Chinese Fiscal Policy

During our trip and studies in China we discussed many aspects of their fiscal policy that were different from America's. In this paper I will discuss four specific areas I see that could be improved, and will make strategy suggestions on how to improve. The areas under discussion will be financial markets, trade surplus, foreign exchange policy, GDP/inflation risk, energy consumption and the Asian financial crisis.

Macroeconomic policies are developed and enforced by the National Development and Reform Commission and the Chinese Central Bank. In the Q1 Quarterly Update released by the World Bank May 30, the main points revolved around policy on liquidity and rebalancing the economy. The overall economy does not appear to be overheated as demand and supply are growing in lock step.

Chinese Markets

Even though the economy is not currently over-heating, Beijing is concerned about this phenomenon due to an increase in market investment, specifically, in the Shanghai Index which has reached and closed north of 4000 this year multiple times (all time high), and is up some 225% in 2007. Asset valuations (soaring P/E ratios) continue to be a concern which only strengthens the case for tighter monetary policy, and higher interest rates to tie up consumer's money in bank deposits, as opposed to speculating in the market for higher returns. However, profits continue to grow at a 40% annual clip, setting new records month after month which are used by some analysts to sustain index growth. A big cause of the drive of money into the stock market is due to the returns on bank deposits failing to reach the CPI inflation level (approx. 2%). This is a chief cause for concern because it is more fiscally responsible for the Chinese to spend all their income immediately, or invest in higher return assets which in turn lowers the overall liquidity of the government, and banks and poses a potential risk. However, it is estimated that only approx. 1/6th of total GDP is representative of investments held on the Shanghai/Shenzhen indices by individual investors, hardly an amount that would harshly damage the economy if a correction were to occur. On top of this, the government's exposure is even less. Though there are no solid numbers behind this statement, it is estimated 1% of the total deposit base is tied up in the stock markets. Again, this doesn't appear to be a huge issue. Measures containing inflows into the stock markets include temporarily halting approval for new mutual funds and better enforcing the ban on bank credit for buying stocks. Another way to slow the growth of these speculators is to levy a capital gains tax, which is not done currently. I support a capital gains tax combined with an increase in deposit rates to approx. 3% minimum to balance the overall economic picture and at least be on par with CPI growth. I believe a capital gains tax is right around the corner since it was implemented in the real estate markets just a few months ago.

With the recent run-ups in the markets, any correction (although proper from a financial perspective) could damage the psyche of the average Chinese investor who has just gained trust in the system. The underlying incentives for investment, including a strong economy, respectable underlying profitability and strong cash flows, but also the pricing issues mentioned above and loose monetary conditions and low interest rates, have remained intact. The authorities have tightened monetary policy slightly (though they remain loose on relative terms), including modest interest rate spikes, hiking reserve requirement ratios, and attempting to mop up liquidity. Finally, CSRC, the capital markets supervisor, has also launched an investigation into insider trading and price manipulations. The Chinese authorities need to continue acting transparent when it comes to illegal market activity, insider trading, price fixing/manipulation, and providing false information to the general public. Without all those characteristics, the Chinese public might become timid investing in the markets.

Trade Surplus

Trade surplus continued to rise on the back of export growth to the EU. This was driven by the low cost production and finished products finding new destinations. There are many markets that have not been tapped around the world which will only continue growing China's exports unless domestic sales are focused upon. The Chinese government is trying to figure out if the growth should be counted the same as pure Chinese growth because most of the production is coming from foreign companies. This is a main driving reason behind the government trying to limit FDI to a certain degree.

Rebalancing the economy is the easiest way to slow the trade surplus. The Chinese need to shift from a "production" to a "services" based economy, along with more reliance on domestic as opposed to foreign demand. There are various strategies and policies that can be enacted to stimulate this growth. It could stymie growth in the manufacturing industry by cutting the many subsidies these companies receive (including tax credits, below market prices for land, energy, utilities and resources). The government could promote internal competition in the services industry (not a very competitive environment in any industries), enact favorable tax laws for these companies (subsidies, credits), and level the playing field for foreign direct investment in this area (allow more foreign companies to have more ownership). By allowing FDI in this sector, it allows the Chinese to see first hand the success many of the service industries have brought to countries abroad. Also, the government could still regulate the services industry so as to not allow foreign companies to do a "cash and grab". Joint ventures are a very common agreement in China, and these types of agreements are mitigating factors for foreign companies that do not have good intentions for the domestic economy.

These are good times to tackle the rebalancing agenda. Growth in GDP, profits, and wages remain high and stable, which means the impact of the measures that need to be taken can be easily handled, or can be compensated for by a government that has excessive tax revenues and revenue increases in recent years. In fact, the longer the delays in taking measures -- in particular those aimed at pricing correctly inputs such as energy, utilities, and the environment -- the more costly it will be.

Foreign Exchange

The major advantage China has over many other countries from a macro perspective is their currency pegging to the dollar. Though this policy has loosened some this year and their currency is permitted to move a few basis points per session,