China Stimulus: It Isn't Enough

What's next after China's stimulus?

Dear readers,

This article was initially written for a Dutch magazine on investing. I thought it would be a nice read for you guys as well. Below you can find a quick overview of the China stimulus and what needs to happen next to reignite the Chinese economy (and its stocks).

Introduction

Since early October, all eyes have been on China—not only due to its recent economic stimulus measures (which we’ll explore shortly) but also because of China’s significant impact on many European businesses.

This effect was evident over the past week, with companies like ASML and LVMH reporting relatively weak results, partly due to underperformance in the Chinese market. LVMH, for instance, saw a 16% drop in revenue in Asia, primarily driven by a sharp decline in demand from China. Conversely, sales in Japan rose by 20%. Looking at LVMH’s guidance, it appears they do not anticipate an immediate recovery in the fourth quarter, which is unsurprising given that the measures from the People's Bank of China (PBoC) have had little to no impact on consumers.

Let’s delve deeper into this in the following sections.

China’s Economic Stimulus: What Did It Entail?

Alongside the PBoC, the Chinese Communist Party (CCP) has also confirmed that it will take steps to reignite China’s economy—a necessary move to secure their 2024 growth target of 5%. However, China’s biggest challenge remains the structural issues within its real estate market. Additionally, there is an alarming youth unemployment rate, with 18.8% of 16-24-year-olds not studying or working, a result of both economic stagnation and restrictive labor laws.

So, what exactly did these measures involve?

Monetary Easing: Similar to the United States and Europe, the PBoC has reduced interest rates and lowered the Reserve Requirement Ratio (RRR), which is the percentage of deposits that banks must hold as reserves rather than lending out. By lowering the RRR, banks can lend more, thus injecting more capital into the financial system, ideally stimulating economic activity. This reduction of 50 basis points (0.50%) represents a liquidity injection of 1 trillion RMB, or approximately $137 billion.

The PBoC also reduced the short-term policy rate, another step intended to increase liquidity. By lowering this rate, banks can borrow from the PBoC at a lower cost, which again increases liquidity.

In addition, interest rates on both business and consumer loans have been lowered. The deposit rate, or interest paid on savings, has also been reduced, encouraging consumers to spend rather than save, which should boost consumption.

Although the stock market initially surged after these monetary and fiscal stimulus announcements, many stocks quickly declined as the Chinese government remained hesitant about further stimulus measures. Nonetheless, this initial stimulus has positively shifted market sentiment, which is a promising first step for Chinese stocks. In response, large institutional investors have closed some short positions.

What Needs to Happen Next?

In simple terms, further stimulus will be necessary to revive the economy. We observed an immediate sell-off in Chinese equities as no additional measures were announced two weeks after the initial stimulus.

The primary challenge is that both monetary and fiscal support will be required to rejuvenate the Chinese economy, with a strong emphasis on bolstering middle-class consumer spending.

An ideal scenario for the Chinese government would be to leverage the so-called "wealth effect," a concept from behavioral finance that suggests people tend to spend more as the value of their assets rises. Investopedia explains it as follows:

“The wealth effect is a concept from behavioral finance that suggests people spend more as the value of their assets increases. The idea is that consumers feel more financially secure and confident about their wealth when the value of their homes or investment portfolios rises. They feel richer, even if their income and expenses remain the same as before.”

In essence, this would mean encouraging the Chinese public to invest in the stock market, subsequently driving stock prices up through monetary and fiscal stimulus. This approach could potentially uplift the entire middle class. However, implementing this concept is easier said than done. For instance, look at the substantial savings held by the Belgian population—convincing people to invest their savings isn’t straightforward.

Of course, the wealth effect is a logical theory. People do, in fact, feel wealthier as the value of their stock portfolios or real estate increases, which can lead them to spend more. However, therein lies the issue: the real estate problem in China is enormous. This problem initially surfaced with issues (and later the bankruptcy of) Evergrande, once the largest real estate developer in China, though the underlying issues had been brewing for some time.

Conclusion

China’s recent economic stimulus measures, including interest rate cuts and reduced reserve requirements for banks, have so far had limited impact on consumer spending and economic growth. While the stock market initially surged, it quickly corrected.

European companies like ASML and LVMH have reported weak results, partly due to reduced demand in China. Despite efforts by the PBoC and CCP to stimulate the economy and achieve a 5% growth target in 2024, structural challenges like the real estate crisis and high youth unemployment persist.

Further monetary and fiscal stimulus is essential, with a focus on increasing consumer spending. Leveraging the wealth effect could be a potential pathway to achieve sustainable economic growth.