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Watch out for this kind of China stimulus

John Phillips | CNBC

For most market players, talk of stimulus in China tends to be the monetary kind. But as the country unveils its five-year policy blueprint this week, authorities are expected to use fiscal policy in conjunction to steer the economy out of a slowdown.

The 13th Five-Year Plan (FYP), a 100-page document outlining development initiatives for 2016-2020, will be at the center of the country's fifth plenary session that kicks off Monday. Doubling gross domestic product by 2020 from 2010 levels remains the top priority for policymakers but this time around, strategists say more focus will be given to fiscal policy, including increased spending.

The Five-Year Plan should drive home the recognition that Beijing won't follow the standard Wall Street prescription for growth - quantitative easing - but instead, a policy of reforms and infrastructure-based stimulus, explained Mark Tinker, head of AXA Framlington Asia.

Economists widely believe that China's current economic headwinds, as seen by recent third-quarter growth numbers, are a result of both cyclical and structural factors and warrant a medley of monetary measures such as interest rate cuts as well as "mini stimulus," a term popularized last year when Beijing introduced aggressive fiscal support.

The People's Bank of China (PBOC) duly delivered on Friday night local time, cutting the one-year benchmark bank lending rate by 25 basis points to 4.35 percent, effective from Oct. 24. The one-year benchmark deposit rate was also lowered by 25 basis points to 1.50 percent. It was the central bank's sixth rate cut since November.

John Silvia, chief economist at Wells Fargo, told CNBC on Monday that such moves should be seen separately from the long-term structural and regulatory reform China would undertake to manage its transition to a service-based economy, which he said could take "anywhere between three to five to 20 years."

"The interest rate change is more of a cyclical, short-run - what are we going to do now?" he said. "It will help the property sector. I do think it helps, obviously, equity valuations because you're lowering the discount rate applied to equity earning."

Longer term, Internet industries, strategic industries such as new generation IT and energy savings, as well as the service sector are likely to be singled out for development, according to Bank of America Merrill Lynch's China strategist David Cui.

"To support these favored sectors, we expect the government to provide fast-track of project approval, tax relieves, subsidies, priority access to financing, infrastructure buildout, among others," Cui said.

Public welfare sectors such as inter-city transportation, urban subway systems, ultra-high voltage power grids, charging stations for electric cars and healthcare are also likely to receive special investment injections given the Plenum's theme of 'higher quality, efficiency, equality and sustainability,' he continued.

More government coordination is expected to maximize efficiency once investment is confirmed.

"We expect more detailed policies for allocating fiscal revenue and expenditure between central and local governments, in order to align responsibility with expenditure. There will be tighter and more transparent regulation on local government budgets," HSBC said in a recent report.

It's not just the economy likely to benefit; markets could rally too.

Fiscal stimulus is what will determine the next leg of Chinese performance, and markets are following these prospects closely, as Wednesday's move suggests, noted Jason Ambrose, CEO and founder of Vanda Research.

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"The reason that China's stock market fell 4 percent last Wednesday was because you had a PBoC advisor saying they are already doing too much fiscal [stimulus]. That may be true if they are doing it in a stealth manner, but the market didn't believe that."

But those expecting a big-bang approach could be disappointed. Measures are likely to be introduced in a drip-feed fashion, and get reflected in the data over time, which will benefit longer term investors, according to Vanda Research.

Of course, stimulus alone won't do the trick.

"Because of the overlapping of a structural downturn and a cyclical slowdown, the authorities are aware that stimulus is unlikely to turn around the trend … Reform is needed to cultivate new growth engines. Hence we expect reforms to accelerate after the grand [Plenum] meetings," said Jacqueline Rong, economist at BNP Paribas, in a recent note.

Outside of the fiscal side, reforms of financial markets, including capital account liberalization measures, state-owned enterprises, and institutions are also expected.