Abstract: China should implement guiding targets for economic growth as long as it keeps inflation and financial risks in check. As COVID-19 gradually comes under control, China should strive to maintain high economic growth with expansionary fiscal policy, given that it has adequate monetary policy tools to cope with the consequent crowding-out effect. Infrastructure investment is a key pillar sustaining the Chinese economy. In addition to countercyclical adjustment, it can help boost the country’s potential economic growth.
I will focus my speech today on short-term macroeconomic issues. However, this does not mean that structural, long-term issues are less important. They are equally important. Downplaying the importance of structural reforms is the last thing I mean when I talk about the importance of macroeconomic policy. Instead, any macroeconomic policy will become a castle in the air without structural reforms.
I. CHINA NEEDS TO SET GUIDING TARGETS FOR ECONOMIC GROWTH
First, China did not set a target for GDP growth in 2020. China’s targets for economic growth have never been prescriptive; instead, they are meant as a guide. Such guiding targets are a must for coordinating the endeavors across sectors, provinces and economic entities.
In practice, each sector has in its mind a presumptive target for economic growth. For example, when the Ministry of Finance set its deficit ratio target in 2020 at 3.6%, it had already assumed a certain level of annual economic growth. Then, why don’t we just implement a uniform target to coordinate everyone’s efforts?
For a country like China, setting guiding targets for economic growth is a must. Even in fully market-oriented countries, fiscal authorities or central banks will signal to the market with their predictions of economic growth so that the market can react accordingly.
Second, China has set the goal for economic growth in 2021 at above 6%. But I think it should have been higher. “Above 6%” is a range, without a specific ceiling. I would have preferred a clearly-defined point target. Otherwise, the target could lose much of its efficacy as an incentive.
But where should we set the point target? For example, if a race walker, after walking 100 kilometers on the first day, fell ill on the second day, and recovered on the third, how far should he walk upon his recovery? Should it be 100, 80 or 200 kilometers? If aiming at a three-day average of 100 kilometers, the target would be 200 for the third day, but this is beyond reach. But should we just put it at 60? Not necessarily.
Thus, we must do this in a case-by-case manner, taking into account realities while we determine a target for economic growth. We need to leave space for flexibility, but not too much. This is a grave challenge facing policymakers.
Third, China needs to set a growth target, and not set it too low. There are geopolitical factors at play here given its competition with the United States.
The economic growth in China has been on a continuous downward ride ever since it peaked at 12.2% in Q1, 2010. We were expecting an L-shaped trend, prepared that it would take time for the decline to cease. We weren’t anticipating it to cease within a year or two, but now, six years have passed, and the decline is still going on. Exactly when will it stabilize?
Figure 1: GDP growth in China on a continuous downward ride since Q1 2010
We just cannot accurately estimate the potential growth rate of the Chinese economy. Is it 5%, or 6%? Hard to say. I personally do not trust econometric calculations, especially given the current situation in China. Any arithmetic estimate of China’s potential economic growth can serve as nothing more than reference.
Ever since 2012 when the growth rate of the Chinese economy fell below 8%, Chinese economists’ estimate of the country’s potential growth has kept coming down. Most had believed it to be 8%; when this proved wrong, they thought it was 7%; later 6%; and now most assume it to be below 6% (adjusted for the base effect), at 5.5% or 5%. We don’t know where it really is.
If we set a low growth target (the potential growth rate), and design macroeconomic policies accordingly, we would of course enjoy much flexibility, and we can make it come true. However, the potential economic growth is not going to stay where it is. If we keep paring it down, we may never be able to dial it back up given the inertia and the hysteresis effect in ecomomics.
II. POTENTIAL CONSTRAINTS ON THE ADOPTION OF EXPANSIONARY MACROECONOMIC POLICIES IMPOSED BY INFLATION AND FINANCIAL FRAGILITY
The following two factors should be taken into consideration during the process of stimulating growth.
First, stable prices. When inflation goes too high and sees a continuous upward trend, it indicates that the economy has excessive demand.
Second, financial stability. If China experiences a severe asset bubble or any other form of financial instability, China may have to endure a decline in economic growth.
China’s inflation rate has remained at a low level measured by CPI, showing that the country still has room for more rapid economic growth. Although PPI has grown very fast compared to the same period last year; however, it is not much different from the level of ten years ago if one looks at the fixed-base index. More importantly, like the rest of the world, the increase in PPI is mainly due to the supply chain interruption caused by the pandemic and the rising raw material and energy prices, which can be seen as supply shocks. However, the difference between China and the United States and other countries is that in the United States, the increase in raw material prices can be transmitted to CPI while in China the increase in PPI cannot be fully transmitted to CPI due to insufficient effective demand.
The CPI being at a too low level is not necessarily a good thing. For developing countries, inflation of 3% or higher is rather normal. While there is no need to be concerned with temporary inflation rise, it is rather important to prevent people from forming inflation expectations. A vicious circle between inflation and inflation expectations should be carefully watched out as it may cause inflation to get out of control.
In short, the current increase in PPI is not enough to constitute an important constraint on the implementation of expansionary macroeconomic policies.
China’s excessive leverage is another important reason why many economists oppose the adoption of expansionary fiscal and monetary policies. Though the corporate sector indeed has a high leverage ratio, it is not to say that expansionary fiscal and monetary policies are bound to trigger a financial crisis. China's banking system remains healthy on the whole.
For example, indicators such as the non-performing loan ratios of major Chinese banks remain at a relatively low level. For another example, the government has paid careful attention to the tough issue of local government financing platform debt, and regulation over such debt has achieved good results.
China's distinct national conditions featuring high savings, absolute dominance of state-owned financial institutions, and the country's superior ability to cope with emergencies allow it to have higher tolerance for debt than Western countries.
In the long run, China should reduce financial vulnerabilities through reforms, such as developing direct financing, strengthening the competitiveness of enterprises, etc.; in the short term, it has to rely more on increasing nominal economic growth to reduce the leverage ratio. The macro leverage ratio refers to the ratio of debt to GDP, and debt reduction generally leads to a decline in GDP. Therefore, if the country’s efforts focus on cutting debts, it may cause its GDP growth rate to fall faster than the debt growth rate. As a result, the leverage ratio will actually rise instead of fall.
III. STIMULATE DOMESTIC ECONOMY AND ADOPT AN EXPANSIONARY FISCAL POLICY
At present, China should bring fiscal policy into full play so as to stimulate domestic economic growth. When the economy is in a state of contraction, monetary policy can only act as a second violinist as you can’t push on a rope. However, it doesn’t mean that a looser monetary policy wouldn’t make a difference. For example, if policy measures are adopted by the central bank to lower the interest rate and the yield curve, it can at least reduce the financial burden of private enterprises.
China's fiscal policy expansion in 2021 is obviously insufficient. According to the 2021 fiscal budget, growth rates of fiscal revenue and expenditure are respectively 18.1% and 8.1%. In practice, in the first half of the year, fiscal revenue increased by 21.8% and expenditure was 4.8%. So for the first half of the year, actual revenue growth exceeded the budget by 3.7 percentage points, and expenditure growth fell short of budget by 3 percentage points. Such austerity is rarely seen in history.
In the late 1990s and early 20th century, although banks were suffering serious non-performing loans and the financial system was much more fragile than it is today (it is said that all of China’s large state-owned banks were “technically bankrupt” at that time), the risk of financial crisis was soon overcome with China’s robust economic development in 2002, a result of the implementation of expansionary fiscal policy.
I think the continuous decline of China’s economic growth for over 10 years is related to the premature withdrawal of the then loose fiscal policy in 2010. In sharp contrast with China, Western countries have implemented QE and zero interest rate policies since the outbreak of the financial crisis in 2008. In 2021, in the face of the threat of inflation, the Biden administration still insists on the $4 trillion stimulus packages.
Adopting a more expansionary fiscal policy may lead to a rise of the yield curve and produce a "crowding-out effect" on private investment. In this case, the central bank can adopt relevant measures to lower the interest rate. The People's Bank of China recently mentioned that it does not rule out the possibility of purchasing assets although there is no such need yet, but it is undoubtedly good news. In fact, we have enough monetary policy tools to hedge against the "crowding-out effect" that may be produced by expansionary fiscal policies.
IV. DRIVING FORCES OF ECONOMIC GROWTH
Chinese economic growth has been highly dependent on investment and exports. It becomes necessary to reduce their proportion in GDP while increasing the share of consumption. But when the economy is in a deflationary state or when residential consumption and autonomous investment demand are somehow lagging, we must support infrastructure investment through increased government spending in order to stimulate economic growth and facilitate the autonomous growth of the components of aggregate demand.
Since mid-2009, the growth rate of China's fixed asset investment has been falling practically month by month, with the cumulative year-on-year growth rate down from 33% in June 2009 to 5.4% at the end of 2019. Fixed asset investment has turned from a major economic driver to a drag. Infrastructure investment declined the most rapidly in fixed asset investment, declining from 51% year on year in June 2009 to 3.3% at the end of 2019. The modest rise of infrastructure investment had no countercyclical effect during the spread of COVID-19 in 2020.
In February 2021, fixed asset investment grew 33.6% year on year, with manufacturing, infrastructure, and real estate investment hitting 37%, 35%, and 37%, respectively, but this is partly due to the base effect. It is therefore disturbing to see the decline in fixed asset investment and its components in the second half of 2021. Infrastructure investment was one of the biggest reductions. As of September, the cumulative year-on-year growth rate for infrastructure investment was only 1.5%, compared to 14.8% and 8.8% for manufacturing and real estate investment.
The higher growth rate of manufacturing investment is largely fueled by the high rates in exports and real estate investment. The world's supply capacity should recover in 2022 when China's export growth rate is expected to slow, dampening manufacturing investment. Real estate investment has grown more slowly as a result of the tightening of real estate control, and this trend is expected to continue into 2022, putting negative pressure on fixed asset investment growth. Meanwhile, consumption growth may be tough to achieve due to the economic slowdown and pandemic-scarred uncertainty. Against this backdrop, I believe infrastructure investment is the only way and a must for the government to stabilize the economy.
Infrastructure investment is the anchor for China's economy. Considering the lack of growth momentum, infrastructure investment acts as a counter-cyclical adjustment as well as a booster to China’s economic growth.
Many emphasize the inefficiency of infrastructure investment but forget that it provides public goods which should not be judged by the commercial returns.
Others argue that China is over-investing in infrastructure, which is not the case, as this year's floods have exposed the lack of infrastructure in China. Infrastructure does not, of course, refer solely to "railway, highway, and airports". China should invest more in infrastructure in a range of areas in order to increase its innovation capability and green economy, as well as deal with its ageing population.
Considering China’s growing ageing, diminishing working-age population, and increased environmental regulations, many infrastructure projects may be better done sooner rather than later; it will cost even more if they are not done now.
Local governments have long been important players in infrastructure investment. On the one hand, incentive mechanisms should be enhanced to motivate local governments to support infrastructure investment; on the other hand, redundant construction, "white elephant" projects and "tofu-dreg" projects must be avoided.
I believe that China has room to increase the expansionary aspect of its macroeconomic policies. By doing so, China will be able to boost infrastructure investment, which will allow it to curb the economic slowdown and stabilize the growth rate at approximately 6%.
This is the speech made by the author on October 22 at the Closed-Door Seminar I on China’s macroeconomic policy and performance in Q3 2021 at the 3rd Bund Summit. It is translated by CF40 and not reviewed by the author himself. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
