China's quest for balanced stimulus

Reining in debt expansion remains a priority alongside buttressing economic growth.
Group Research, Nathan Chow, Duncan Tan01 Mar 2023
  • Modest fiscal expansion expected at NPC alongside debt management focus
  • Local government finances are strained as interest costs surge when debt jumps
  • Central transfers and policy bank supports should help alleviate municipal stresses
  • 2023 bond supply could be less easily absorbed - Expect steepening pressures
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Modest fiscal expansion

Calibrating the right amount of stimulus requires a delicate balancing act to cement growth without exacerbating debt risks. The conjunction of weakening global growth, lingering impacts from years-long regulatory crackdowns, and uncertainty over the sustainability of domestic demand recovery necessitate further stimulus to meet the growth targets. However, unrestrained deficit spending could accelerate the rise of debt piles. Over-stimulation may also lead to high inflation, asset bubbles and wastage of resources. The challenges ahead remain abound.

As such, at next week's National People's Congress meeting, policymakers will likely opt for a modest boost in stimulus by raising the 2023 fiscal deficit target to around 3% of GDP from 2.8% last year. And they will likely do so under the prevailing thesis of fiscal prudence, particularly at the local government level where debt has jumped most drastically.

Municipal finances were particularly strained last year primarily due to falling land sales (previously a key source of local government income) and sizable tax/fee reductions to businesses during the pandemic years. Local revenue, which would have risen 5.9%yoy absent the tax rebates, fell 2.1% in FY22. Rising expenditure caused local debt to surge 15%yoy to RMB35tn.

Debt servicing costs have skyrocketed following record-high special bond issuance. Interest payments on them alone reached RMB634bn in 2022, equivalent to a hefty 6% of total spending under the government fund budget. Mandatory fiscal consolidation would be triggered should this ratio exceeds 10%, crimping local authorities’ capacity to sustain economic expansion through countercyclical measures.

Hence, reining in debt expansion remains a priority alongside buttressing economic growth. The Central Economic Work Conference in December highlighted the urgency to rescue beleaguered municipal finances by maintaining fiscal sustainability via risk-controls. In our view, keeping special bond issuance quotas steady and using more of them for rolling over maturing bonds is a wise short-term strategy. A credible long-term plan is warranted for the staggering RMB15tn in local bonds (about 40% of outstanding debt) maturing over the next five years.

Central government is likely to shoulder more responsibility to stimulate growth given its substantially lower debt level relative to other major economies. This includes increasing fiscal transfers to localities in order to compensate for lost land sales revenue. Likewise, the PBOC can raise the lending limit for policy financialinstruments to finance infrastructure projects through policy banks.

This balanced approach should safeguard fiscal impetus without significantly worsening municipal finance. Such pragmatism should reinforce market confidence in China’s outlook.

Bear-steepening curve

Based on our expected 3% fiscal deficit target, we project net 2023 issuances of central and ordinary local government debt to be RMB3000bn and RMB800bn respectively. The larger YoY increase and greater reliance on central government financing are due to the strained state of local government finances and relatively lower debt ratios of the central government. On special local government bond issuance, we expect quota to be kept unchanged at RMB3650bn. Net issuances would thus add up to RMB7450bn in 2023, representing a 1.5% increase over 2022.

2023 bond supply could be less easily absorbed, primarily due to the context around liquidity conditions and growth. For much of last year, because of the economic impact of the zero COVID policy, liquidity conditions were kept exceptionally loose (as seen by DR007 staying substantially lower than the OMO rate). The deterioration in the growth outlook also drove bond yields to trend lower.

But this year is entirely different. Liquidity conditions are tight and as seen in the profile of daily OMOs, PBOC appears to want to avoid excessively injecting liquidity. The chances of incremental monetary easing, in the form of OMO/MLF rate cuts or liquidity easing, are expected to be lower. Therefore, we expect some bear-steepening curve pressures from issuances.

If we get announcements of further easing and more support for the property sector (a weak spot in the recovery), it could drive the next leg higher in CNY rates. In that scenario, we think some of the recent market scepticism around the breadth and durability of the recovery would unwind.

To read the full report, click here to Download the PDF.  


Nathan Chow 周洪禮

Senior Economist and Strategist - China & Hong Kong 高級經濟學家及策略師 - 中國及香港

Duncan Tan

Rates Strategist - Asia

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