China’s economic downturn seems to have reached a new stage. It can be illuminated from a multitude of perspectives. One of the most poignant is how the Chinese financial system is entering a liquidity trap, which occurs when a central bank attempts to push money into the economy, either by lowering interest rates or directly incentivizing or even forcing banks to lend. But despite these efforts, demand for loans falls flat. No one, neither consumers nor investors, is willing to borrow.
In recent months, the Chinese government has lowered interest rates and made it easier to take out mortgage loans. It also has repeatedly prodded banks to lend more. But the economy remains awash with cash in the financial system while lacking in consumer demand. Since interest rates are still relatively high and have not come down to zero, as happened in Japan, China faces more of a partial liquidity trap. Yet, the banking system is bursting with cash as deposits are amassed at an alarming rate, since both corporates and households are over-saving.
In other words, both consumers and investors are unwilling to borrow, creating lackluster credit demand and growth. The reasons for this are well-known. Households and companies have gloomy expectations and weak confidence in the economy. This is first due to clampdowns that started last year on key Chinese business sectors, especially within technology and property. The problems in the property sector are especially pronounced.
The initial crackdown on the real estate industry was well intentioned with the primary objective to lower leverage and thus risks in the sector. Since August 2020 the policy known as “three red lines” restricted developers’ unsustainable borrowing and forced them to sell down assets. But this has severely limited their ability to continue building and selling new projects.
As a result, the property market has seen large price declines and slid into a sector-wide depression with the entire industry at risk. Since a massive 70 percent of Chinese household wealth is tied up in housing, a prolonged real estate downturn risks tanking the whole economy and further depressing consumption.
This consumption downturn is being exacerbated by China’s zero-covid policy. As more and more large cities are forced to lock residents in their homes for days, even weeks, when cases are discovered, people have stopped viewing homes and making purchases. And more broadly, the looming threat of a lockdown is having a deep impact on the consumer psyche. Any business owner must now fear sudden closure, while employees fear a lay off with no warning. No one is incentivized in this situation to consume, even less to make longer-term investments.
On the local level governments have attempted to forcefully respond to these trends. Actions have mainly focused on loosening various restrictions on real estate purchases initially put in place to dampen demand several years ago. Now, the focus is on stimulating demand with measures to make it easier to get mortgages and to purchase multiple flats for different family members. Local governments are also setting up bail-out funds to invest in unfinished housing projects, finish them and then deliver the properties to their original buyers.
However, many of these measures have had little impact. More hope rests on central government policies, but these have been uncharacteristically incoherent and unhurried. The complexity of the situation, especially given prior policy priorities, is daunting. So far, the central government has repeatedly cut mortgage rates and taken to fully guaranteeing new bond issuance by some private developers, effectively reopening a financial lifeline for these companies. A new plan has also been put forward to use special loans from state policy banks to complete pre-sold homes.
The central government has further stepped-up investment in large infrastructure projects, such as the massive south-north water transfer scheme, as well as renewable energy installations and power transfer projects. However, these measures are unlikely to be sufficient. Much of the urban public has lost confidence in the government’s economic model.
To restore faith in the economy, the Chinese government will probably have to unleash an unprecedented wave of financial support and stimulus to turn sentiment around. In addition, the zero-covid policy would have to be fundamentally adjusted. Yet, stimulus measures and loosening credit standards risk reinflating already substantial bubbles and creating other financial contradictions.
This dilemma provides an interesting use case for the digital yuan or e-CNY. The e-CNY is likely to be the first major Central Bank Digital Currency (CBDC) issued globally. Such digital currencies differ from both physical cash and traditional electronic payments in that they are digital tokens. However, unlike private cryptocurrencies, such as Bitcoin or Ether, these tokens are official state-backed tender, issued in a centralized and regulated manner by central banks.
The e-CNY is based on a centralized platform model like the massive Chinese payment apps Alipay and WeChat Pay. However, it makes use of some of the technologies developed in the crypto community by using trusted computing and special encryption based on hardware and software integration. This creates a programmable digital currency that boasts much greater security, practically removing the possibility of counterfeiting. Most importantly, given its digital nature, all transactions are visible and traceable by the People’s Bank of China (PBoC)
The e-CNY’s most significant aspect is therefore how the PBoC can achieve the ability to trace and track economic activity in real time. If sufficient computing power and Artificial Intelligence (AI) are added to analyze the mountains of data generated, monetary operations in China could see fundamental change.
The present downturn in the economy is nearing depressionary dynamics, where interest rate decreases, policy loosening, large state investments, and other measures have insufficient effect. Beijing thus faces the uninviting prospect of repeating monetary operations similar to those undertaken in the West. Perhaps not quite Quantitative Easing (QE), but broad-based state-induced stimulus. In the end, these are crude tools that push money out into the economy regardless of need. Such a sledgehammer approach carries grave risks, since currency over-issuance can create inflation and financial bubbles.
This provides a fascinating use case for the e-CNY. If in full use, it could possibly arrest the present economic downturn in a much more precise and pinpointed manner. Monetary authorities could identify areas of the economy in most dire need of support. E-CNY transactions can evidence exactly where revenue shortfalls are occurring, hence enabling highly targeted interventions and income supports. Such a system could also instill confidence in the economy by consumers and investors, though much would depend on exact implementation, the legal framework, privacy concerns and a host of other issues.
Certainly, China stands at the cusp of a monetary revolution. The e-CNY is at this point in time still in the trial-and-error stage with various localized trials throughout China. However, throughout 2022 increased integration with China’s dominant payments apps is fostering more widespread use. Both Alipay and WeChat Pay now seem committed to promoting the e-CNY. Since each of these apps has about 900 million users, rapid nationwide adoption of the e-CNY is possible when greenlighted.
Such a fundamental technological, financial, and, ultimately, social transformation should not be rushed. It is likely, though, that Chinese monetary authorities will be studying the present downturn in light of the knowledge that there could be a much more precise and effective means of managing and even forestalling it. Welcome to a new world of money!