The Chinese government treats its GDP target as politically sacred. Thus officials at every level are deeply reluctant to ever “miss the target.” In fact, this aversion has been so acute that, for years, Beijing’s response to an economic slowdown was predictable. Policymakers would become nervous about downward pressure on the economy and the impact on social stability, so they invariably unleashed some form of stimulus to ensure that the year-end growth target would be met, whether it was 8% or the current 6.5%.
This habit, which has been hard to shake, has also acclimated market expectations: when the GDP target is in peril, expect a stimulus to follow.
But what if this habit has finally been shaken? What if, when a slowdown hits, the Chinese government will instead passively accept it, doing only enough to keep the economy from falling into a full recession? In other words, what if a stimulus won’t be coming? In that event, from now through 2020, China is likely to enter a period of reduced credit, low inflation, and subdued growth.
In fact, this is likely already becoming the de facto reality, which should undermine the accepted market wisdom of how Beijing typically responds to an economic down cycle. It is especially important to understand this shifting attitude now since the Chinese economy is expected to once again face economic headwinds from persistent credit tightening and brewing trade tensions.
I believe there are several main reasons behind Beijing’s shifting priorities:
First, another stimulus requires the creation of debt, which is widely viewed as a key vulnerability in the Chinese economy. In this instance, the economic vulnerability also aligns with political vulnerability, since a stimulus would be interpreted as abandoning Xi Jinping’s signature deleveraging agenda. Backing away from deleveraging would likely prove more politically damaging than most expect, particularly as Xi has banked his personal credibility on ensuring financial stability and reducing debt. Having made numerous announcements publicly himself, Xi would likely be criticized internally for deviating from such a priority at the first sign of uncertainty. In fact, Chinese state media has already sent unambiguous messages that China needs to hunker down and absorb some near-term pain to get through the deleveraging process.
Second, the nature of China’s current deleveraging campaign means that the process cannot be easily fine-tuned without derailing it altogether. This is because the approach to debt management has primarily relied on an administrative mandate, rather than on market-based tools such as interest rate adjustments. The recent National Audit Office report, for example, unambiguously states that there is a policy of zero tolerance for any local government off-budget borrowing.
To fully comply with the latest zero tolerance policy, some local governments have simply decided to suspend all government borrowing, regardless of whether the borrowing is on- or off-budget. The knock-on effect has led many local governments to also suspend the construction of half-finished projects. This probably isn’t the most efficient way to contain local government debt, but for such an enormous country, where management is increasingly centralized, a zero tolerance mandate has to be clear and absolute. If Beijing wants to tweak or weaken the mandate by adding a few exceptions to incentivize local government borrowing, then local governments will surely exploit these loopholes swiftly and design ingenious ways to make almost all their new borrowing legitimate. Indeed, this is something they have repeatedly done in the past.
If the “aversion to missing the target” truism holds for the central government, then this truism holds for local governments: if you yield an inch, they’ll take a mile. In fact, this is precisely why the GDP target mandate worked so effectively—it was clear, comprised of a single number, and there was no doubt that this was the state’s priority above all others. That same principle is now applied to the deleveraging effort.
Therefore, if and when local governments—consummately expert at detecting small changes in the political wind—get the smallest whiff of a loophole or detect any waffling on deleveraging, that will quickly render the mandate largely ineffective. This means that when it comes to dealing with local government debt, Beijing only has two choices: follow through on its original mandate, or else abandon it all together. There is no in-between option.
Given the severe constraint the deleveraging mandate imposes on local governments, they cannot easily fall back on capital investments to offset a potential economic shock. At the same time, state-owned enterprises (SOEs) are now also subject to the same stringent mandate. Since local governments and SOEs together account for at least one-third of China’s investment, this means that a significant part of the Chinese economy probably won’t increase borrowing even if more credit is made available.
This is the political context in which the People’s Bank of China (PBOC) recently cut the reserve requirement ratio (RRR). Although this cut was widely interpreted as a precursor to China pivoting to stimulus mode, the PBOC took this action primarily in consideration of the uncertainty trade tension has created. This was hardly a stimulative move, but should really be interpreted as an accommodative action to provide a bit more liquidity to fend off the anxiety created by the tariff that took effect on July 6.
In fact, the RRR cut only means that Chinese banks now have more money to lend. But whether the increased supply of credit will translate into an actual increase in lending remains to be seen. Since the state sector is forbidden from borrowing as liberally as it is accustomed to, the additional liquidity will find an increasingly smaller number of borrowers. In addition, because of a potential economic slowdown and the onset of a trade war, many private firms will hold off on borrowing amid rising uncertainty. Consequently, the impact of the RRR cut on lending and spending will likely be much smaller.
Third, another aggressive stimulus akin to the 2008-2009 program is no longer an appealing policy option when the associated costs are considered. Such steroidal stimulus will only exacerbate China’s vulnerabilities and increase the likelihood of a financial crisis, something Xi is adamant about preventing. Since Xi will rule China for at least another decade, he is likely more willing to tolerate short-term economic pain without jeopardizing his signature policy on curbing financial risk. Time is on his side.
And history is on Xi’s side too, since China has been through similar belt-tightening before.
During the last round of deleveraging in the late 1990s and early 2000s, Beijing stuck with deleveraging even as the economy significantly underperformed. During that period, bank lending to inefficient SOEs dried up, and many state firms were forced to shut down or restructure. Although the expansion of the private sector eventually revived the economy, weakened SOEs caused the economy to suffer. This can be seen in the deflationary trend in Figure 1. Because of deleveraging, the Chinese economy experienced a three-year period of weak demand before returning to a protracted boom starting around 2003.
Figure 1. Deflation During China’s Last Deleveraging Cycle
Note: 2000 price level=1. Year 2000 is chosen as base year to exclude the impact of the Asian Financial Crisis.
Source: National Bureau of Statistics.
Fourth, Beijing can actually meet its 2020 doubling of GDP goal even if it tolerated a slowdown. According to the 13th Five-Year Plan, China needs to average 6.5% growth from 2016-2020 to achieve a doubling of GDP from the 2010 level. But that target was set before the fourth General Economic Survey and GDP accounting method revision, which will likely lead to an upward revision of China’s GDP by at least 5% in 2019. What this means is that Beijing can achieve its 2020 target with a growth rate of around 5% through the next 2.5 years.
The bottom line is that Beijing’s priorities have changed, and that is likely to lead to a different set of policy choices than what we’ve grown accustomed to. The factors above suggest that, short of a significant shock to the economy—for instance, if the trade war spirals completely out of control—Xi isn’t likely to reverse course on his deleveraging agenda and the PBOC is unlikely to stimulate to such an extent that credit starts growing significantly faster than GDP again.
 There are two complications when comparing the current deleveraging effort to the last round in the late 1990s. On the one hand, China’s current deleveraging task is likely much smaller. Last time, all major banks were insolvent and required state bailouts. This time, the problem in China’s banking sector is believed to be much smaller. On the other hand, joining the World Trade Organization provided a huge boost to the Chinese economy in the early 2000s in bolstering external demand. But with the ongoing trade tension, trade is more likely to be a drag on growth. On net, however, these two factors will largely cancel each other out.
 Because the general economic survey covers previously under-reported economic activities, China’s GDP has usually been revised upward after each survey. For instance, after the last survey in 2013, the national GDP was revised up by 3.4%. In addition, the GDP accounting of housing purchases will change from being based on historical cost to market value. Given the rapid rise of property prices in China over the past decade, it is estimated that this change in methodology can increase China’s GDP by as much as 5.5%. As such, Beijing is under less pressure to ensure 6.5% growth and can still meet its doubling of GDP by 2020.
 The Chinese government’s unemployment target is 5.5%, and the current official unemployment rate is 4.8% as of May. Based on the usual correlation between GDP and unemployment change (e.g. Okun’s law), it seems Beijing is willing to accept a growth slowdown of at least 1.5% of GDP. (To put this into perspective, the impact of the announced tariffs on $250 billion of Chinese exports is estimated to cost around 0.5% of China’s GDP.) Because of the existing pool of rural migrant workers, a growth slowdown of this magnitude will probably lead to a smaller increase in the unemployment rate in China compared to advanced economies. This is because when urban jobs disappear, many migrants will choose to stay in rural areas. A detailed analysis of the relationship between China’s unemployment rate and economic growth can be found here.