China – Fantastical fiscal fireworks

　　·Apparent massive boost to spending in Q4 will be limited in reality
 　　·We see reasons for more downward pressure on interbank interest rates in Q4, given lack of RRR hikes
 　　·Gradual monetary loosening in Q4 should support growth after Chinese New Year in late January
 　　The Ministry of Finance (MoF) likes to see out the end of the year with fantastical fiscal fireworks. Boom! Whoosh! Ka-bang! That will likely be the sound of the MoF's official spending figures in its supplementary budget for Q4-2011. The talk will be of a big fiscal stimulus to the economy and more liquidity on the banks' books - a storyline which will fit with more substantial evidence of monetary loosening. (We look for more generous monthly loan growth of CNY 600bn+ in the final months of the year.) However, it would be wrong to imagine that the MoF is providing an immediate boost to growth. The effects will be positive, but they will not be immediate or out of the ordinary.
 　　The MoF is likely to "spend" an eye-watering CNY 4-4.5trn in Q4-2011. Such a figure will be necessary to ensure that the consolidated government budget deficit gets close to the official CNY 900bn target. Full-year spending for 2011 is therefore likely to exceed the original budget by about 19%. As usual at this time of year, the MoF will likely ask the National People's Congress (NPC) Standing Committee to quietly sign off on a new budget, to allow it to spend more.
 　　This is the result of two things: first, the MoF's slightly bizarre practice of consistently underestimating revenue growth at the start of each year (it estimated 8% growth this year, despite years of evidence that revenue grows faster than the overall economy); and second, official revenue growth of some 25% y/y this year, which exceeded more reasonable forecasts. So not only does end-of-year spending need to catch up with the official budget (which would mean CNY 3trn of spending in Q4), but it needs to exceed it (another CNY 1-1.5trn). If this interim budget was not passed and spending was not boosted, we would likely end the year with a CNY 650bn budget surplus rather than a CNY 900bn deficit. Targets have to be met, after all. An alternative to all of this would be to boost the Budget Stabilisation Fund (BSF), an idea we explore below. Chart 1 shows revenue and spending growth, including estimates for Q4; the implied acceleration in spending growth in Q4 is clear.
 　　
 　　This picture of a government swimming in excess cash may be mildly disorienting for the casual China observer. Mass indebtedness is the usual caricature of the government balance sheet, but as we explained recently, there are important boulders of fiscal support offsetting the terrible indebtedness of local governments (see Special Report, 18 July 2011, "China - Solving the local government debt problem"). We have also previously explained the slightly byzantine organisation of the budget and the MoF's Single Treasury Account (STA), which may be worth another look in order to gain a fuller picture of what we are discussing today (On the Ground, 13 January 2011, "China - Sorting out the country's biggest bank account").
 　　In short, in Q4, budgetary funds should be released from the MoF's STA (which in theory encompasses all government accounts, both central and local), and paid to those who have done work for the government or used to finance new purchases. It is still not entirely clear how the government gets away with paying 20% of its bills in December each year (and 40% in Q4), but that is a puzzle for another day. (We suspect, for instance, that most expenses - office furniture, cars, study sessions in Hawaii, etc. - are paid for in December, a bumper time for merchants to hike prices and take local officials out for karaoke.) Because this is the practice every year, we do not expect it to provide a significant fiscal boost to the economy, though it does appear to be mildly stimulative. Chart 2 shows our estimate of China's "fiscal impulse", which measures the impact of shifts in the budget on GDP growth.
 　　Chart 2 shows the fiscal stimulus in late 2008 and early 2009 (though most of it came through the banks), the subsequent withdrawal of that stimulus, and the basically neutral position the MoF has adopted since then. (The fiscal impulse has a lagged effect on real activity.) When MoF officials talk about "proactive fiscal policy", they seem to mean changing what the government spends its money on, rather than its overall macroeconomic impact. In other words, less concrete and more education and health spending. (The problem with this argument is that most of the government's concrete-laying activities are carried out off-balance sheet and are financed by the banks.)
 　　
 　　An alternative to spending all these funds - which is a hugely inefficient way of running the budget of an economic giant - would be to place excess cash in the BSF. This fund was established a few years ago to smooth year-to-year budgets but is still very small, absorbing only CNY 150-200bn of excess revenues each year. If (and it is a big if) the BSF could be enlarged to absorb, say, CNY 1trn this year, a large chunk of the rushed spending could be avoided and instead used to offset fiscal pressures in what is likely to be a much tougher 2012. We thoroughly support the idea of expanding the BSF, but we do not know if it is under consideration. (We outlined other fiscal reform ideas in our January 2011 note.)
 　　Assuming the year-end fiscal fireworks go ahead as usual, a second effect will be that the funds are deposited in commercial bank accounts. In theory, the banks can lend these funds - and this has gotten some people excited. Suddenly the banks will be able to lend again, they argue.
 　　However, we note that the main constraint on most big banks' lending is the loan quota (for some smaller banks, it is their capital adequacy and loan-to-deposit ratios). In this context, the market will closely watch loan growth numbers for Q4 (CNY 600bn+ a month would be positive) and listen for any talk of a bigger 2012 loan quota.
 　　The commonly perceived impact of the "release" of the fiscal funds on interbank interest rates is to push rates down. We should not take this for granted, though. Overall liquidity conditions will depend upon the PBoC's other open-market operations (bill issuance and repo operations), as well as other deposit growth (which require the banks to pay required reserves back to the PBoC). In previous years, the fiscal outflow in December often did not end up increasing the banks' excess reserves (which in turn pushes down interbank rates). In our view, this makes a reserve requirement ratio (RRR) cut more likely than not before the year-end - the MoF funds may not do enough for liquidity. Pressure for a RRR cut will be even greater before the end of January, given strong loan demand in the month and the fact that Chinese New Year falls in late January. In the run-up to the holiday, there is always a big liquidity squeeze.
 　　We expect official loan CNY growth of CNY 8.5-9trn in 2012. This is a big number, but our inflation outlook is benign, the informal financial sector will be deleveraging, and policy makers will want to boost growth from Q2-2011 onwards (see On the Ground, 25 October 2011, "China - Forecast revisions, 2012-13"). Local government investment vehicles will need financing, projects will need to be re-started, and the banks are still the only real source of financing.
 　　Against this generally constructive backdrop, the official manufacturing PMI slipping below 50 is still a risk in Q4 - and presents an opportunity for the market to panic. But as official policy becomes more supportive, this should be enough to turn China sentiment. Fiscal fireworks should help to improve sentiment, even if the reality is closer to a whimper than a Whoosh!