchase newly issued central and local government bonds. To what extent the recapitalization will incentivize the banks to respond to Beijing's initiatives and extend credit toward sectors like real estate remains to be seen.  

For real estate developers, local governments will be allowed to issue additional special bonds to purchase idle land plots and excessive housing inventory back from them. Depending on the scale, this could potentially become a government bailout for some distressed developers if implemented successfully. But the self-financing requirement with local special bonds means that any land plots or housing projects that local governments purchase with the bond proceeds will have to generate enough returns to cover the interest cost of bond issuance, otherwise it would only exacerbate local governments' already huge debt burdens. The PBOC back in May created a relending facility to support local state firms with purchasing excessive inventory to be converted into public housing units, but that facility has rarely been used. Beijing's renewed push, albeit this time through fiscal policy, may again fail to garner enough interest from localities to be effective.

In any case, all these measures are meant to keep risks to the overall financial system at bay rather than directly stimulate domestic demand. What the Chinese government urgently needs to do now is to substantially raise its direct spending. Local governments have not spent all the money authorized in their budgets this year, creating a contractionary effect. The central government is now asking localities to execute their budgets more fully by issuing all the remaining special bonds that they can issue and investing the proceeds in projects with certain return prospects, especially in infrastructure, by the end of the year. But the problem remains a lack of eligible projects. Even if local governments can manage to issue all the remaining bonds, they may still find it difficult to spend the money.

A more effective way to increase government spending, as I have argued before, would be for the central government or local governments to issue more general bonds, which do not have restrictions on return prospects like the special bonds, and to invest the proceeds in areas that would directly benefit the Chinese people—such as strengthening the social safety net, public health, and education—especially for rural residents and migrant workers. But doing so would require Beijing to overcome both its longtime fiscal conservatism and its bias against direct spending on households, which will not be easy.¹

Note

To be fair, the Ministry of Finance announced at a press conference in October 2024 that a one-time life allowance had been provided to poor households prior to the National Day holiday. This is an encouraging move, but the Ministry refused to give the total amount of allowances and the number of beneficiaries, leaving observers to doubt if the program was of any meaningful scale.