China: Government Fiscal Operations 101
Its abundantly clear that investors/journalists/observers had misplaced understanding and therefore expectations in China.
The following content contains scenes of verbal violence that will offend certain reporters and China Watchers, as well as a looooong dose of nerdy technical details related to Chinese Government Fiscal Operations. Viewer Discretion is *Strongly* Advised.
A long long time ago (maybe not that long) when I was just a young’un starting out in the industry, a senior investor sat me down for a ‘reality check’ after I pranced around the office like an idiot loudly exasperating about how certain events ‘missed’ expectations: “when reality is inconsistent with your expectations, its not that reality is below or above expectations but rather that your expectations were incorrect.”
This advice really stuck to heart and I’ve since tried (although at times unsuccessfully) to avoid using language that suggests events ‘beat’ or ‘missed’ estimates.1 Instead, I try to frame things as good or bad, and comment whether they were above or below market expectations (it is difficult to avoid recognizing that differences between market expectations and reality will result in increasingly significant and rapid repricing of securities).
Most importantly, if your job depends on you correctly setting expectations, it seems stupid to not have a robust mechanism of understanding how things work, and certainly idiotic to let news articles/media set expectations for you.2
Why am I talking about this now?
It’s been abundantly clear in the past few weeks (since 9.24 and 9.26) that too many China observers (journalists, investors, self anointed experts alike) have no idea about the basics of how Chinese fiscal budgeting works.
In general, there is a fundamental conflation of the specific mechanisms of Chinese government fiscal tools and a fundamental lack of understanding of the specific nomenclature (let alone the specific uses) of government debt. Consider the following WSJ article from the Editorial Board where they were unable to correctly use the last name of the Minister of Finance:
Seems like a low bar for journalists to at least get the names right. But if you layer this on with the lost-in-translation that frequently happens, this has resulted in a ripe case of setting mistaken expectations.
So as opposed to giving a view of how many trillions of stimulus there will be, this will be another ‘101’ post - this time about Chinese government finances. However, before I give you the facts, let me go through three key buckets of mistakes:
The “Top Leadership Doesn’t Know How Bad It Is” Theorists
The “Deflation is Good” Enthusiasts
The “NDRC is going to launch a 10 Trln RMB bazooka” Hopium Addicts
#1: The “Top Leadership Doesn’t Know How Bad It Is” Theorists
This has been a favorite theory of China Permabears. Occasionally reinforced by questionable journalism3, this theory paints a scenario where the Senior Leadership in Zhongnanhai have no understanding about the current economic woes that’s been evident since 2H2023. The favorite trope is that there is an Information Coccoon4 up top and mid level bureaucrats/apparatchiks are ‘afraid’ of providing real information for the Politburo Standing Committee.
Let’s this dismiss this once for all - they see everything. Look, if someone like me, a shitposting investor on Twitter and Substack, can get access to fairly comprehensive high frequency data of how milk and real estate are selling on a weekly basis, you should bet your entire net worth that Zhongnanhai sees everything going on in the economy. You should imagine that there is a Business Intelligence System (like that blue screen that all public companies in China will show you in their display room) that has live data of all the high frequency data you can think of from all industries consolidated into a report for senior leadership to consume.
I’ve spoken to people who have been invited to these meetings in Zhongnanhai for meetings with senior leadership5 and the feedback has been consistent that the senior leadership knows all the problems people/companies are facing. This is further confirmed by companies who submit their proprietary high frequency data to Zhongnanhai.
The correct read of the ‘slow pace of policy shift’ can originate from many legitimate reasons (economic philosophy, tolerance of pain being extremely high, or different priorities), but ‘they don’t know’ is simply not the reason.
Therefore, according to sources familiar with the matter, those who claim that senior leadership does not have access to real economic data are full of shit.
#2: The “Deflation is Good” Enthusiasts
There is another camp of China watchers (Generally China permabulls who cannot imagine bad news out of China) who claim that the current deflationary pressure in the economy is somehow good - the argument suggests that ‘things are getting cheaper’ and therefore better for low income population in China - common prosperity amirite?
Similar to the enjoyo00o0ors of Chinese products/services at an extreme value proposition when they visit Shanghai for 6 days, what this type of people do not understand/appreciate is that the source of aforementioned ‘cheapness’ is a function of low wages6 - a remnant of when financial repression was still net benefit to the Chinese economy. Put another way, further wage gains will not happen unless companies’ revenues and profits are growing. Conversely, if deflation continue to deteriorate, either companies will cut workers/wages or will cut corners on quality - neither of which are ideal outcomes.
Which brings us to the policy shift in 9.24. It was abundantly clear to those with access to high frequency data that the economy in Q2 and Q3 of 2024 started to deteriorate considerably - you can easily tell from the Q3 earnings release of Chinese companies in the past few weeks. Had there been no change in policy, the housing/consumption/economic debt/deflation loop was going to take a significant step down - and that is precisely why the policy shift happened on 9.24/9.26.7
As for the argument that “houses are now finally cheaper” - yes this has been true for 2022/2023 - as a result of house price deflation *and* wage growth from advanced manufacturing investments - affordability has improved considerably. However, to the extent that the deflationary pressures from housing and pockets of overcapacity has reached a point where its impending consumption (including home purchase intention), stimulus was a necessity to prevent a spiral.8
To be clear, dis-inflationary new technology is great and should be celebrated - but note the difference between deflation and dis-inflation. Adding disinflationary pressure on top of a deflating housing bubble without any stimulus offset is a recipe for turning cyclical deflation into a structural debt/deflation loop and economic doom. So get your mind right, deflation is not good.
#3. The “NDRC is going to launch a 10 Trln RMB bazooka” Hopium Addicts
Where do I even start with this one. First of all, the NDRC is an *execution* agency responsible for coordinating, approving, and implementing policy/projects among all the other Ministries. It has zero, I repeat, zero responsibility/authority to make any changes to the government budget.
Secondly, when there is supposedly a “10 trillion bazooka” - it helps to understand that the current problems in China today (at least relating to debt and real estate) are largely a function of the 2015 vintage of urban village demolition/shantytown renewal projects, which, itself, was a package of policies designed to counter the hangover from the 4 trillion RMB of stimulus in 2008. The logic of ‘launching a 10 trillion RMB bazooka’ to reflate the real estate sector - which just deflated at considerable cost - is beyond stupid.
However, to be crystal clear, this does not mean it there is no need for additional stimulus, nor does it mean there will not be any stimulus. It helps to be crystal clear in understanding what are the critical problems and where the shortfalls are, as well as *how* the central government is going to look to alleviate the current economic situation.9
This is what leads me to the topic of this post. In context of the upcoming NPC meeting, I’ve decided to write a short primer on Chinese Government Budget explaining to you each of the line items - so you won’t be mislead by a random Bloomberg or Reuters headline claiming there was X trillions of fiscal stimulus.
China Fiscal Operations 101 - The Four “Books”
Book #1 - “General Government Budget”
Book #2 - “General Government Fund Budget”
Book #3 - “SOE Budget”
Book #4 - “Social Security”
Book #1 - General Government Budget (~20 trillion RMB)
This is the basic government budget. Incomes are generated from Taxation Revenues & Non-Taxation Revenues (fines etc) as well as Regular/General Government Bonds (Local and Central), and supplement from Book 2 (see below). When the Two Sessions in March announces a ‘deficit of 3%’ - it explicitly refers to Book #1 bonds issuance.
Looking at Jan-Sept government revenues, it has been running about ~5% below 2024 initial government estimates and as such there is expected to be a ~1.3trln RMB deficit vs. initial budget. Expenditures from General Government Budget - such as Healthcare, Education, National Defence, Transfer payments to provinces, and Social Security (Book #4, see below) cannot be cut, and therefore, funds will need to be raised to plug this hole.
As for how? The government has sufficient room under the debt ceiling (debt that has been approved but not raised left over from previous years, yes there is such a thing) approved by the NPC as well as Reserve Funds/SOE Profit Repatriation (including PBoC operating profit) to offset the gap in 2024. As Minister Lan specifically called out, Book #1 will be balanced with all necessary spending spent.
Book 2 - “General Government Fund Budget” (Somewhere between 5-10 trln RMB)
You should consider this as ‘investment/asset-based income’. Incomes are generated from asset disposals (including land use rights, which represents some 80% of this line item). If you track this line, it has significantly deteriorated in the past years, driven by the deterioration of real estate market. Additionally, Special Purpose Bonds (Local and Central Government) are included in this line item (and *not* included in general deficit).10
In terms of expenditures, it can relate to land sale (compensation for land reclamation, infrastructure related to land sale etc) and used to supplement to Book #1. Critically, LGSPBs must be tied to a specific project or use case - and are *not* included government fiscal deficit.
An important aspect of Book #2 is that it does not need to balance - as its expenditures is driven by the income - as opposed to book 1 - where expenditures are not necessarily conditional on income.
Book #3 - SOE Budget (~300bln RMB)
This specifically refers to the SOE profits from those SOEs under the purview of the SASAC but *not* the SOEs under the purview of Ministry of Finance, which are actually included in Book #1. This is a relatively small line item at ~300-350bln RMB and therefore not a significant.
Book #4 - Social Security (Separately run, so dollars matter less for government budget)
This is relatively straight forward, incomes come from premiums contributed by those paying into the scheme (Healthcare and Retirement/Unemployment Insurance) at all levels. Administration of social security programs are done locally and driven by local income and reimbursement standards. Crucially, this book is accounted for separately and the existing asset pool is run as a pension fund.
Importantly, Book #4 income cannot be used in Book 1/2 expenditures but Book 1 budget can be used (and has been used in past years) to augment Book #4.
The above is 30 minutes of my quick work sitting on a High Speed Rail Train in China - I wrote this because it’s been extremely annoying to see reporters of reputable press use erroneous terms and confuse the f*** out of investors who aren’t as well versed on this subject matter.
If you read the above, specifically my portion on the four books and find what I wrote somewhat helpful (but also not entirely clear or somewhat confusing because you’ve not heard of it before), you *really* need to find your favorite sell side analyst and have them give you a 101 session (I am under no such obligation to provide you with anything other than what I feel is necessary). Otherwise, you really should not be opining on the upcoming fiscal stimulus measures or touching Chinese assets.
It is as stubborn/arrogant as how Capital Group internally refrains from using the word ‘performance’ and sticks to ‘results’ - but bite me.
Classic example of tail wagging the dog (in Chinese this would translate less eloquently as ‘屁股决定脑袋’ - or ‘ass driving the brain’)
‘According to sources familiar with the matter’ is only accepted in journalism it seems - if I tried to write a report like this at work I would be fired immediately unless I was clear and specific about who my sources are.
So called 信息茧房
This list isn’t as exclusive or as difficult to get as you think it is - considering many CEOs have been invited - including CEOs of Anta and Boss Zhipin.
All else equal, companies grind as much as they can out of employees - the average Chinese workers are working the hardest they’ve ever worked while making less on a per hour basis - especially in the past couple of years. That wages have grown in the past decade does not mean that wages are appropriate reflection of the work output of laborers.
This is further evidence the senior leadership in Zhongnanhai sees everything.
This is further evidence that the top leadership has absolutely crystal clear understanding of economic reality. I personally believe this so called ‘lateness’ of the pivot is a result of high tolerance for pain - after all, which other world leader in the world have lived in a cave infested with fleas?
If you don’t know where they might stimulate, I suggest you read the readout of the 3rd plenum that came out in July.
Practically speaking, the Local Government Special Purpose Bonds (‘LGSPB’) quota was set at 3.9 trln RMB for 2024. So when Reuters is out there talking about “4 trln stimulus” in 2025 - I have no idea whether the reporters are talking about LGSPB or Central Government Special Purpose Bonds (‘CGSPBs’). The LGSPB quota for 2025 is likely to be set at 4 trln or higher - so if this was supposedly the 4 trln number that Reuters quoted, it is actually *not* new fiscal policy vs. baseline and therefore moot.
im not sure if you are familiar with Matt Levine, a journalist at bloomberg, and often quoted as the king of financial blogs. one of Matt's signature is his use of footnotes.
i think if Mr. Levine read this piece he would give you a like.
Thanks for sharing this! Very informative