Chinese growth in Q1 will be significantly affected by the coronavirus outbreak, and the government can be expected to do its best to move the economy back to trend. But how strong policy support will be in practice, and what policies the government will focus on, are not yet certain.

While some stimulus is required for a prompt and sufficiently strong rebound, a massive GFC-sized stimulus is not necessary or likely, in our view. Compared to a big demand shock as we saw in GFC, this time, there has been both a significant supply shock and a demand shock. As long as supply can return to normal quickly, stimulus may not have to be particularly large to get the economy back to initial equilibrium, though it would be required if policymakers want to boost activity meaningfully above trend in H2 and “make up for” lost output early in the year. Policy stimulus would inevitably push macro leverage higher, but the government will try to avoid large deviation of credit growth from nominal GDP growth and mitigate costs through structural measures.

Ramping up public investment is likely to be the most effective measure to boost demand, given the state-controlled banking sector and large SOE sector in China. Tax cuts and accommodative monetary policy are needed, particularly to help firms ease short-term liquidity pressures to mitigate spillover of supply shocks to the demand side. But their effects on boosting demand could be limited, particularly when firms/households do not have strong incentives to borrow and spend.

We expect the augmented fiscal deficit ratio to increase by 3pp in 2020, driven primarily by greater special bond issuance and stronger policy bank support. We expect the total social financing (TSF)-to-GDP ratio to increase by 4pp this year to accommodate infrastructure investment, facilitated by further RRR cuts and relatively low interest rates. And measures to further increase banks' capital to strengthen their lending capability would also be important.

In coming months, it will be important to monitor those data points that may suggest that cyclical policy is stronger/weaker than our expectations, such as the annual quota for special bonds, any new financing policy on infrastructure investment, or any data on the pace of infrastructure investment approvals.

This shock is different. During the GFC, the primary shock was from the demand side, while this time there have been both a significant supply shock and a demand shock. In this case, even with the similar size of the initial negative impact on output, the cyclical policy stimulus needed to get the economy back to an initial equilibrium (or even above) could be notably smaller, after the virus spread is controlled. But if prolonged supply disruptions and lagged/insufficient policy responses lead to widespread shutdowns and a deterioration in employment and income, or global activity slows significantly in the meantime, there could be additional demand shocks. Then the needed stimulus could become larger. So the most important policy response at this point is to get supply back as soon as possible and mitigate these second-order effects on aggregate demand.

The policy approach is different. The current approach is less likely to lead to a prolonged overshoot. This is shown by two major aspects: the change in the policy objective function from growth stability as the most important goal to a (tight but pragmatic) balance between growth stability and financial stability, and the change in underlying institutional features. Chinese policymakers have been criticized for disproportionately relying on a debt-fueled economic model. This model is related to some underlying institutional features—for example, a large fiscal imbalance for local governments and historically loose fiscal discipline. But a meaningful increase in government special bonds for financing and a notable strengthening of fiscal discipline in recent years could help avoid an overly large stimulus through affecting how the policy stimulus is implemented/financed. There could still be a risk of overshooting, though the likelihood/magnitude should be meaningfully less than in 2015/2016 and in 2008/2009.

For fiscal policy, in addition to tax/fee cuts or discretionary government spending/subsidies (with the gap/deficit financed primarily by general government bonds), a ramp-up in infrastructure investment is frequently and heavily used by the Chinese government to stabilize growth (e.g., during the global financial crisis, and in 2015/2016). Infrastructure investment is basically state-driven discretionary spending—quasi-fiscal policy—but in big part is financed by off-budget sources (e.g., local government special bonds, policy bank support, local government financing vehicle (LGFV) bonds, land sales revenue, shadow banking). We have developed our augmented fiscal deficit measure to capture the broad fiscal policy stance including off-budget activity.

For monetary policy, at present China essentially employs a hybrid policy framework—on the one hand the PBOC still directly affects bank lending (total amounts, pace or structure) through administrative policy such as window guidance (or macro-prudential policy), and on the other hand the PBOC targets the short-term interbank repo rate through open market operations. In addition, it still sets deposit benchmark rates and also has other policy rates related to liquidity tools, such as the OMO rate/medium-term lending facility (MLF) rate/standing lending facility (SLF) rate. With the reform of the loan prime rate (LPR) in August 2019, the MLF rate—the benchmark rate for the LPR—can also directly affect bank loan pricing.

To alleviate liquidity pressures, the government has announced several measures (especially targeting SMEs), such as the PBOC providing liquidity support directly through relending/rediscount tools, pushing banks to provide short-term loans/roll over matured loans/allow firms to postpone repayment, reducing tax/fee burdens (such as VAT and social security contributions), and subsidizing firms for stabilizing employment. It would not be surprising if the government were to announce more of these types of measures in the near future. In our view, such measures are crucial to mitigate the spillover of supply shocks to the demand side.

To restore demand, ramping up public investment (quasi-fiscal) is likely to be the most effective measure to boost demand. This is particularly the case in China given the large roles of state-controlled banking sector and a still-large SOE sector (as well as local government financing vehicles). Private demand, including household consumption (particularly services) and private investment is likely to remain sluggish in the near term.

Debt/leverage concerns: Policy stimulus would inevitably push macro leverage higher, and what the government could do in the short term is 1) avoid over-stimulating; and 2) mitigate debt risks through structural measures. On the first aspect, in addition to the notable strengthening of fiscal discipline, the government has been emphasizing that TSF growth should be roughly in line with nominal GDP growth. This has in recent years led to a much smaller deviation of TSF growth from nominal GDP growth, and accordingly less pressure on macro leverage (e.g., the latest monetary policy report mentioned that because of this, the increase in macro leverage has been much smaller than the previous period between 2009 and 2017 when leverage ratios increased by at least 10pp per year on average). This approach could put an upper bound (range) on TSF growth—although we expect this bound could be higher this year due to the virus shock (Exhibit 3), the increase in the leverage ratio would still be smaller than that in 2016/2009. On the second aspect, the Chinese government has been taking structural measures (such as debt-to-debt or debt-to-equity swap programs) in an effort to deal with risks related to outstanding debt in the SOE sector and local governments, which have been the major drivers of China’s leverage issue.

Housing prices and speculation: The Chinese government has in recent years been taking a different approach to housing regulation—a combination of short-term regulations through various restrictions to squeeze the housing bubble and the development of long-term mechanisms (e.g., development of a rental market, land system reform, fiscal regime reform) to ensure a healthy and less speculative housing sector. While some city-specific loosening is likely, a full relaxation of short-term regulations would jeopardize the effectiveness and credibility of efforts in developing long-term mechanism. This is the major reason why we are unlikely to see a nationwide relaxation in controls and a return of the housing sector as the cyclical tool we saw in previous years. On the other hand, it is also very unlikely that we would see a further tightening in housing regulations.

FX stability: Accommodative monetary policy could potentially add depreciation pressure to the RMB. In order to have a more independent monetary policy (to take care of internal factors), the PBOC could either increase the flexibility of the RMB or strengthen its expectation guidance, or do both. Indeed, the PBOC has been tolerating mild CNY depreciation as long as that does not lead to significant risks in the FX market—e.g., deviation of the closing rate from the fixing has been small, and the countercyclical factor (CCF) has been also mild recently. With the Fed's 50bp intermeeting cut (further Fed cuts expected by our US team) and some other foreign central banks likely to cut rates in coming weeks, FX stability could be less a constraint for monetary policy.

Inflation: Headline CPI inflation is likely to remain elevated in coming months primarily because of pork inflation (the coronavirus could also add upward pressure on food prices in the near term; Exhibit 4). However, we do not think this will be a major constraint for monetary policy, due to the shift in the balance of the PBOC’s reaction function towards growth stability (e.g., R007 down by around 30bp to 2.4% on average in February and DR007 down by around 20bp to 2.2%), which was also recently mentioned by senior PBOC officials. We expect the balance towards growth stability to continue in the near term. But elevated inflation may limit the room for interest rates to decline rapidly.

The annual on-budget fiscal deficit target and annual quota for new special bonds

Any new forms of policy bank support, such as the 2015 special construction fund

Any new financing policy on infrastructure investment, such as the 2019 announcement on allowing local government special bonds to be used as equity

Any news or data on the pace of infrastructure investment approvals (see recent news), which could provide leading information on infrastructure investment

The interbank 7-day repo and other monetary policy tools (we expect another 150bp cut in the RRR, a 40bp cut in the MLF rate, and the DR007 average at 2.2%)