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China’s Policy-Induced Slowdown

Oct 20, 2023
  • Yu Yongding

    Former President, China Society of World Economics

China’s economic performance has been inspiring considerable pessimism lately. In the second quarter of 2023, the Chinese economy grew by just 6.3% from a year earlier – a figure that is disappointing because of the low base in the second quarter of 2022, when pandemic restrictions were still suppressing economic activity. And in July, China’s consumer price index (CPI) entered negative territory for the first time since 2021, sparking fears of a deflationary spiral. 

Whether all the pessimism is warranted ultimately depends on the answer to one crucial question: Does the recent decline of China’s GDP growth rate reflect fundamental changes to economic conditions – such as population aging, diminishing returns to scale, the deterioration of the latecomer advantage, and rising environmental costs – or can it be addressed with more effective macroeconomic policies?

In fact, while there is little doubt that the era of sustained double-digit growth is over, China is well-positioned to achieve a significantly higher growth rate than most developed economies in the foreseeable future. After all, China’s per capita GDP is still less than a quarter that of the United States. 

The key to success lies in policy: while staying the course of reform and opening up, China must use fiscal and monetary levers to respond to growth and price data. Should both growth and inflation be sluggish, fiscal and monetary expansion are in order. Conversely, if inflation rises sharply, a tightening should follow, even if it results in lower growth. 

For now, barring black swan events, a surge in inflation appears unlikely. China’s CPI has been hovering around 2% since May 2012, and its producer price index has been negative for the better part of the past decade. PPI fell into negative territory in March 2012, remaining there for 54 months. It was then negative for 16 of the next 17 months, beginning in June 2019. It remains in negative territory now, having been so since last October. 

Meanwhile, China’s GDP growth rate has been on a consistent decline, falling from 12.2 % in the first quarter of 2010 to 6% in the fourth quarter of 2019. From 2020 to 2022, China’s average annual growth rate was about 4.6%. Amid this combination of weakening growth and low (or even negative) inflation, the case for growth-boosting fiscal and monetary expansion is strong. 

Over the last decade, however, the Chinese authorities have taken a cautious approach to growth, setting annual targets a few basis points below the previous year’s actual growth rate. The government argues that keeping growth targets conservative affords it more space to pursue reforms aimed at upgrading China’s growth pattern and improving the quality and efficiency of economic development. But whether the pursuit of higher GDP growth would actually impede this effort is a matter of debate. 

What is clear is that China’s government is committed to limiting fiscal imbalances. That means keeping government bonds below 60% of GDP, and the budget deficit below 3% of GDP – often by a significant margin. While the budget-deficit-to-GDP ratio stood at 2.8% of GDP in 2009, it was cut to 1.1% in 2011, as the government rushed to exit its CN¥4 trillion ($555 billion) stimulus cycle. Many Chinese economists and government officials are proud of having done a better job than most European countries at following the fiscal rules set by the Maastricht Treaty. While there is no denying that the Chinese government’s contingent liabilities are high, owing to local government debt, China’s fiscal position is still much stronger than most Western countries’. 

To be sure, China’s budget-deficit-to-GDP ratio has risen since 2015. But this has been largely the result of tax cuts, not an increase in government expenditure. Though few Western observers would acknowledge this, supply-side economics is more influential in China than in the US. 

As the government has pursued a cautious fiscal policy, the People’s Bank of China has been juggling too many objectives: economic growth, employment, internal and external price stability, financial stability, and even allocation of financial resources. In particular, it has had to respond to the cyclical changes in the housing price index: if the index rises sharply, the PBOC pulls back the monetary-policy reins. More broadly, the PBOC has committed not to pursue “flood irrigation” – that is, flooding the economy with liquidity – but instead to stick to a “precision drip-irrigation” approach. 

Undoubtedly, China could have achieved higher growth over the past decade with a more aggressive macroeconomic-policy approach. While it is too late to change the past, China can still achieve a more dynamic future, but only if it implements a carefully designed fiscal and monetary expansion focused on boosting effective demand and, ultimately, growth. 

Fortunately, there is reason to hope that Chinese policymakers will move in this direction. The government recently identified insufficient demand as a key macroeconomic challenge facing China, and declared that China should “take advantage of the improving momentum, step up macro policy adjustments, implement the prudent monetary policy in a precise and forceful manner.” 

This is perhaps the most important change to China’s macroeconomic-policy guidelines in recent years. If the Chinese authorities translate it into effective policy, higher and more stable growth will follow.

Copyright: Project Syndicate, 2023.

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