Why economic stimulus no longer works for China

Mainland monetary policy is adding to the total stock of money without having a noticeably pro-growth effect on the economy

PUBLISHED : Monday, 23 June, 2014, 10:42am
UPDATED : Tuesday, 24 June, 2014, 8:08am

There is a dispute between those who see mainland economic policy as merely being "fine-tuned" and those who see active stimulus. The debate is misguided: the level of stimulus may be relevant to the current state of the economy, but it will not affect where the economy is headed.

Regardless of whether it is scattered or intense, monetary stimulus no longer works for the mainland economy and cannot boost growth.

Consider using a hose to fill an empty swimming pool with water. At first, the hose has a dramatic effect. When the pool is filled, though, the hose merely causes the water to overflow.

This is the situation in many countries where stimulus has been applied for most of the past decade. Chinese conditions, unfortunately, resemble less a pool and more a small lake.

The Federal Reserve says the stock of broad money (M2) in the US was US$11.2 trillion at the end of the first quarter. Using Beijing's statistics, China's M2 stood at US$18.7 trillion, a staggering two-thirds larger.

The ratio of M2 to national wealth is a measure of how much money is circulating within an economy. Gross domestic product should not be used here because it resets each year while M2 accumulates over time.

The stock of wealth in the US is at least twice as large as in China. This means China's M2 to national wealth ratio is three times higher than in the US, even though American monetary conditions are quite loose in themselves.

The ill-advised post-Lehman credit boom is one reason for China's predicament. So are years of negative real interest rates - the ultimate sign of irresponsible monetary policy.

The extent of excess liquidity can be seen in commodities fraud. Stocks of metal are being illegally used as collateral, because firms have become accustomed to an endless amount of credit.

The debate of fine-tuning versus active stimulus is a debate over how fast the water is coming out of the hose. It does not matter how full the hose is, though, because the water is flowing into a lake.

One counter-argument is that stimulus must be important because it worked in May, when there were signs of modest economic improvement. But mainland economic data is not nearly accurate enough to render the very slight upticks in industrial production, retail sales and other indicators at all meaningful.

First, there is a simple question of accuracy. It takes smaller, richer countries months to compile the same numbers China publishes in two weeks.

Second, there is also the Communist Party's implicit requirement that no sharp downturns be acknowledged, for instance when policymakers in Beijing panicked in early 2009. A few months of negative results in early 2014 called for stabilisation to be reported.

This is where stimulus is actually informative. Its extent indicates how policymakers view the economy - strong enough to leave alone or in need of official medicine, even if the medicine no longer really works.

The good news: those who see only minor stimulus can claim, with some justification, that it is because the economy is performing adequately. After all, employment is the top priority and the jobs situation is acceptable.

While the property market is suffering, from a national standpoint it needs to suffer. Higher property prices and sales would only heighten macroeconomic risks.

Similarly, slower growth in fixed investment is long overdue. Rebalancing towards consumption cannot occur without a check on investment and such rebalancing is necessary for living standards to continue rising.

The principal worry about the economy seems to involve GDP growth, but the obsession with GDP is misplaced.

The Party will only permit a gradual decline in officially announced GDP growth. And if jobs are available and the economy is truly orienting towards consumers, the pace of true GDP growth is almost irrelevant.

So stimulus will not work but, happily, is probably not needed. Instead, what is worrisome is that implementation of fundamental reforms has not begun.

Implementation of a few pro-market changes should occur later this year. But powerful steps to promote clearer land rights, labour mobility through the hukou reforms, financial competition and corporate innovation have not moved forward.

China did not proceed with additional market-oriented reforms in 2005 in large part because there did not seem to be a need - the economy was strong. Then it did not reform in 2009 because the economy was fragile.

Now economic performance is middling, there is a government which has loudly promised change, and yet little action has taken place. What is the justification this time?

If the economy needs to be as vigorous as a decade ago for another round of market reforms, they will never occur. The era of extraordinarily rapid increases in employment, production and exports is over.

For every month that passes without powerful action, the mainland eases further into the middle-income trap, where once fast-rising economies slowly drift towards stagnation. This gradual failure, not the extent of stimulus, is what matters.

Derek Scissors is a resident scholar at the American Enterprise Institute