How China can protect its economy – and the world’s – amid US recession headwinds

China, with its low inflation, can continue to boost its economy and stimulate demand, which will shore up the global decline
Beijing just needs to keep its monetary policy prudent and look out for the yuan becoming too strong

Fang Zihao

Published: 12:30pm, 27 Jun, 2022

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The US economy was already overheating in November, when unemployment fell below the “natural rate” – the lowest sustainable level without creating inflation. Inflation had also surged, to nearly 5 per cent for the core consumer price index, which excludes food and energy prices, well above the Federal Reserve’s target rate.

But it was not until March that the Fed began to raise interest rates, which remain well below the “neutral rate” – a theoretical level at which Fed policy is neither accommodative nor restrictive. This delayed reaction has made US inflation worse and the wage-price spiral is becoming a reality.

So the Fed is having to raise interest rates sharply and quickly. This rapid tightening will strain global liquidity and cause a severe contraction in global demand, leading to financial turmoil and possibly a global recession.

In this context, China needs to exploit its expansionary fiscal policy and prudent monetary policy to create more certainty in an uncertain world.

China’s expansionary policy will not bring about domestic inflation. Its imported inflation will gradually fade as the Fed drains off excessive dollar liquidity. While China’s unemployment rate is high, especially among young people, inflation is below target. If China were to undertake demand-side stimulus, inflation would remain low before domestic unemployment dropped to the natural level.

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China’s service sector has been badly affected by the pandemic and many urban residents saw their incomes shrink significantly. However, the ongoing tax rebates will stabilise demand with most households less able to spend.

The fiscal stimulus, worth about 2 per cent of the economy, should be sufficient for now, given the multiplier effect and that China’s second-quarter growth could be four percentage points below the annual target.

As signs emerge of faltering foreign demand, the government could consider offering more support, such as a maternity allowance for parents with more than one child and payments to households in areas with excellent pandemic prevention, to help stabilise demand and economic expectations.

Ensuring equal access to basic public services will more effectively strengthen consumer confidence and promote common prosperity, but it may take much longer to achieve.

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Although these fiscal measures may cut the savings rate, they may not reduce effective capital formation and economic potential. The domestic private sector currently lacks confidence and is unwilling to invest. But the increase in household income from government payments can boost demand, and thus enhance business confidence and drive investment.

Meanwhile, the central bank should maintain a prudent and neutral monetary policy. As fiscal stimulus increases domestic demand amid weakening global demand, there will be upward pressure on domestic real interest rates and the yuan. The central bank should work to keep domestic rates flat so as not to discourage private investment.

It should also avoid a quick easing of the domestic financial environment as this could lead to a jump in property prices. With shifting global demographics, decarbonisation and the localisation of industrial production, global interest rates and inflation have entered a long-term upwards trajectory, implying a decline in global bonds, equities and real estate valuations.

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A further rise in China’s already-high housing prices could make foreign assets appear more attractive, potentially causing capital flight and affecting financial stability.

More importantly, the central bank should keep the yuan’s real effective exchange rate stable, and in particular avoid a disproportionate appreciation.

The yuan’s real effective exchange rate rose to its highest rate in March after two years of overseas production interruptions. As other countries reopen their economies and resume industrial production, Chinese exports have become easier to substitute.

In this environment, a stronger yuan would hurt China’s export competitiveness, reduce labour demand, lower local wages and raise the dollar prices of domestic assets, hurting income and wealth distribution.

Today, Chinese goods have little price advantage. According to the purchasing power parity conversion factor, when the Japanese yen per yuan rate exceeds 22, the prices of goods and services produced in China will be higher than those in Japan. As the yen is still falling, many worry the yuan and other Asian currencies may soon suffer a blow.

However, many Japanese companies have moved their factories abroad, Japan lacks energy and labour, and is less competitive in most emerging industries. Thus, a rapid and large depreciation of the yen may not have a great impact in the short term on Asian economies, including China.

But China should still take the lead and strengthen economic coordination with other Asian countries and newly industrialised economies, to avoid any competitive currency devaluation.

As US fights inflation with the dollar, what about the rest of the world?

Against the backdrop of the Fed’s preoccupation with tightening demand, many countries that depend on low-interest US dollars and merchandise exports will be subject to economic headwinds and turmoil. In contrast to the overheated US economy, China’s economy may be in a recession, marked by low growth, low inflation and high unemployment.

Therefore, Beijing will need to stimulate the economy and expand demand, to provide a hedge against the decline in global demand and stabilise the turbulent global economy.

Fang Zihao is currently studying for a PhD in economics at Koc University in Istanbul