Abstract: Macroeconomic policy space varies across countries, over time, and under different circumstances. China currently enjoys ample policy space to stick to a policy framework that is firmly grounded in economic reality and serves the country’s best interests.
Over the past few years, the pandemic and constant changes worldwide necessitate a deeper understanding of the timing, magnitude and effect of macroeconomic policy. When drafting policies, it's critical to consider policy space; there should be adequate room for unanticipated challenges and dynamic pursuit. The Chinese government must have a thorough and systematic grasp of its policy space in cross-cycle and counter-cyclical adjustment, so as to implement the policies effectively and fully and provide strong support for steady economic operation.
Ⅰ. THERE IS NO COMMON STANDARD FOR POLICY SPACE.
There is no specific criteria of policy space that suits all countries at any time, but some of the rhetoric about policy red lines appears to have taken hold.
In the case of government debt, for example, the 1992 EU Maastricht Treaty established strict limits on a country's fiscal deficit and total public debt, capping them at 3% and 60% of GDP, respectively, a commitment that was reaffirmed in the 1997 EU Stability and Growth Pact. The subsequently released EU Council Regulation (EC) No1466/97 and No 1467/97 provide for budget monitoring and penalties in the event of noncompliance, making them enforceable. However, the two red lines of 3% and 60% were heavily dependent on EU members’ general growth expectations and government debt in the 1990s. As the situation changed, some countries began to question this fiscal discipline as being too rigid. In particular, deficits ballooned repeatedly after the 3% red line was breached in Germany and France in 2002, while the finances of large countries such as the UK and Italy were also unsatisfactory. Finally, under the weighted majority voting system, Germany and France were able to break fiscal discipline without being penalized. By 2003, the Stability and Growth Pact existed in name only, and the era of one-size-fits-all fiscal discipline was then officially abolished through a formal legal process (Hu Kun, 2018).
Since then, the US, Japan, and major wealthy countries in Europe have all had government debt-to-GDP ratios well above the 60% red line, prompting a rethink of issues related to fiscal discipline.
Following the global financial crisis of 2008, two Harvard professors, Kenneth Rogoff and Carmen Reinhart, established the 90% red line, claiming that when the government debt-to-GDP ratio hits 90%, economic development slows dramatically. This has drawn a lot of attention as well as debate, not least because three professors from the University of Massachusetts, Herndon, Ash, and Pollin, have strongly criticized the theory. There hasn't been much agreement on whether there should be a precautionary red line or cap for government debts.
Since the outbreak of the covid-19 pandemic in 2020, Europe and the United States have implemented ultra-loose fiscal and monetary policies, paying no more heed to fiscal discipline. According to the International Monetary Fund (IMF), in 2020, the general government debt in the UK amounted to 104% of GDP, in France, 115%, in the United States, 134%, and in Japan, 254%. However, economists in Europe and the United States show a strong consensus on providing fiscal and monetary stimulus. Practices of developed countries have repeatedly refreshed our understanding of the government debt ceiling, and so far we have not seen a clear debt limit.
But what’s stranger is that many developing countries with debt-to-GDP ratios that are significantly lower than the red line of 60% have seen the outbreak of government debt crises. For example, Chad in Africa, whose central government debt-to-GDP ratio was only 47.9% in 2020, was deeply caught in a debt crisis. There are many other countries having a similar situation to Chad. It can be seen that keeping one’s debt-to-GDP ratio lower than the red lines of 60% or 90% won’t prevent a debt crisis. Surpassing the 60% or 90% red lines won’t necessarily lead to a debt crisis.
In fact, macroeconomic environments vary greatly from country to country, so the applicable debt ceiling can be completely different. Specifically, it depends on a number of factors, including the economic growth expectation of a country, term structure of debt and interest rate levels, purposes of debt, net national savings, domestic and foreign debt ratio, and currency structure of debt, etc. In some countries, economic growth expectations are weak, short-term debt dominates the term structure, and debt fails to form effective investment. Moreover, the whole country lacks savings and has difficulties with the balance of payments, and is heavily dependent on external debt. If this is the case, even if the ratio of government debt to GDP is significantly lower than 60%, a debt crisis will inevitably occur.
However, China has a different situation. The ratio of external debt is lower, and the term structure is sound. The country boasts surplus in balance of payments for many years, huge foreign exchange reserves and stable economic growth expectations. Moreover, RMB has even become a reserve currency. Therefore, China should not be bound by the outdated dogma of western countries. It should recognize that it still has considerable policy room, which can provide strong support for the smooth operation of the economy.
II. POLICY ROOM WILL NOT NECESSARILY BE USED UP
From the perspective of cross-cyclical adjustment, the macro policy space does not follow the law of conservation. For policy space, the more it is used, the larger it may grow. On the contrary, if policy makers are too prudent to use policy tools, or act too late, it may lead to contracted policy space.
In this regard, China can learn lessons from the crises that occurred in Sweden and Japan in 1991 and 1997, respectively, where the banking sectors were hit by mass bankruptcies. The two governments responded in a similar way: in the first phase, liquidity was provided to distressed banks, and deposits were fully guaranteed, so market confidence was stabilized; then banks were nationalized (recapitalized with government capital), restructured and merged; at the same time, non-performing assets were transferred to state-owned asset management companies that took charge of selling those assets.
But the timing of government action were completely different in these two countries. The Swedish government acted swiftly and decisively to stop the crisis; it took over the banks directly. But Japan did not realize the severity of the crisis until many years later, and it took another several years after that to formally introduce policy measures. Three years after the crisis, more than 50% of bank losses in Sweden were written off; however, in Japan that ratio was only 10%.
Famous economist Jean Pisani-Ferri who once served as an economic advisor to President Macron analyzed the different rescue plans adopted by Sweden and Japan in his book Economic Policy: Theory and Practice. The conclusion is the forceful measures taken by the Swedish government brought the economy back on track relatively quickly, a result that actually reinforced the government’s policy space. However, Japan had a different story. Bank restructuring was delayed which led to a longer banking crisis and a far higher cost of government bailouts than that in Sweden. Meanwhile, the reluctance of Japanese banks to lend further increased bankruptcies of enterprises, and as a result, turning some previous high-quality loans into non-performing assets. In response, the government had to inject more capital into banks, and more government debt became inevitable. Companies declared insolvent, cheated with their financial statements, and used profits and government bailouts to repair their balance sheets, leading to what Richard Koo, chief economist at Nomura Research Institute, calls a "balance sheet recession". At the same time, Japan's economy suffered stagnation for a long time. As GDP is the denominator of the debt burden ratio (DBR), the DBR also rose as a result, and policy options were reduced.
Japan has always been prudent with fiscal policy. In 1996, the ratio of Japanese government debt to GDP ratio reached 92%, which was deemed as too high by the Japanese government. When the economy improved slightly, then Prime Minister Ryutaro Hashimoto came up with a plan of financial restructuring and implemented a consumption tax increase. As a result, the country fell into recession again in 1998. After that, the Japanese government completely gave up the control of its fiscal deficit. Today, Japan has a debt-to-GDP ratio exceeding 250%, but the fiscal pressure facing the Japanese government is not that severe due to its zero and negative interest rates. This phenomenon is rather ironic. If Japan had taken firm measures to address the crisis at the beginning and stabilized market confidence and growth expectations, its government debt would not have ballooned to today's levels. However, the Japanese economy has remained stable for a long time despite the high debt levels, a phenomenon far beyond most economists’ expectations.
In 1998, China also encountered the most difficult year of the 1990s. At that time, the non-performing loan ratio of the banking sector was quite high, and it was on the verge of widespread bankruptcy by international standards. Economic growth was significantly weakened. Economists at the time had worries that "China's fiscal situation may deteriorate rapidly, making it difficult for the government to rely on expansionary fiscal policies for a long time"; "the M2 to GDP ratio is too high"; "China's long-term growth potential is declining due to population aging, environmental pollution, labor productivity declines, etc."
If we look at the case today, we can find that China’s government debt at that time could not meet the criteria set under the World Bank and the IMF's Debt Sustainability Framework (DSA), not to mention having abundant tool options. Referring to the IMF’s prescriptions for Southeast Asian countries at that time, China should not adopt expansionary fiscal and monetary policies either. Rather, it must tighten its macro policy. The view prevailing domestically at that time that the M2/GDP ratio was too high could also hinder the monetary policy from playing its role.
Fortunately, China’s macro policy has not been bound by these dogmas. Due to the expansionary fiscal policy and the strong rescue and rectification measures targeting the financial system, the crisis was resolved at the emerging stage, which effectively stabilized the economic and financial fundamentals, and provided a good foundation for the next round of economic prosperity at the beginning of the new century.
III. EXTERNAL FACTORS ALSO HAVE IMPACTS ON POLICY SPACE
In addition to the above discussions on policy space, the interconnectedness of the global economies and changes in the international environment also affect China’s policy space dynamically. In particular, the divergence of domestic and external economic cycles and different paces of policy implementation can exert an impact on China's policy space. But how external shocks may affect policy space largely depends on how China responds to the shocks.
From mid-2015 to 2016, the US shifted its monetary policy from QE taper to interest rates hikes, while China’s domestic financial risks were constantly exposed and the downward pressure on the economy increased. At that time, China's policy space was significantly squeezed, especially with monetary easing being caught in a dilemma.
Since the end of 2021, there has been a misalignment of economic cycles in China and the US. In the US, the Fed launched its first round of interest rate hikes in mid-March. As for China, the main task of its monetary policy is to ensure abundant liquidity. Against this background, the interest rate spread between China and the United States has narrowed significantly recently, even approaching 30 basis points at one point, hitting a historical low. Nevertheless, the RMB exchange rate has not encountered the depreciation pressure that it faced in 2015 and 2016. Rather, it has remained relatively strong, indicating that there is still considerable room for monetary policy independence.
In this context, it is also important to understand the deviation of the RMB exchange rate from the interest rate parity. There are at least two reasons for this deviation:
First, trade surplus is strong. In the first two months of 2022, China saw a trade surplus of 116 billion US dollars, reaching a record high with a year-on-year increase of nearly 20%. Behind the surplus is the persistently overheated demand and insufficient supply in Europe and the United States. This output gap is further reflected in greater inflationary pressure. Relatively speaking, China hasn’t suffered from inflationary pressure, and it is even facing insufficient demand. Therefore, it is the logic of purchasing power parity that enables the large trade surplus to support the RMB exchange rate.
Second, the deviation of the exchange rate from interest rate parity can also be explained from a risk perspective. Forecast of growth in the United States has constantly been lowered. In October 2021, the IMF predicted that the growth rate of the United States in 2022 would be 5.2%. In January 2022, the IMF lowered the forecast to 4%. Since then, international investment banks have also lowered their growth forecasts for the United States. In early March, a model established by the Federal Reserve Bank of Atlanta estimated that the US annualized QoQ would fall to 0.1% in the first quarter. It can be seen that the current US interest rate hikes were passively launched under the background of unsatisfactory fundamentals and significantly weakened growth expectations. It is a result of responding to the upward pressure on inflation. The rate increases have raised market risks, so this is "bad" rate hikes. China has set a higher growth target, and the expansionary policy adopted to stabilize the economy is "good" easing, which will help reduce risks, stabilize China's growth expectations, and boost investor confidence. The contrast between the two countries’ risks partly explains the deviation of the RMB exchange rate from interest rate parity. Supported by the above factors, the RMB exchange rate will no longer be put under pressure even if the interest rate gap between China and the United States becomes significantly smaller than the historical level of 80 basis points. China still enjoys abundant monetary policy space.
To sum up, macroeconomic policy space varies from country to country, from time to time, and from situation to situation. Government debt exceeding red lines of 60% and 90% is neither a necessary nor a sufficient condition for a debt crisis to occur.
Compared to other countries, China enjoys sufficient macro policy space. On the other hand, cross-cyclical adjustment requires policy makers to neither use up policy room at one time nor be too prudent with it.
Under the current circumstances, China has ample policy room to stick to a policy framework that is firmly grounded in its economic reality and serves its best interests. As long as policy is used properly and timely, it can improve market expectations and boost market confidence, thereby further expanding future policy space and forming a virtuous circle.
This article was first published in China Finance (magazine). It was first published online on CF40’s WeChat blog on April 1, 2022. It is translated by CF40 and has not been reviewed by the authors. The viewpoints herein are the authors’own and do not represent those of CF40 or other organizations.
