Will China’s surprise stimulus work?

Start with the hope. China went for a triple boost last week: cuts to interest rates and other easing, loans to investors and to companies to buy back their stock, and a promise of something “fiscal" in yet-to-be-defined size.

Investors loved the idea of central bank support for share buying, not surprisingly. No need to rely on the “national team" of state-directed buyers that stepped in after the 2015 bubble popped if the central bank will support prices directly.

But it was the politburo’s use of the word “fiscal," and its surprise decision to focus its September meeting on the economy, that really fired up the hopes. If China starts doling out trillion-yuan ($140 billion) stimulus here and there, could it get the economy out of its housing-induced slowdown?

The parallel for investors is 2008, when China was the first to launch massive stimulus in response to the global financial crisis. It worked, and investors remember. But the stimulus also left China with a legacy of huge local government debt, overcapacity and excess housing, worsened by the country’s subsequent failure to shift from state-directed investment to household consumption.

The last stimulus mattered hugely to investors outside China too, as the country sucked in resources for its infrastructure binge and helped support global demand. Smaller stimulus means it almost certainly won’t have such a grandiose effect this time (though copper and other industrial metals had a very good week). If it turns out to be really big, it will be a bane rather than a boon: China has been exporting deflation, and turning that into a source of global inflation would be unhelpful for the rest of the world.

We still don’t know exactly what China will do. What it needs are three things, only one of which it has addressed, and in a weird way, so far:

Change sentiment. Chinese consumers and investors have been in a dismal mood since the housing bubble began to deflate. Before the People’s Bank of China announced its rate cuts and stock-support program, shares were trading at just over 10 times estimates of earnings over the next 12 months—the biggest discount to the S&P 500 in data back to 2010.

Such cheapness helps explain why the new policy and politburo comments led to such an extraordinary gain, with the CSI 300 index of the largest companies up 15.7% in the week. After all, even the most bullish economists don’t expect support on the scale of November 2008—when the weekly gain was 15.8%.

Clearly investor sentiment changed. It isn’t obvious that this will feed through into household willingness to borrow and spend, though. Chinese households have much less invested in the stock market than Americans, and rely instead on housing and cash savings. To the extent that the market is a signal of wider sentiment, even more manipulation by the government could make its information even less useful. 

On the other hand, pushing it up certainly makes investors wealthier, and that will make them, at least, feel better.

Switch to consumption. China can’t avoid a Japan-style balance-sheet recession and the resulting deflation by doubling down on infrastructure investment, housebuilding and exports. Centrally directed investment has left China with savings rates that are far too high, too many half-built homes and too much reliance on exports.

The result has been terrible returns on investment in sectors the state encouraged, such as clean energy and electric vehicles, a shift to exports to try to deal with overcapacity and so more tensions with major trading partners.

If President Xi Jinping directs fiscal support to consumers, perhaps by bolstering the puny welfare net, it might both reduce their very high savings rates and make them feel better.

Boost productivity. The hardest thing for the government to do is to stop meddling, but it need only look at what’s happened to the economy in the past decade to see why it needs to get out the way. Total factor productivity, which measures how effectively capital, workers and land are put together, has been decelerating since 2010. The obvious reason is that Xi’s autocratic rule has centralized power even more, directing bank loans and capital to favored sectors and state-owned enterprises—and as a result starving more dynamic businesses of resources.

The hope visible in the stock market could last a while as fiscal stimulus details emerge. Stocks are still only just above where they stood in May. There might even be some effort to support consumption, which, while long promised, could start the much-needed rebalancing of the economy.

But it is hard to believe that Xi will be willing to restart the reform program he nixed in favor of what he called “common prosperity"—most visible as a crackdown on the private sector and wealthy elites.

Getting out of the deflationary hole China dug itself is vital, and in the short run all stimulus will help. But for the long term, the form state support takes matters. China needs to stop digging and start consuming.