The influx of tourists at Luoyang Longmen grottoes this summer epitomizes the significant size of the country’s domestic market. Photo: Weng Rong/CSST

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This far in 2023, China’s economy has exhibited signs of recovery and improvement, demonstrating robust resilience and vitality. However, at the same time, with external demand continuing to rapidly decline, the domestic economy has faced inadequate overall demand within specific timeframes. This situation necessitates fostering a strong synergy between investment and consumption to expand domestic demand.

 

Room for bigger domestic demand

First, China’s consumption structure still has considerable potential for improvement, particularly as its per capita GDP exceeded $10,000 in 2019, marking an important milestone in China’s transition to a post-industrial era. When we look at the development experiences of advanced industrialized countries like the US, Germany, Japan, and South Korea, we see that during the transition to a post-industrial economy, a country’s consumption structure is commonly upgraded. China’s current urban household consumption expenditure structure is roughly comparable to the levels in Japan and South Korea in the 1970s and 1980s, indicating considerable room for consumption upgrades. Specifically, there is room for the widespread adoption and upgrading of consumer goods like automobiles, where China lags behind developed countries. In addition, urban-rural consumption disparities are still prevalent. 

Furthermore, the growth in high-end service consumption, encompassing “science, education, culture, and healthcare,” has been relatively sluggish, primarily due to inadequate effective supply in these areas. By increasing investment in these and other high-end consumption sectors to stimulate demand while continuing to promote market-oriented reforms in high-end service industries to enhance industry efficiency can unlock a vast space for Chinese residents in discretionary and high-end service consumption areas.

Second, China’s urbanization process is still in an intermediate stage, with significant potential for both incremental and stock improvement.

Since the beginning of the reform and opening-up, China’s rapid economic growth has been closely linked to industrialization and urbanization. This process has not only driven significant investments in infrastructure and real estate but has also improved the consumption patterns of urban residents, resulting in the emergence of new industries such as housing, automobiles, leisure, and tourism. However, when compared with major Western countries, China’s urbanization rate still lags behind, indicating the necessity to continue unleashing domestic demand through a new phase of urbanization.

Meanwhile, advancing the equalization of basic public services, with hukou (household registration) system reform as a representative measure, can help sustainably unlock a substantial amount of demand on the basis of existing urbanization efforts.

Third, a high savings rate serves as the foundation for maintaining effective investment. Investment has played a critical role throughout China’s economic development, and the basis for sustaining China’s high investment rate is its elevated savings rate. Improving the efficiency of capital allocation will be an effective approach to addressing the declining capacity of capital supply in China. In the medium to long term, comprehensive reforms of the financial system and enhancements to the financing structure, primarily through indirect financing, are necessary. In the short term, proactive measures should be taken to enhance the ability of financial institutions to serve the real economy and further improve investment conversion efficiency.

On one hand, this involves enhancing the existing multi-tiered capital market and promoting greater openness to attract more overseas long-term capital. On the other, it entails continuing to leverage the active role of commercial banks and development banks. This involves enhancing the integrated investment and financing service capabilities of commercial banks, guiding them to provide support to cooperating enterprises through diversified service means. Development banks should support major infrastructure projects and promptly supply policy-based medium to long-term credit, mobilizing additional investment from the private sector to create a leverage effect.

Fourth, high-quality financial openness provides new support for domestic capital stock. Theoretical research suggests that international capital tends to flow to countries and regions with higher productivity. Since 2018, China’s financial regulatory authorities have steadily promoted the opening of the financial sector, including relaxing market access conditions and promoting two-way opening of financial markets through high standards and various channels. Looking ahead, as capital and financial accounts continue to liberalize, the net inflow of foreign direct investment is expected to stabilize, and debt and equity investments are also expected to shift from net outflows to net inflows.

In the context of China’s declining savings rate due to an aging population, the continuous and stable inflow of foreign funds will provide new support for domestic capital stock. In the medium to long term, due to its higher economic growth rate, China’s natural interest rate (the long-term level and trend of the real interest rate determined by economic fundamentals) is expected to remain significantly higher than that of major economies, including the US.

Fifth, there is ample room for macroeconomic policy. The Chinese government maintains sufficient flexibility in its policy framework, which provides a favorable policy environment for achieving stable economic growth. Regarding monetary policy, the weighted average reserve requirement ratio for Chinese financial institutions is approximately 7.4%, suggesting there is room for further reserve requirement ratio reductions. The persistently low price levels resulting from insufficient consumption momentum and slowed income growth imply that the current real interest rates are relatively high, allowing for potential policy space for further interest rate cuts.

In terms of fiscal policy, the debt level of the central government in China remains relatively low. Under the theoretical assumption of international balance of payments, government sectors provide base money through its own deficit spending, which is then transformed into net income for the domestic private sector. China can leverage its fiscal policy space by conservatively increasing the issuance government bonds while simultaneously reducing the debt levels of local governments.

 

Domestic-oriented macroeconomic reforms 

On one hand, the focus should be on stimulating domestic demand and expediting macroeconomic control reforms. In the face of the emerging trend of deglobalization and weakening external demand, China should prioritize the domestic circulation, aiming to boost domestic demand and promote domestic economic integration.

To begin with, net exports should be gradually replaced with domestic fiscal deficits and foreign exchange reserves replaced with the issuance of government bonds, establishing new channels for currency issuance. Since the implementation of the mandatory foreign exchange settlement and sale system in 1994, foreign exchange reserves have been the main source of base currency for China’s central bank for a long time. Going forward, China should provide base currency through central government deficit spending to firmly ensure monetary sovereignty. 

In this context, the government can support the improvement of people’s livelihoods and enhance social security, thereby promoting increased consumer spending. Additionally, by allocating funds towards independent innovation and new infrastructure projects, the government can reduce investment risks for the private sector and increase their investment returns, thereby stimulating investment enthusiasm.

Next, we need to fundamentally change China’s export-oriented economic development model. By encouraging the development of high-end industries domestically and reducing export tax rebates, China can reposition itself in the international division of labor away from the lower end of the industrial chain. The resulting gradual reduction of the current account surplus will usher in a new phase in foreign trade, achieving trade balance or even a slight deficit.

Meanwhile, it is essential to enhance the internationalization of the Renminbi and actively promote its use for trade and pricing in international transactions. This can serve as a means to increase the supply of the national credit currency to the global market in exchange for real economic resources and boost the net income of domestic residents.

Last but not least, it’s important to establish a robust domestic circulation and achieve the integration of the domestic economy. While fiscal deficits play a crucial role in monetary issuance mechanism reform, it is even more critical for a large developing country like China to prioritize the exploration of the vast potential within the domestic market. This entails creating a cycle of cumulative profits for businesses and income for workers, fostering regional cooperation and specialization, and establishing a symbiotic relationship between urban and rural markets within the framework of domestic economic integration. 

On the other hand, fiscal policy should be more expansionary, and monetary policy should prioritize lowering real interest rates. These measures are crucial in the short term to address the issue of insufficient demand. Regarding fiscal policy, there should be a shift from income-focused policies such as tax cuts and fee reductions to expenditure-side policies like consumer subsidies and government investment. For example, implementing nationwide distribution of consumption vouchers can effectively stimulate consumption while addressing the problem of overproduction. This approach also helps avoid a passive situation in which household savings increase through direct cash transfers. Additionally, policy-driven financial loans should be directed towards low-yield public infrastructure investments to support new urbanization.

Regarding monetary policy, lowering real interest rates to reduce medium to long-term interest rates and risk premiums is essential. This can be achieved by various means, including reducing the cost of funds and increasing asset valuations to promote credit expansion. This, in turn, can improve cash flow conditions through the efforts of market participants, ultimately providing strong support for consumption and investment.

  

Fei Zhaoqi is a research fellow at the Institute of Finance and Banking at CASS. Gu Danyang is a doctoral student at the School of Applied Economics at the University of Chinese Academy of Social Sciences. 

Edited by WENG RONG