Why China can’t afford to wait and see about economic stimulus

The Chinese economy is operating significantly below its full potential despite the rosy year-on-year growth numbers
With rising unemployment, worsening deflation and growing systemic risks, policymakers need to do what’s right for both economy and society

Aidan Yao

Published: 12:30am, 28 Jun 2023

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Investors are growing impatient with the lack of a policy response to China’s faltering economy. Onshore equities have retraced almost all their gains from the first half of the month, while offshore equities have fallen almost 7 per cent from their month-to-date peak. The insufficient follow-through on Beijing’s hints about a comprehensive stimulus package has dimmed hopes for a fast turnaround of the world’s second-largest economy.

So what is holding Beijing back from taking the necessary steps to stop the economic bleeding? Below are a few possible explanations, along with my assessment of their validity.

For a start, Beijing could have been caught off guard by the brevity of the post-Covid recovery. Like everyone else, the authorities might have thought that pent-up demand unleashed by reopening could fuel strong economic growth throughout 2023, during which policy would be best left on autopilot.

In that scenario – which was also the working assumption of the market at the start of the year – policymakers would not have to contemplate any new stimulus until possibly well into 2024. The lack of foresight and planning for the current economic downturn could have contributed to the delayed action.

Second, the authorities may be concerned about the side effects of policy easing. This, unlike in many developed economies, has less to do with inflation in the current environment. In fact, for an economy on the verge of falling into deflation, China would welcome any positive price impulses.

However, the exchange rate is a different matter. A sharp and disorderly depreciation of the renminbi could drive unbridled capital outflows that put financial stability at risk.

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However, negative interest rate differentials – caused by diverging policies between the People’s Bank of China and the United States Federal Reserve – are only one driver of exchange rate and capital movements. A thriving economy and booming capital markets – supported by forceful policy easing – could boost investment at home and lure capital from abroad. With the economy and confidence successfully revived, I’m not convinced that the renminbi will do poorly and that capital will flee China.

Another argument against large-scale monetary easing is the need to protect banks’ interest margins. This is seen as necessary to motivate banks to continue lending in adverse economic conditions, and ensure a certain degree of profitability for them to offset potential bad loans from lending to property developers and local governments’ funding vehicles. Therefore, the argument goes, Beijing cannot cut interest rates too aggressively and risk instability in the banking system.

My rebuttal of this is that, in the absence of decisive policy actions, worsening economic conditions will strain borrowers’ balance sheets, making them more likely to default on their loans. However, if the authorities act earlier and more aggressively to bolster growth, defaults among borrowers would not rise as much or could even decline, saving the banks from ever having to use their capital buffer against non-performing loans.

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Finally, proponents of policy prudence would argue that, with this year’s 5 per cent growth target easily achievable, Beijing should conserve policy room for later. While this is statistically correct, one must be clear-headed about the extensive contribution from the base effect to such a result. This luxury will not exist in 2024, making it much more difficult to sustain the current growth rate if Beijing does not tackle the economic challenges head-on.

Furthermore, with regard to policy prudence, one needs be reminded that sound management of macroeconomic policy is not a dogmatic pursuit of arbitrary growth rates, particularly if those rates are distorted by statistical irregularities. Instead, the objective should be to align the economy with its growth potential in order to achieve full employment while keeping inflation low and stable. Achieving 5 per cent GDP growth is no good for society at large if it is accompanied by rising unemployment, worsening deflation and growing systemic risks.

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It doesn’t take a Nobel Prize-winning economist to know that the Chinese economy is currently operating significantly below its full potential despite the rosy year-on-year growth numbers. Failing to recognise this and refusing to provide what the economy needs to close its substantial output gap is, in fact, a dereliction of duty on the part of macroeconomic policymakers.

To summarise, in my view, none of the above arguments against an immediate economic rescue hold up. The only valid concern, as discussed in my previous article, is leverage, which has increased each time stimulus was undertaken since the global financial crisis.

However, policy easing per se is not to blame: the increase in debt was really a function of liquidity and credit being misallocated to unproductive parts of the economy, fuelling property booms and massive infrastructure build-ups in remote regions.

In other words, leverage should not be seen as a hindrance to policy easing, but as a reason Beijing needs to execute its policy differently this time to minimise unintended consequences. The key lies in shifting the focus of stimulus from property and infrastructure investment to consumption and innovation.

Making this paradigm shift won’t be easy, as it requires policymakers to abandon their old philosophy, and embrace something new and untested in China. These changes need to be introduced now if the Chinese economy is to be saved from a potentially painful and prolonged balance sheet adjustment, like the one that resulted in Japan’s lost decades.

Aidan Yao is a macroeconomist with more than 15 years of experience in both public- and private-sector organisations