Since the coronavirus outbreak in January, Beijing has announced a raft of policies to stabilize the economy, though short of a big-bang stimulus. These measures include 1) reducing employers’ social security contributions; 2) delaying loan payments; 3) cutting interest rates; and 4) increasing fiscal expenditure.
Some argue that these measures aren’t sufficient in light of the bleak economic figures for January and February. But as many economists agree, this large contraction in economic activity was inevitable and likely desirable in getting the epidemic under control. The immediate economic fallout may be more severe than expected, but that doesn’t mean Beijing’s policy responses have been ineffective. That’s because the policy actions were primarily aimed at preventing failure among the most vulnerable parts of the economy—small private businesses—rather than bolstering growth.
Now that the epidemic has officially become a global pandemic, governments around the world are faced with similar challenges of how to manage the economy and to calm market jitters. Since China was the first major economy that experienced the coronavirus shock, its recent experience could offer important clues for how to handle the economic fallout that follows.
It is instructive, then, to assess the effectiveness of Beijing’s policy responses so far, which may yield useful insights for policymakers in various countries grappling with the economic impacts of this crisis.
The Diagnosis: Policy Responses Limited
Public health crises are unique because they don’t typically destroy physical assets but reduce human activity and therefore erode demand temporarily (assuming it’s not a highly lethal infection). A return to normalcy depends almost entirely on whether the pandemic has passed.
Therefore, the best that policy interventions can hope to achieve is to ensure that companies maintain employment throughout the outbreak, so workers have the income and confidence to consume once it has passed. In other words, the key to any effective policy response will be in preventing firms from going bankrupt and laying off workers.
The Test: Credit Spread
An important test of policy effectiveness, then, is the extent to which a specific response has helped to reduce corporate default risk by examining the credit spread. The spread—which is the difference in the interest rate a risky borrower has to pay over risk-free sovereign debt—is a main gauge of how markets price in default risk, or the likelihood of firms going bankrupt (see further explanation in Methodology).
Therefore, tracking the movement of the credit spread shortly after a policy response can reveal the effectiveness of that policy. That is, if the spread widens, then the risk of corporate default is higher, and if the spread narrows, then that suggests the policy is effective in reducing risk. It can also be assumed that the bigger the contraction in the spread, the more effective the policy response.
For China, the credit spread between private firms and central state-owned enterprises (SOEs) is the most meaningful. That’s because central SOEs are the most protected and pay the lowest interest rates, while private firms are the most exposed and prone to bankruptcy during this crisis. Thus, a narrowing of the credit spread between private firms and central SOEs means investors believe that the default risk of the former group has decreased relative to the latter group.
Assessing Policy Effectiveness
The effectiveness of the four policy responses outlined above is assessed based on each’s respective impact on the credit spread. I examined cases of large spread movements since February 3 and found only one case on February 19 in which a significant decline in default risk was the result of a policy response (see Figure 1).  The other eight cases—with the exception of the February 3 and March 2 anomalies that will be explained below—either did not respond significantly to policies or were mainly reacting to risk-taking behavior resulting from monetary easing (red bars).
Figure 1. Biggest Reduction in Private Sector Default Risk on February 19Note 1: The chart shows daily change in the credit spread from February 3 to March 11, which is calculated as the change in the closing price from the previous trading day. Green color = spread reduction as a result of policy response; red color = spread reduction as a result of risk-taking behavior.
Note 2: The data for 2020-02-11, increasing fiscal expenditure, is 0.02%.
So why did February 19 see the largest contraction in the spread among the cases examined? The previous night, Beijing announced its decision to cut employer social security contributions through June, with smaller firms receiving a larger reduction. It was estimated to save employers around 600 billion yuan ($86 billion). The policy was not meant to boost headline GDP but to extend a life line to smaller firms through the crisis period. And this showed up in the private-SOE spread, which subsequently dropped by 2.5%, or 6.5 basis points.
It is also worth noting the two policy responses on February 11 (increasing fiscal borrowing by $121 billion) and February 20 (lending interest rate cut of 10 basis points) that didn’t have as big of an impact on the private-SOE spread. Although both announcements were viewed as stimulus—government bond yields and steel prices increased—they had a modest impact on the spread, with fiscal spending having almost no effect at all. This market response implies that while fiscal spending supports headline growth, it does not offer much help to private firms.
Finally, it is difficult to attribute a specific policy response to spread movements on February 3 and March 2, as other factors were likely at play. On February 1, Beijing announced that small firms can refinance and the central bank will extend $47 billion in low-interest loans to affected firms. That should’ve narrowed the spread, yet instead the spread widened dramatically on February 3. This anomaly likely reflects less the ineffectiveness of the policy, but rather the general panic on the first day that markets opened after the extended Spring Festival. That day, the Chinese stock market fell 7%.
Similarly on March 1, China’s new banking super regulator issued a formal guidance to postpone loan payments until July that was also aimed at shoring up small firms’ solvency. Although the spread contracted in response as expected, it’s difficult to attribute that reaction to the policy announcement. That’s because there was a flurry of positive news at the time, chief among them Premier Li Keqiang’s statement that a trial coronavirus vaccine will be available in coming months. That news could’ve had more of an impact on the spread then the delaying of loan repayments.
The Treatment: Alleviate Burden on Employers?
Broadly speaking, there are two takeaways from the above analysis. First, in terms of dealing with the economic impact of the coronavirus, fiscal policy is more effective than monetary policy. This is particularly relevant as many central banks are testing the limits of monetary easing. Although the current near-zero interest rate environment enables governments to take on more debt, running a large fiscal deficit is not free. Therefore, governments need to prioritize how best to leverage fiscal policy.
Based on China’s experience, it prioritized targeted cuts, such as the reduction in social security contributions, over launching a major fiscal stimulus. That policy response proved more effective than either lowering the interest rate or corporate refinancing. Moreover, this temporary action on employer contributions has the added benefit of reducing immediate labor cost, making it easier to maintain employment. Alleviating the burden of employers, particularly small private businesses with thin margins, may be more effective than protecting consumers via policies like income tax cuts.
Since the credit spread is how markets price the risk premium of one asset over another, it’s important to delineate between the types of risk that lead to spread movements. The spread can widen or narrow based on perceived risk of corporate default. Alternatively, the spread can move based on risk-taking behavior from investors as a result of monetary easing.
For the purpose of this analysis, we are only interested in spread movements that are responsive to perceived change in default risk. Therefore, the cases in which spreads narrow because of risk-taking are not considered here. But to determine which spread movement was the result of risk-taking behavior vs. default risk, we used two indicators to screen the cases: hot-rolled steel future price and central government bond yield.
Since the short-run supply of steel is basically inelastic, changes in the steel price is mostly due to demand factors. If steel prices are stable, that implies demand and the economic growth outlook remain stable. Hot-rolled steel is a better proxy for the overall economy because it is used in manufacturing, whereas rebar steel is primarily used for construction.
Government bond yield is the interest earned on a sovereign bond, one of the safest and most stable assets to hold. An improvement in the growth outlook typically leads to higher bond yields. But aggressive monetary easing can create a situation whereby even as the growth outlook improves, the bond yield decreases. This creates a low-interest environment that markets may expect to last well beyond the period of economic recovery, which encourages investors’ risk-taking behaviors. Therefore, in a situation where the bond yield falls while the economy is improving, as indicated by stable steel prices, it signals that there’s likely a rise in risk-taking behavior (see Figure 2).
Figure 2. Spread Movements, Bond Yields, and Steel Future Prices Since February 3Note: Daily change is calculated as % change in the previous day’s closing price.
Houze Song is a research fellow at MacroPolo. You can find his work on the economy, local finance, and other topics here.
 The window for observing market reaction to a policy announcement is limited to the next trading day only, except in the case of a morning policy announcement. In that case, same-day market impact is examined. Keeping a small window is meant to exclude the potential influence of other factors.
 All major economic policy responses to the coronavirus were announced around or after February 3, the day China’s bond market reopened.
 The focus is on large daily spread movements, defined as >1% change compared to the previous trading day. But I also looked at other days when the negative outlook on growth had little effect on the spread to see whether policy intervention was the reason. But I did not find such cases in the time period examined.
 Policy announcements may be anticipated by markets well in advance. And when that happens, using the announcement day market reaction to assess policy impact could lead to biased outcome. But in the case of the social security cut announcement, there was little evidence of markets anticipation before February 19.
 On February 26, the Chinese central bank increased low-interest loans to small firms by another $71 billion. But that policy’s impact on the spread was modest.
 The spread can also narrow because of improving economic fundamentals that are independent of policy intervention. But there were no such cases during the period examined.
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