(Version in 中文)
Anticipation of the U.S. Federal Reserve’s exit from quantitative easing has dominated headlines in recent weeks. Half a world away, less conspicuously, but no less importantly, China, the globe’s second largest economy, is designing its own policy adjustments: firstly, unwinding the fiscal and monetary stimulus that helped shield it from the Great Recession and lifted global growth (but which also created some vulnerabilities), and secondly transitioning out of a growth model that has generated spectacular growth over the last three decades, but which is now running out of fuel.
Managed well, these twin adjustments would allow China to prolong its economic miracle in a sustainable way, with a significant positive impact for the rest of the world.
Why are these adjustments needed?
In the years prior to the global crisis, China’s economy was propelled by rapid productivity gains from forceful restructuring of the state-owned sector, a bold clean up of the banking system and the country’s dramatic entry into the global trading system through accession to the World Trade Organization. These forces paved the way for a decade of growth powered by investment and exports.
A similar big-bang is needed now, but this time centered on consumption and services. After the global crisis erupted, China has relied heavily on a mixture of loose monetary and quasi-fiscal policies to help weather the storm. While propping up growth, these policies have also left problems in their wake in the form of rising local government debt and an overstretched financial system. They have also arguably thrown the structure of the economy more out of kilter, by making it increasingly reliant on ever higher levels of (increasingly inefficient) investment and credit.
The challenge for China now is to transition away from the credit and investment-led pattern of recent growth, to a more consumer-based and sustainable model. The latest assessment of the Chinese economy by the International Monetary Fund has some ideas about how to achieve this. The new Chinese leadership is itself keenly aware of these challenges. It has repeatedly emphasized its unwillingness to support unsustainable growth through another dose of stimulus. Expectations are high that a bold new phase of reforms will be announced this fall, which will allow China to decisively shift the pattern of its growth.
So what should we be looking for during the coming months?
China’s economy has slowed from the double-digit growth rates of the past but there are good reasons why, including demographic change and natural laws of gravity associated with catching up with the rest of the world. The trick is to stay calm as this happens and avoid shoring up growth excessively, while being ready to respond if the employment situation worsens significantly.
So in the near term, China should begin to pull in credit growth (as signaled through the interbank market last month). In particular, consistent with recent official statements, credit flowing through the less well-regulated parts of the financial system—and to sectors that are already struggling with overcapacity and excess leverage—should be curbed, including through tighter regulation and supervision. At the same time, quasi-fiscal support through local governments—which has contributed to government debt rising to nearly 50 percent of GDP—should be unwound steadily to ensure that China’s traditionally sound public finances remain strong in the years to come.
Calibrating this withdrawal will be tricky, of course, given residual uncertainties about both the global recovery and domestic growth momentum. But if growth slows too sharply, there would be scope to quickly reverse gears on the fiscal side and provide some targeted stimulus. However, it should be very different from that of the last few years by being conducted through the budget (and not the banks and local government platforms) and be directed at supporting household incomes and consumption (and not the corporate sector and investment). This would help facilitate the second of the twin adjustments that China needs to make, as discussed below.
Growth for all
The other major task that the Chinese policymakers recognize is the need to steer the economy onto a different growth path—one that is more sustainable by being more consumer based, inclusive and environmentally friendly. With investment already accounting for nearly half of economic activity and exports unlikely to be as buoyant as in the pre-crisis years, consumption needs to become the main growth driver. Moreover, the capital and resource‑intensive model of China’s investment-led growth has had unfortunate by‑products in the form of damaging pollution and high levels of inequality.
To engineer the shift, China will have to rely on market forces and price signals, to help banks and firms discover new growth engines in a changed global and domestic environment. Reforming the financial system and the corporate sector will be paramount in this context, so as to make funding available on more market-based terms to a broader set of borrowers who can use the money to invest in a new range of sectors, including both domestic ones—such as labor-intensive service industries—and higher value-added exporting ones. These reforms will need to be carefully calibrated and sequenced, and will take time to fully bear fruit—but they should not be put off simply because they are complicated.
At the same time, they need to be complemented by other steps to boost consumption and worker’s incomes. Three strands are needed: firstly, reducing the incentives for investment by putting in place fairer resource prices, interest rates, and distributing dividends from state-owned enterprises, secondly, boosting household incomes through higher wages and lower social security contributions, and thirdly, lowering precautionary savings by continuing to strengthen the social safety net and increase spending on pensions and healthcare. Achieving these will also call for structural changes to the fiscal relationship between the central and local governments, so as to enable social expenditure obligations and priority infrastructure needs to be met without local governments having to fund themselves through indirect borrowing and land sales.
Together, these reforms have the potential to create a virtuous circle that generates long‑lasting benefits. The transition will certainly not be an easy one, given China’s size and increasing complexity. It will also involve accepting somewhat lower growth in the next few years as these measures are put in place. But the end result will be a stronger and more sustainable economic model, which sees the fruits of China’s growth more equitably shared and allows it to remain a powerful engine of the global economy over the next decade and beyond. Moreover, a successful transition would lower the risk of China experiencing a hard landing in the medium term that would leave it mired in the notorious middle-income trap. The new Chinese leadership has announced their commitment to reforms. It is now time for action.
