In his speech at the 2015 World Economic Forum meeting in Davos, Chinese Premier Li Keqiang acknowledged that China’s economy is facing strong headwinds. Annual GDP growth in 2014 was 7.4%, the lowest rate since 1990. But, to stabilize economic growth, he pledged that China will “continue to pursue a proactive fiscal policy and a prudent monetary policy.”
China’s current economic slowdown was policy-induced. During the last two years, the government has tightened fiscal and monetary policy, in the hope of offsetting the adverse effects of the large stimulus package implemented in response to the 2008 global financial crisis. Li’s Davos speech was intended to signal that the Chinese government will not allow the growth rate to slip further.
China’s stimulus package was by far the world’s largest and most effectively implemented. It stabilized growth in China and moderated the global economic contraction. But it left in its wake some serious problems for the Chinese economy.
Most important, the country’s economy has become highly leveraged. Housing prices shot up, real-estate developers borrowed recklessly, and local governments became heavily indebted. As a result, broad money (M2) increased rapidly, and now stands at more than two times China’s GDP – one of the highest levels in the world.
This flood of money rang alarm bells for Li and President Xi Jinping when they took office in early 2013. The government has since reined in money-supply growth and started to impose limits on local governments’ borrowing. Monetary expansion has decelerated. The budget law has been revised to allow local governments to issue government bonds, and their borrowing from commercial banks is being closely monitored.
These policies have raised capital costs, with monetary tightening, in particular, taking a large toll on local governments and real estate developers. Because slower growth forces them to borrow new money to pay their maturing debts, interest rates are bid up, and businesses in the real economy are crowded out, creating a further drag on growth.
Meanwhile, producer prices have been falling, while consumer prices are flat. So, like much of the rest of the world, China is facing the risk of deflation. Indeed, global deflationary pressure would have emerged much sooner had China not launched its two-year stimulus plan in 2008, which boosted investment demand and thus delayed the fall in world commodity prices. Now that the fall has arrived, domestic deflation has become a real threat, particularly given slower domestic fiscal expansion.
That is why China’s government would do well to recall the Asian financial crisis of 1997. In response to Deng Xiaoping’s famous tour to the south, which provided a needed boost to the reform process, investment increased rapidly in the first half of the 1990s. As a result, China’s annual inflation rate soared to an all-time high of 24% in 1994. The government’s subsequent measures to curb inflation might have engineered a soft landing; but the financial crisis hit China severely, leading to six years of deflation.
The main lesson of the Asian financial crisis – or, for that matter, of any financial crisis – is that deflation is the ultimate threat to recovery. Because the 1997 crisis was confined to East Asia, China was able to escape deflation after it joined the World Trade Organization.
But today is different. The entire world is in the grip of deflationary forces. If China enters the vortex, its trade partners will not be able to pull it out this time. So the key question for China’s government is whether the country can do so on its own.
The proactive fiscal policy that Li pledged at Davos will help, but monetary policy also needs to change. The conundrum facing China’s authorities is that monetary expansion would merely fuel a run-up in asset prices, rather than resulting in higher credit flows to the real economy.
The blockages used to be local governments and zombie real-estate developers. But that is likely to change this year. Borrowing by local governments will be strictly monitored, and their new debt financing will come mainly from government bonds. And, though most observers believe that China’s first-tier cities (Beijing, Shanghai, Guangzhou, and Shenzhen) will still struggle in 2015 to digest the huge housing stock they built up in recent years, some second- and third-tier cities have already reached the bottom, and have started to recover.
China is the largest trading country in the world, prompting calls for Chinese leaders to assume greater responsibility for the overall health of the global economy. China’s post-crisis stimulus package demonstrated the authorities’ willingness to do so. Likewise, the government’s anti-deflation effort will help not only China, but the rest of the world as well.