Abstract: The article examines a significant paradox within the Chinese economy: a notable deficiency in demand characterized by feeble consumption, investment, and external demand, culminating in low price levels. The findings underscore that the central predicament stems from consumer confidence and expectations, extending beyond mere aggregate demand policies. Ultimately, based on these outcomes, the paper suggests anchoring policy to a more elevated inflation target to invigorate domestic demand and enhance balance sheets.
Since the beginning of this year, the economy has been showing signs of recovery, which is no small achievement. The first-half economic performance deserves recognition. However, there is a clear consensus that, in the short term, the lack of demand remains a significant contradiction, as previously highlighted in several previous Politburo meetings. This lack of demand is a comprehensive insufficiency, affecting various aspects rather than being isolated to specific areas.
For example, contrary to expectations, consumption did not experience an explosive recovery after lifting the Covid lockdown. Instead, it showed a more moderate rebound. Investment demand was, as we all observed, also weak. Though some investments performed well, they were mainly dragged down by the real estate sector. By the second quarter, the change in data on external demand was more pronounced, and there was a tendency for the nominal value of exports to turn from positive to negative growth. Inflation remains relatively low, as reflected in prices, with the CPI showing a year-on-year growth rate of zero in June and the PPI displaying a negative year-on-year growth rate. At the same time, the policy has demonstrated relatively strong resilience. Fiscal policy's nominal spending lags behind nominal GDP growth, while on the monetary policy side, despite the ten basis points’ interest rate adjustment, nominal interest rates are decreasing slower than prices, leading to rising real interest rates. Overall, the situation indicates insufficient demand and lower prices, hence the title - "Economic Performance in a Period of Low Inflation."
Nevertheless, there is a debate about whether macro policy should be more proactive at this point. For instance, scholars like Zhang Bin and Yu Yongding advocate for strengthening macro policy and implementing counter-cyclical adjustments. Other scholars emphasize the need to bolster fiscal policy, particularly at the central government level, to support demand. As to monetary policy, scholars like Zhang Bin advocate for more noticeable downward adjustments in policy interest rates. All of these are views that macro policy should be stronger.
On the other hand, some skeptics also contribute to the discussion. They acknowledge the importance of strong macro policy but raise additional concerns. For example, many people believe that the primary contradiction in macroeconomic policy lies not in aggregate demand policy but rather in confidence and expectations. Restoring confidence and reinforcing expectations are fundamental aspects that cannot be solely addressed through aggregate demand policy.
There are also other concerns about fiscal and monetary policy. Some experts believe that the country's leverage ratio and debt levels are already relatively high, and further stimulus or macro-policy efforts may not be the best approach. In the case of already high leverage, is it a good practice to continue to increase leverage? Specifically speaking, in the monetary field, China's credit growth is characterized by substantial increment and rapid growth speed. And the size of new social financing - over 30 trillion yuan in the past three years - raises questions about how much more money and credit growth are needed to support this economy.
Moreover, some other experts believe that there may be multiple reasons why economic entities are not sensitive to interest rates. Even if the interest rate were cut by 100 basis points, economic entities might not increase leverage or borrow significantly. Additionally, concerns are raised about the already low spreads of financial institutions, suggesting that further interest rate cuts could exert great pressure on these institutions and may not effectively achieve the desired results, potentially leading to increased financial risks.
These doubts are reasonable, and the above issues are worth considering, as the related discussions hold great significance. I will introduce three recent studies that align with Zhang Bin's study, emphasizing that the macro policies’ strength, implementation, and intensity significantly impact economic performance. If policies seem ineffective, it may not be due to excessive action but rather a lack of boldness in implementation.
I.The Household Sector Does Not Have "Excess Savings"
First, one of the fundamental reasons the consumption recovery has not been strong enough is that the household sector does not have excess savings. The household sector fails to save the money it has earned over the past three years to spend today. From the data, the premise of "excess savings" does not exist. This is influenced by the orientation and implementation of policies over the same period, as most relief policies have been targeted at enterprises, primarily implemented in a financial, rather than exclusively fiscal, manner. Consequently, disposable income growth in the household sector has been relatively slow, resulting in no super-expected growth and hence no additional income or excess savings. Furthermore, the sluggish growth in consumer spending cannot be solely attributed to constraints of consumption scenarios, as both the decline in consumption of contact services and goods are pronounced. If consumption scenarios were constrained, one would expect increased goods consumption.
Why does the country not have excess savings? We believe that it can be attributed to a pronounced change in residents' income expectations. Previously, there was a strong expectation of high income growth, which has now shifted to a more rational expectation of moderate income growth. As a result of this adjustment in expectations, saving behavior has naturally changed, leading to a rise in the warranted saving rate. If this analysis holds, the path of future consumption growth may need to be projected more cautiously, with consumption growth remaining relatively modest for some time. Additionally, an increase in the savings rate would exert minimal pressure on prices, particularly the CPI. Moreover, it would lead to a downward shift in the risk-free interest rate, resulting in phenomena such as the regularization of deposits and the preference for insurance products with a 3.5% interest rate, all indicative of a downward shift in the risk-free rate of interest. Furthermore, this would lead to a larger external surplus which, if it cannot be absorbed by domestic demand, would need to be shifted to foreign markets.
All of these outcomes are the result of policy choices. In response to the same shock, the macro policies adopted by the United States and some European countries differed, particularly with the United States implementing policy measures targeting households directly, which leads to visibly different consumer behavior compared to China.
II.There Is Not Too Much Money, But Not Much
The second perspective concerns new social financing, which may not be as substantial as it appears. Over the past three years, the annual growth of social financing has exceeded 30 trillion yuan, leading to concerns about excessive money supply and questions on “where the money has gone”. It is not that there is not enough money, but that the money has not been put to use and is "idle" in some places, and once the money is returned to consumption, it may become an inflationary force at once. Our study concludes that although there has been considerable credit growth in the past few years, there has not been an excessive amount of money.
Firstly, the actual new social financing, excluding interest expense, is not as significant as perceived. Interest expenses are passive and entail debt servicing every year. However, most entities also require new financing to service debt, resulting in interest rolling over. Our conjecture estimates that interest expenses over the past three years amounted to around $10 trillion, leaving the real growth in social finance at approximately $20 trillion. While this is a substantial sum, it is not as large as it might seem.
Secondly, the assessment of whether there is more or less money depends on the magnitude of external shocks. Over the past three years, China has faced strong shocks, and the growth in social financing can be seen as a hedging behavior to correspond to these shocks. The bigger the shock, the more money needed to correspond. In our view, compared to the shocks of the last three years, we do not have too much money, but not much. For example, higher growth in household sector incomes has not occurred, and in fact their pockets are not full. As another illustration, let's consider the impact of the 2020 pandemic on the real GDP in the United States. By making a conservative estimate, we can conclude that the pandemic had a 10-15% impact on the US's real GDP, which means that if there were no response, real GDP would fall by 10-15%. We can't make a direct comparison with the United States, but I don't think there would be much difference in magnitude. In the face of shocks larger than this, the additional growth in social finance in our country is not too much.
Therefore, there is no need to worry about an excess supply of money leading to high inflation as the extra money is hedging against a negative shock. Going forward, there is really no need to worry about high inflation because there isn't that much money, but more about low inflation. Furthermore, even if we observe relatively rapid increases in social financing this year or next, we should not evaluate the situation against conventional criteria. Given the greater growth pressures we face, a bit more increment in social financing than usual is necessary. Consequently, we should not interpret this as having too much money in the economy.
III.Deleveraging may Require More Leverage (at Lower Interest Rate)
The third perspective focuses on stabilizing leverage or demand. Some experts argue that China's macro leverage ratio is already high and has increased even further over the past three years. According to the People's Bank of China, the macro leverage ratio was around 250% before the pandemic and reached nearly 280% by the end of 2022. With such a high macro leverage ratio, even though there is not enough money, our leverage ratio cannot stand, can it? Will the leverage ratio get out of control with such strong policies if we increase leverage? Both concerns are indeed legitimate. Interestingly, a somewhat counter-intuitive but reasonable conclusion emerges from our analysis: The best policy option to maintain a reasonably growing leverage ratio, or even to bring it down, is not to control the growth of the leverage ratio but instead to utilize low-interest rates to increase leverage. In other words, low interest rates can be the most effective way to control the leverage ratio.
Mathematically, the leverage ratio is quite straightforward: it is the nominal debt divided by the nominal GDP. The numerator corresponds to the nominal interest rate growth, while the denominator is calculated based on the nominal economic growth rate. This essentially creates a race process between nominal interest rates and nominal growth rates. Our calculations indicate that around one-third of the new debt in the past ten years has gone toward interest expenses, and a similar ratio can be observed in the 10 trillion yuan interest expenses annually between 2020 and 2022. If we lower the nominal interest rate from, for instance, 4 percentage points to 2 percentage points or from 6 percentage points to 3 percentage points, the impact on interest expenses of debt is decisive. This adjustment can reduce interest expenses by half, and this part is completely non-negligible. Thus, adjusting nominal interest rates has a number of functions. And from a debt perspective, such adjustment is decisive for the growth of the debt stock even if it does not affect the investment and consumption behavior of microeconomic entities.
Two different macro policies can be envisioned based on this understanding. On the one hand, a demand stabilization policy with a relatively low nominal interest rate would result in a relatively high rate of debt growth, correspondingly leading to a higher rate of nominal GDP growth. On the other hand, a leverage stabilization policy would maintain a relatively high nominal interest rate, resulting in a moderate debt growth rate and correspondingly leading to a relatively low nominal GDP growth rate. Surprisingly, the results of our calibration show that, in absolute terms, debt growth in a demand-stabilizing policy would be much faster than under a leverage-stabilizing policy. However, due to the impact of lower interest rates and higher inflation, the macro leverage ratio would actually be lower than it would have been under a leverage-stabilizing policy (with higher interest rates and a relatively low nominal growth rate). In other words, lowering interest rates to increase leverage can paradoxically lead to a lower leverage ratio in the end.
I disagree with Zhang Bin on one point: I do not think that monetary policy alone can lower interest rates to an extremely low level. Other factors, such as implementation issues, need to be considered. Some sectors may not be sensitive to interest rates, and it requires additional policies to complement the monetary measures. The incentive and capacity of households and firms to increase leverage are limited; thus, the government sector may need to take action. While monetary policy can lower interest rates, the government sector may need to increase leverage, as it currently has the most capacity. Therefore, this issue cannot be addressed solely by monetary policy.
IV. IF THERE WAS MODERATE INFLATION
Zhang Bin and I looked at these issues completely independently, but in the end, we came to very similar conclusions. He said that low inflation is a dangerous thing, and I was looking at this the other way around. Imagine inflation is not near zero but hovers around 2.5% or 3%, which is still within the range set by the government's work report, what does it mean to maintain more moderate inflation?
First, moderate inflation will significantly boost domestic demand. It will improve business profitability and fiscal revenue; it can reduce real interest rate and allow households to strike a better balance between consumption, saving, and investment; it can also improve the nominal household income, which will make a very strong impact on people's expectations.
Second, moderate inflation is also meaningful from a stock perspective. When the leverage rate is rather high, mild inflation can help balance credit and debt, improve the cash flow of businesses and the government, and adjust relative prices. For example, some prices show a rigid downward trend. If the economy experiences a mild inflation, the downward rigidity will be digested and absorbed in a few years, which is good for the market to adapt.
Therefore, in this sense, I agree with Zhang Bin’s view that policy should anchor a higher inflation target to prevent China’s economy from falling into a low-inflation environment.
Q&A
Caijing Magazine: My question is about the exchange rate. We just talked about monetary policy. The Fed is going to maintain a high policy rate, which means the interest spread between China and the US will not narrow but instead expand in the future. The central bank's monetary policy thus needs to make a choice between stabilizing the economy and stabilizing the exchange rate. Once a lower interest rate is adopted, it might have huge impact. Given the expanding China-US interest spread, what choice should the central bank make?
Guo Kai: Stabilizing the exchange rate and stabilizing the economy are not contradictory, but in fact aim for the same direction. There are many factors that affect the exchange rate, and interest spread is only one of them. When the Fed adopted a zero rate, the dollar did not collapse; when the ECB did the same thing, the euro did not fail; Japan has maintained a zero rate for a long time. The key is people’s overall confidence in the economy. Maintaining a stable policy can realize that. Or, like Gao Shanwen mentioned, a deeper fundamental reform can also do that. Or it could be achieved by adopting a policy to reduce the heat in aggregate demand in the short term. If we take a middle path which does not promise the first or second possibility Dr. Gao mentioned, this will be an awkward situation.
CGTN: In your view, which economic sector will be the main driver of China’s economic growth in the second half of 2023? What governments and companies should do to stimulate investment, consumption, and employment?
Guo Kai: I think the issue can only be explored in the opposite way. If the GDP growth fares better in the second half of the year, what is the most likely way it will realize that? First, we think that exports might be stronger than we thought. Despite weaker external demand, China's exports are resilient. As the domestic market is more competitive, many companies might end up choosing to absorb their capacity through the international market. Thus exports may perform surprisingly better than expected. Second, consumption is a slow variable. The propensity to consume and household income will not change immediately. So if the economic growth improves significantly, the main driver could only be investment. It is difficult to predict whether this investment comes from the stabilization of the real estate market or from the government's additional support for infrastructure investment. But logically, the main driver can only be investment.
Financial Times: How will the international geopolitical uncertainty affect the effectiveness and space of China’s macroeconomic policy?
Guo Kai: Based on the current situation, the overall international environment will witness marginal improvement in the next 1-2 months or the following period. Although there are some tensions globally, China and the US have started engagement. In this sense, the external environment will stabilize instead of worsening and even improve marginally.
This is the keynote speech made by the author at the Seminar on CF40 Macroeconomic Policy Report (Q2 2023) themed “Navigating Weak Demand and Low Inflation: Lessons from the US, Japan and Europe” on July 24, 2023. The transcript has been edited for length and clarity. It is translated by CF40 and has not been subject to the review of the author himself. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
