The Chinese government’s decision not to come up with a big stimulus package despite the ongoing economic slowdown has confused foreign observers and the Chinese public alike. A possible explanation for the Chinese leadership’s cautious approach could be the enormous debt overhang from the 2008 crisis.
SHANGHAI – China’s aggregate demand has declined significantly over the past three years. In addition to the ongoing impact of China’s anti-COVID policies, the country has also been weighed down by the slowdown in global demand. Exports fell by 14.5% yoy in July, a stark contrast to robust export growth of 17.2% in July 2022. Amid these downturn pressures, the government’s decision not to announce a massive stimulus package, as many had expected, become alien and Chinese observers are deeply at a loss.
While China’s leaders are certainly aware of the ongoing economic slowdown, they may see the risk of a bailout as greater than the risk of inaction. Or maybe they have more confidence in the domestic economy’s resilience to a global recession and believe the economy will recover quickly on its own.
Regardless, China appears to have decided not to take any further action. In fact, China currently faces significant obstacles to further economic intervention. Finally, the accumulation of massive debts, particularly at local government levels, has left China with limited room for manoeuvre. In addition, the external environment has become increasingly unfavorable for China since at least 2018, presenting the country with challenges unprecedented in the last 40 years
As a result, China has taken an increasingly cautious approach to macroeconomic management. An interesting example of this is monetary policy. For example, at the onset of the COVID-19 pandemic in March 2020, the US Federal Reserve immediately cut interest rates to near zero. In contrast, the People’s Bank of China cut interest rates by just 0.2 percentage point. While the Fed has been raising rates rapidly in response to rising inflation, raising rates by five percentage points since March 2022, the PBOC has made a series of modest rate cuts to reflect GDP growth and lower demand.
This approach is also the main reason China has avoided runaway inflation over the past two years. This was made clear in a speech by former PBOC Governor Yi Gang in April during his visit to the Peterson Institute for International Economics in Washington, DC. During his speech, Yi stressed the PBOC’s adherence to the so-called “mitigation principle,” which states that central bankers should refrain from taking drastic measures in uncertain circumstances. While this well-known concept was first introduced by Yale economist William Brainard in 1967, Yi’s speech provided valuable insight into the shift in China’s economic policy thinking in recent years.
In theory, more conservative monetary policy could better align short-term actions with long-term goals. To this end, central banks should set real interest rates as close as possible to the potential growth rate of output. The pioneering work of Nobel laureate Edmund S. Phelps on the Golden Rule savings rate illustrates the benefits of this approach.
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Because Yi’s speech reflects the current thinking and changing political style of China’s top policymakers, it helps explain why China’s economy has become less volatile in recent years. By reducing countercyclical measures, China has managed to sustain growth even without a surge in demand. This could be in line with the government’s development plan, which aims to minimize the huge costs involved in achieving unbalanced growth, such as the rapid accumulation of short-term financial risks.
Indeed, China’s move away from aggressive macroeconomic policies could be attributed to its leadership recognizing the threat posed by the country reaching a critical threshold of systemic financial risk a few years ago. Given the nature of the Chinese political system, such risks would be seen as an unacceptable threat to social and political stability.
As a result, China launched comprehensive risk reduction measures in 2016. Policymakers adopted risk reduction as the guiding principle and shifted from aggressive macroeconomic policies to a more prudent approach. To mitigate risk and counter the over-financialization of the real economy, China launched a wave of deleveraging and targeted financial interventions that targeted the wealth management industry and prompted a correction in the heavily indebted financial and real estate sectors.
Risks and uncertainties also increasingly arise from external constraints. Two decades ago, when the Chinese economy was relatively small and had a fixed exchange rate, its domestic politics were largely insulated from external influences. But China’s economy has grown too big and its relationship with the world’s economies has changed dramatically, prompting China to tread more cautiously in the face of uncertainty. For example, the PBOC must now closely monitor changes in the interest rate differential between the US and China and assess the possible impact on China’s capital markets and the renminbi exchange rate.
Still, China’s departure from aggressive macroeconomic policies should come as no surprise. Risk reduction measures might have proved effective in preventing a financial or debt crisis, but the pandemic and subsequent COVID-19 measures have impacted the economy’s ability to rebalance and recover, leading to a further fall in demand .
Getting aggregate demand back to pre-pandemic levels is crucial to accelerating China’s economic recovery. To this end, China’s fiscal and monetary policies can be more proactive since risk mitigation policies have been in place for so long. As policymakers face a delicate balancing act, the growing risk of a prolonged downturn underscores the need to find more effective solutions to the pressing challenges facing the Chinese economy.
But China could do more to bring its economy back into balance. By committing to implement structural reforms, lowering entry barriers and opening up sectors currently closed to foreign competition – such as education, training, consulting and healthcare – China could create numerous market opportunities for the private sector and move closer to achieving long-term economic stability .
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