Zhang Ming: Changes in the external situation and China's response strategy

The author Zhang Ming is the Vice President of the Finance Research Institute of the Chinese Academy of Social Sciences, Deputy Director of the National Finance and Development Laboratory, and a member of the China Chief Economist Forum. This article is the outline of the speech given at the annual meeting of the China Chief Economist Forum for 2025 held on January 4th. I. Changes in the External Situation 1. In the next two years, the risk of major geopolitical conflicts breaking out globally is expected to ease. The Trump administration is more focused on short-term practical interests with a businessman's style, and does not pay much attention to ideological issues. It is expected that the conflict between Russia and Ukraine could end as early as this year, combined with Trump's simultaneous pressure on European alliance countries. Therefore, there is a window of opportunity for China to speed up the restoration of relations with European countries in the near future. Tensions in regions such as the Middle East and the Taiwan Strait may also ease. However, if the Democratic Party wins the midterm elections in the US Congress in two years, there may be changes in Trump's foreign policy style. 2. In the next two years, further intensification of the US-China trade war is a high probability event, but Trump's imposition of tariffs will not be all at once. Trump's trade policy style is largely determined by his adviser, Lighthizer, who does not hold a key position in Trump's second term. Lighthizer's style is to simultaneously pressurize all countries with trade surpluses with the US, using tariffs as a bargaining chip to force concessions in trade and other areas, and imposing all tariffs at once will reduce the bargaining power. Therefore, it is expected that by 2025, the Trump administration will either impose a 10-20% tariff on all Chinese goods to the US, or choose specific goods and directly increase tariffs to 60%. Subsequently, the Trump administration will evaluate the impact of this round of tariffs on US import costs, inflation, and the standard of living for middle and low-income households, and then decide on the next steps based on the response from the other side. A new round of tariffs is expected to occur at the intersection of the second and third quarters of this year. 3. The fragmentation and aggregation trend of the global industrial chain and supply chain will intensify. 4. Trump 2.0's impact will significantly increase inflation expectations, reduce the magnitude and pace of interest rate cuts by the Federal Reserve, and lead to the continuous consolidation of the US dollar interest rates and exchange rates at high levels. This may have the following effects: first, increased volatility in the US stock market in 2025; second, a moderate decline in global commodity prices in two-way fluctuations; third, continued pressure on capital flows and exchange rates in emerging market countries. II. Effects on China 1. Export growth will be under pressure, and the trade surplus will decline. Due to the potential occurrence of a new round of tariffs in the second and third quarters of this year, there is still a window of opportunity for export and import competition in the first quarter of this year. In addition, since Trump's tariffs will not be imposed all at once, the pressure on China's export growth in 2025 is still manageable. However, on the flip side, Chinese export enterprises' ability to bear additional tariffs of over 20% has become quite limited. They will have to increase the speed of exports, reduce prices for promotions, and shift exports to domestic sales, but each decision will face new problems and challenges. 2. Capital flows will be under pressure. On one hand, influenced by the US-China rivalry and the fragmentation and aggregation trend of the global industrial chain and supply chain, the scale of foreign direct investment (FDI) inflows is limited, and to alleviate the pressure of US tariffs, Chinese companies are accelerating their overseas investment. In the future, there may be a continued deficit in direct investment; on the other hand, the prices of US stocks, US bonds, Bitcoin, and gold are currently booming, and there may be net outflows in Chinese securities investments. Currently, domestic financing costs in China are lower than overseas, and other investment outflows may rise. 3. The pressure on the RMB exchange rate. Firstly, the current depreciation of the RMB against the US dollar is not because the RMB is weak, but because the US dollar is too strong. Secondly, a weakening of the international balance of payments may lead to greater pressure for the RMB to depreciate against the US dollar. Thirdly, the most important factor in determining bilateral exchange rates is not interest differentials, but relative economic growth expectations (nominal GDP growth rate). Fourthly, if the RMB faces depreciation pressure due to market supply and demand, it is not harmful. However, devaluing the exchange rate should not be used as a tool to hedge against US tariffs, as this would significantly harm China's welfare level. 4. Limited downward space for long-term interest rates. In order to stabilize capital flows and exchange rates, the central bank is not willing to allow long-term interest rates to decline too rapidly. In order to prevent non-bank institutions from leveraging up excessively on bond investments, which may bring significant financial risks, the central bank is also unwilling to allow long-term interest rates to decline too quickly. The seesaw effect between the bond market and the stock market is now very evident. To avoid long-term interest rates from declining too rapidly, the Ministry of Finance can issue more government bonds, and financial regulators should work together to boost the stock market. Stabilizing the real estate market will also help prevent long-term interest rates from declining too rapidly. III. Strategies for Handling the Situation: Stimulus, Transformative, and Reform 1. Stimulus. More proactive fiscal policies and moderately loose monetary policies. In terms of fiscal policy, the broad fiscal deficit should not be less than 10% of GDP, including a central fiscal deficit of 4% of GDP, special local government bonds worth 4.5 trillion, special national bonds worth 3 trillion, and 500 billion transferred funds. In terms of monetary policy, the magnitude of interest rate cuts and reserve requirement ratio cuts should not be lower than in 2024. This means that in 2025, reserve requirements should be reduced at least twice, by 50 basis points each time; interest rates should be reduced 2-3 times, with a cumulative reduction of 60 basis points; the existing lending rates for second-hand houses should be lowered by 25 basis points; and countercyclical macroprudential policies should be implemented. 2. Transformation. In the real estate sector, efforts should be made to stabilize housing prices in core areas of first-tier cities and support top private real estate enterprises. The policy should be to fully lift all lending, purchase, and sales restrictions at once, and provincial local governments should increase assistance to financially sound top private real estate enterprises in the province. In terms of local government debts, debt transformation needs to be comprehensive. In addition to the 6+4+2 plan, the participation and cooperation of central government and financial institutions are also needed. As for small and medium-sized financial institutions, they need financial injections more than large state-owned commercial banks. It is important to note that the fiscal resources for stimulus and transformation should not be confused with each other. 3. Reform. Firstly, to better stimulate consumption, it is suggested to significantly and permanently increase the social security and medical security levels for rural residents and vigorously implement equal public services for new city residents. Secondly, to simultaneously promote consumption and employment, it is necessary to vigorously promote the development and growth of private enterprises, which means opening up the service sector to them, enhancing the protection of the rights of private enterprises and entrepreneurs, and addressing the imbalance of local government revenue and expenditure. Thirdly, it is necessary to increase investment in human capital and infrastructure related to human capital. After all, consumption for human capital investment can enter production.Functions can promote medium and long-term economic growth.This article is reproduced from the "Chief Economist Forum"; GMTEight Editor: Wenwen.