The market is closely watching the long-awaited Third Plenum in China, which will take place in Beijing from July 15-18. Historically, this event has been pivotal in signaling key policy shifts and economic reforms in China. This time around, market participants and China watchers have a very specific question that they hope the Third Plenum can answer, namely whether enough growth-enhancing measures will be announced to revive the Chinese economy after years of underwhelming performance.
So far, there does not seem to be much hope that path-breaking reforms will be announced at the Third Plenum, based on how officials and Chinese academics have been preparing the ground for this event. The problems that have been piling up during the last few years are, however, increasingly serious, from real estate stagnancy to the difficult financial situation of local governments as well as the rapidly declining return on assets, due to over-investment, and the deflationary pressures in the economy.
The recipe to all these woos, as aired by the Chinese leadership during the past few months comes from strengthening China’s manufacturing capacity further, under the mantra of the “New Production Forces.” There is, however, little sign of demand measures, particularly those supporting private consumption. At most some more consumption vouchers are to be expected but certainly not the establishment of a welfare state. Xi Jinping has repeatedly denied any interest in such a model.
More supply without increasing domestic demand will need to end somewhere, possibly in an even bigger trade surplus but this looks increasingly difficult as the West and some key emerging economies have started to impose barriers on Chinese imports. The consequence, thus, will be more deflationary pressures.
The same very gradual approach to solve China’s key imbalance (the stubbornly low domestic consumption) will probably be applied to other pressing issues, such as the deterioration of the fiscal situation – particularly that of local governments, which had long financed their expenses by land sales that have plummeted since 2020.
The financial pressure on local governments is, by now, well known. It affects local civil servants’ salaries and also public services. Given the lack of alternative fiscal revenue and the increasing interest rate burden that local governments need to face, one should expect measures to improve the local government finances at the Third Plenum.
The one that seems most likely at this moment is the transfer of consumption taxes to the local governments. In addition to the revenue, managing government spending will also be key. The government will need to balance the increase in pension and medical costs carefully, given the shrinking working-age population. This will probably include postponing the retirement age, that was already announced in the previous Plenum, but now with real implementation.
A longer-term issue is obviously aging, which has been tackled in the previous plenum with announcements on the easing of China’s system to control domestic migration, the hukou. Such measures should accelerate urbanization but the reality is that China does not have a huge chunk of its population willing to migrate any more (with 63% of the population in urban areas as compared to less than 30% before entry into the WTO) and, most importantly, the job opportunities in the cities are also dwindling
Finally, on the immediate issue of the policy mix, China would benefit from more lax monetary and fiscal policies but the reality is that the space is not really there. Public debt is at 100% of GDP and interest rates are already very low, especially when compared with the US, pushing the RMB to record weak levels. This is why, not even on the mix of demand policies, can we expect any radical change from the Third Plenum.
All in all, expectations for China’s long-awaited conclave for reform, the Third Plenum, should be managed carefully. The announcements will look more similar to Chinese medicine than to a shock therapy, even if China’s health issues are increasingly serious.
This has important consequences for the global economy, namely that China’s demand for foreign products will remain subdued and that Chinese companies will continue to rely on foreign markets to survive. This points to trade wars continuing to hit the headlines and perhaps moving beyond.