As the COVID-19 pandemic swept the world, it took a heavy toll on human lives and economic activity. China’s GDP fell 6.8% year on year in the first quarter of 2020. In a timely response, the Chinese central government proposed to strengthen the adjustment of macroeconomic policy and to implement and pursue a more proactive fiscal policy.
China’s fiscal deficit ratio in recent years has been significantly higher than in previous years, closing at the technical “red line” of 3%. The question of whether China’s current fiscal policy still has room to maneuver and whether it needs to stick to the 3% deficit-to-GDP ratio are intertwined with the effectiveness of the prevention and control of the epidemic and the promotion of socioeconomic development.
Since the global financial crisis in 2008, various economies have entered into a cycle of decline or recession. In recent years, China’s economy has undergone a phase of structural adjustment and transformation of its mode of economic development, so both the actual and potential economic growth are in a downward trend.
In particular, due to the continuous escalation of China-US trade friction, China is faced with increasing uncertainty in trade policy, which impacts economic development. This year, the COVID-19 pandemic has caused a simultaneous shock on the sides of both supply and demand, further exacerbating the risk of downward trends in the economy.
Against this backdrop, many economists are pessimistic about China’s economic growth in 2020, and they have dialed down their annual growth forecasts. The gloomiest of these forecasts is given by Bloomberg economists, at 1.4%. The Asian Development Bank and the World Bank both see growth of 2.3% in 2020. Chinese economist Justin Yifu Lin said a growth rate of 3% to 4% in 2020 would be a good outcome. Liu Wei, an economist and president of Renmin University of China, believed that without further policy stimulus, China’s natural economic growth rate would fall below 4% in 2020. Chinese economist Xu Qiyuan and others forecast a result of 3–3.5%, Standard Chartered Bank 4%, Cao Heping 4–5.5%, and Nomura 4.8%.
As we can see, it is widely presumed that China’s economic growth rate in 2020 will be seriously hampered by the epidemic and will decline significantly compared with that in 2019.
Policy adjustment, 3% fiscal deficit
In recent years, China’s fiscal deficit ratio has lingered between 2% and 3%. In 2016 and 2017, it hit 3%, and it dipped somewhat in 2018 and 2019, though still at the high levels of 2.6% and 2.8%.
In this light, under the premise of continuing to implement various tax and fee reduction policies, whether there is room for fiscal policy to become more proactive and whether the fiscal deficit-to-GDP ratio can be further pushed and exceed 3% have become the focus of debate among academics and policymakers.
One question is particularly important: Is the fiscal deficit ratio of 3% scientific? The fiscal deficit ratio of 3% first appeared in the European Union’s Maastricht Treaty, which came into force in November 1993. The treaty clearly defines two criteria and reference values with which member states should comply: a deficit to GDP ratio of 3% and a debt to GDP ratio of 60%.
Since then, the fiscal deficit ratio of 3% has been regarded as one of the basic fiscal rules by the international community, and also as an unbreakable “red line” by policymakers and economists. However, though this warning line is widely adopted and applied, its scientific nature appears to be difficult to verify.
The practice of fiscal regulation in EU member states after the 2008 financial crisis exposed that this fiscal rule has great limitations. Though the EU has been revising and improving its fiscal rules in recent years, it is difficult to strike a balance between fiscal regulation and fiscal effectiveness.
As a result, these rules do not accurately reflect a country’s actual fiscal risks. Generally speaking, too high of a fiscal deficit ratio signals high fiscal risk. However, we cannot look at this 3% standard rigidly, rather it should be examined based on circumstances.
The global financial crisis in 2008 hit all economies across the globe to varying degrees, and governments resorted to fiscal and monetary policies for counter-cyclical adjustment to cope with the economic downturn. Consequently, since 2008, the fiscal deficit ratio of all countries has exceeded 3%.
According to the International Monetary Fund and the World Bank, between 2008 and 2017, the deficit-to-GDP ratio of the United States and Japan averaged at 6.5% and 6.8%, respectively. The BRICS countries, India, Brazil and South Africa, had an average deficit to GDP ratio of 7.9%, 4.8% and 4.1%, respectively. EU member states also registered a fiscal deficit ratio above the warning line of 3%. Greece and Ireland have been running deficits of more than 10% for years. Portugal and Spain have not yet exceeded 10%, but they have also risen to 8%. France’s deficit-to-GDP ratio is above 5%. Germany had the lowest average deficit ratio in the past decade, but it also topped 3% twice in 2009 and 2010.
It can be seen that during or after the crisis, the fiscal deficit ratio of many countries has exceeded the red line of 3%, even going far beyond it.
In order to make its fiscal policy more proactive, China might also consider crossing the fiscal deficit-to-GDP ratio limit of 3%.
As the world’s second largest economy and a major developing country with a per capita GDP of more than $10,000, China’s economic positioning has not changed, meaning that the pursuit of economic growth and high-quality development is still the top priority. Therefore, the fiscal policy should be proactive, to effectively mitigate the adverse impact of the pandemic on the demand and supply sides through its transmission mechanism.
The COVID-19 outbreak has had a worse impact on China’s economy than the 2008 financial crisis, with both weak external demand and sluggish domestic demand. Hence, it is better to make timely use of the discretionary nature of fiscal policy than to blindly abide by the 3% deficit-to-GDP ratio rule. International experience has already explored its feasibility.
China’s fiscal policy has always been anchored by fiscal balance, but such a balance should be a dynamic one, and the key is fiscal sustainability. China’s deficit-to-GDP ratio has been low and stable all year round, within the range of fiscal sustainability.
Moreover, there is still room for China’s potential economic growth. To get the actual economic growth back to the level of potential economic growth is an important goal for the healthy and rapid development of China’s economy. Only by maintaining the healthy and rapid development of the economy can the fiscal revenue be guaranteed, which in turn benefits the dynamic fiscal balance.
To this end, if we worry too much about deficits and miss the window to ease the downturn pressure, we might not only see a sharp downturn but also put fiscal sustainability at a greater risk.
Amidst the China-US trade friction, many micro-entities, especially private enterprises, are pessimistic about the prospects of China’s economic development, and some enterprises have even started planning to shift or are already shifting their production lines and industrial chains. Under such circumstances, it is difficult to ensure stable employment.
At the same time, the impact of this pandemic has made it extremely difficult to stabilize market expectations. At this point, the primary task of stabilizing expectations is to ensure growth, otherwise a vicious cycle will form. Therefore, raising the deficit ratio has become urgent.
In the economic downturn stage, government income tax revenue decreases while social security expenditure increases, which inevitably leads to a surge in the deficit-to-GDP ratio. However, the deficit is cyclical and will disappear automatically as the economy returns to normal. In recent years, China’s fiscal deficit-to-GDP ratio has been close to 3%, but its structural deficit ratio has not been very high. Therefore, breaking through the 3% fiscal deficit ratio can also be regarded as a policy tool for cyclical adjustment.
Suggestions for proactive fiscal policy
It is worth noting that there are rules to follow in the process of increasing fiscal deficit and expanding fiscal expenditure.
Given the impact of the pandemic on both supply and demand, the government needs to appropriately balance its financial resources to encourage consumer demand while increasing investment in infrastructure, including both traditional and new projects.
At the same time, there is no standard in terms of how much the fiscal deficit-to-GDP ratio should be boosted, which depends on the investment of fiscal funds, target of regulation and multiplier of fiscal expenditure under the impact of the pandemic. According to China’s structural budget gap index in recent years, 3.5–4% would be an acceptable range for the fiscal deficit ratio.
Second, it is necessary to properly increase the issuance of national debt and improve the term structure of national debt.
Third, we should make good use of the expected transmission mechanism of fiscal policy and monetary policy, help small and medium-sized enterprises resume work and production, and help them ride out difficulties, so as to achieve twice the results with half the effort.
Lastly, it is imperative to raise the fiscal deficit to prevent a sharp economic downturn, but that does not mean there is no risk. Facing the COVID-19 pandemic, we should pay attention to the monetary effect of fiscal funds as well as the policy and financial risks triggered by the flow of fiscal funds or the expansion of local government debts.
Wang Liyong is vice president and a professor of the School of International Trade and Economics at Central University of Finance and Economics.