Reform, not relief, for China

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China’s economy requires more than short-term stimulus, even as deflationary pressures intensify.

That’s the message from economists, including those at the highly ranked Peking University’s Guanghua School of Management. Academics at Beijing’s top schools often share recommendations with policymakers.

It’s not that the persistent drop in prices should be overlooked, but that they’re signaling the need for more serious changes — just as China prepares its “15th five-year plan.” It’s a national social and economic development blueprint for the period from 2026 to 2030. China is wrapping up its 14th such plan this year and is expected to reveal details for the next five years in the coming months.

“When we talk about the 15th five-year plan, the key issue is how to grow productivity,” Liu Qiao, dean of the Guanghua School and a finance professor, told me last week.

He’s referring specifically to “total factor productivity,” a measure of an economy’s productivity gains from technology, innovation, economies of scale, or policies, without adding more labor or capital.

According to the International Monetary Fund, China’s total TFP growth fell from 4.1% in the 2000s to 2.6% in the 2010s, and entered a state of decline from 2006. Liu believes China’s TFP needs to grow by at least 2% or more.

To that end, tech innovation is an important part of the upcoming five-year plan, Liu said. But he added that institutional reform is just as important.

The Chinese Communist Party’s grip on the state and its institutions enables it to exert greater influence over the economy than in the U.S., for example.

“80% of China’s total factor productivity comes from institutional reform,” economist Zhou Tianyong wrote in an opinion piece in Chinese business news magazine Caixin, which CNBC translated. Zhou is a former vice president of the International Strategy Institute at the Central Party School, China’s higher education institution for training party leaders.

Zhou pointed out that the textbook definition of technology as a way to boost productivity doesn’t necessarily apply in China, where business and consumer interests are constrained in certain areas. “Without economic system reform, there will be no medium-to-high-speed growth.”

All this may seem rather academic for the average markets discussion more focused on deflation, industrial overcapacity and spillover into trade tensions. But public debate is limited in China. In a country where leaders operate by building consensus behind closed doors, policy signals come largely from key phrases in government documents and high-level speeches.

One of those signals has emerged in just the last few weeks.

Chinese President Xi Jinping led a high-level financial and economic commission meeting on July 1, which called for improving government officials’ understanding of how their performance is evaluated, according to a state media readout.

“Routine assessments [of officials] cannot only focus on how much GDP has grown and the number of major projects, but also on how much debt is owed,” Xi said at another high-level meeting this month that focused on urban development.

The current system for evaluating the performance of government officials has also inadvertently contributed to China’s overcapacity issues, where industries are producing more goods than the market can absorb, according to Goldman Sachs.

Local authorities are incentivised to collect revenue even if manufacturers are losing money under the current production-based tax system, Goldman Sachs Chief China Economist Hui Shan said in a report Monday.

“Solving overcapacity issues requires a different incentive structure for local officials’ evaluation and promotion,” she added.

“None of these fundamental adjustments will be easy or quick to implement.”

As China’s economic growth slowed over the last several years, Beijing has emphasized the need for “high-quality” development. But the country still makes a big deal out of its annual GDP target, which is 5% this year.

Looking ahead, China will likely signal a lower growth target around 4.5% to 5%, Guanghua’s Liu said. But what’s more important in his view is that local authorities may then be able to focus more on consumption, rather than investments, which have contributed to overcapacity issues.

Policymakers will likely also try to reduce the gap in urban and rural income — or “common prosperity” — which can increase support for 255 million people and help boost consumption, Liu said. But in the near term, the economy probably needs a little more stimulus, such as a cash transfer, he said.

Chinese authorities have stepped up plans to further support employment and improve social welfare. But policymakers have so far avoided the mass cash handouts that the U.S. and Hong Kong gave residents to stimulate spending after the pandemic.

In a packed month for policymakers, senior party members are also expected to hold a Politburo meeting to discuss the economy by the end of the month. But analysts don’t have high expectations.

With the first half of the year in the books, the scale of stimulus is pretty much already set, and policymakers are now turning their attention to the next five years, said Zong Liang, former chief researcher at the Bank of China.

He expects policymakers to prioritize consumption over investment, and tilt the balance toward the interests of businesses, noting the state has played a larger role in the past five years.

But he cautioned that Beijing would remain wary of the risks that could arise from relaxing too much control.

Old habits may die hard.

Trina Chen, co-head of China equity research at Goldman Sachs, discussed China’s efforts to manage overcapacity in key sectors like solar, steel and lithium.

Yang Liu, CIO and chairman of Atlantis Investment Management, said that negative views on China’s economy ignore the country’s strengths in artificial intelligence and supply chains.

David Autor, labor economist at MIT, said that the U.S. has not “fully come to grips” with the nature of the challenge it faces from China.

China is going after excessive discounts. Premier Li Qiang last week called for more regulatory oversight of the electric car price war. The market regulator later stated on Friday that it had met with JD.com, Meituan, and Alibaba’s Eleme, and called on them to compete rationally.

U.S.-China trade truce set for extension. U.S. Treasury Secretary Scott Bessent said Tuesday he is likely to hash out an extension of President Donald Trump’s upcoming trade deadline with China when he meets with his Chinese counterparts in Stockholm next week.

Economic uncertainty persists. China kept its benchmark lending rates steady on Monday as the country continues to grapple with weak consumer sentiment and softening growth. But the country’s affluent are feeling just as poorly about the economy as they did during the pandemic, according to consulting firm Oliver Wyman.

Mainland China and Hong Kong stocks rose on Wednesday amid a broader rise in the region, after U.S. President Donald Trump announced that he had completed a “massive Deal” with Japan, which set tariffs of 15% on the country’s exports to the U.S.

Mainland China’s CSI 300 was up 0.02% while Hong Kong’s Hang Seng Index — which includes major Chinese companies — had gained 1.27% as of 3:30 p.m. local time (3:30 a.m. ET). The Hang Seng Tech Index, which tracks the largest technology companies listed in Hong Kong, rose 2.14%. The mainland benchmark is up around 4.7% year to date, data from LSEG showed.

July 24: European Commission President Ursula von der Leyen is slated to meet with Chinese President Xi Jinping during a visit to Beijing

July 26 – 28: World Artificial Intelligence Conference in Shanghai

Next week: U.S. Treasury Secretary Scott Bessent is scheduled to meet his Chinese counterparts next week in Stockholm

Politburo meeting expected by the end of the month