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