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Yao Yang:China needs a more active fiscal policy


I am writing this on a high-speed train between Nanjing and Shanghai, two cities on China’s east coast 300 kilometres apart. The price of a first-class seat is $35. It is a bargain. High-speed railways have reshaped China’s geography. The economic return on infrastructure, on which most of the country’s public debt is spent, is low — but its social return is very high.

When I speak at international conferences, certain questions about the Chinese economy are always asked by the audience. How should we interpret the gross domestic product figures? Is the country moving back to its old investment-driven growth model to pull it back up to its potential? Is the rate of return on capital declining? Will the mounting public and private debt lead to a major crisis? Those are legitimate questions, particularly in light of the discrepancy between the country’s official GDP figures and people’s feelings on the ground.

By the figures offered by the National Bureau of Statistics (NBS), the GDP growth rate has been coming down smoothly, from 10.4 per cent in 2010 to 7.4 per cent in 2014. The 2014 figure has been challenged by market practitioners and economic analysts. Using the growth of electricity consumption as a benchmark, Wang Jian, a renowned economist, calculated that the actual growth figure should be between 4 and 5 per cent for 2014. (

This view, however pessimistic, is consistent with China’s falling prices. The producer price index has been negative for  43 consecutive months. The consumer price index has been barely positive, but it does not properly account for housing consumption. Property prices have been falling in most of the last two years but the CPI does not reflect the drop because the NBS uses a cost-based method for its calculations.

Getting the actual growth rate right is important for the government to adopt the proper fiscal and monetary policy. If it is lower than the potential growth rate, then expansionary fiscal and monetary policies are justified. By an international comparison of growth experience, it is reasonable to believe that China has a potential to grow by 6.5-7.0 per cent, even given the declining labour supply and a decelerated rate of capital formation. Therefore, if the economy is only growing between 4 and 5 per cent, as Mr Wang has claimed, expansionary policies are warranted.

The economy is in a period of deflation, very much like that in the aftermath of the 1997-98 Asian financial crisis. The unprecedented increase in exports between 2001 and 2008, triggered by China’s accession to the World Trade Organisation, pulled up growth in the last round of recession. This time, the country has to resort to domestic demand. That is why the government has started a new round of fiscal stimulus. Is this a move back to the old model of investment-driven growth?
Not necessarily. This round is countercyclical, aimed at bringing growth back to its potential. It is unlikely to halt the pace of structural rebalancing. Since 2010, consumption as a share of GDP has increased by 4 percentage points; manufacturing employment has stopped growing; services have become the largest sector and the biggest driver of growth. Those trends are results of the fundamental law of economic growth and have also happened in all advanced economies.

So to the third question: isn’t the rate of return on capital declining? The answer is yes. But that does not mean investment should end. The rate of return is highly pro-cyclical. In the booming cycle, equipment is fully utilised and capital becomes a binding constraint on output expansion, so the rate of return is high; in the busting cycle, equipment becomes idle and the slack in capital forces down its rate of return. Therefore, the current decline is a consequence of China’s slowing growth, not its cause. In the short term, the most effective way to raise the return on capital is to restore growth to its potential.

The last question is: will China’s mounting public and private debt lead to a major crisis? In most other countries public debt is raised to fund entitlements — pensions and healthcare in particular; in China, it is mostly spent on infrastructure. The debt is always backed by some form of assets, greatly reducing the possibility of an imminent crisis.

The size of local government debts could be a problem. Beijing has been aware of it and has started a program of debt-bond swap to allow local governments to issue long-term government bonds to repay mature short-term bank debts. This is a right direction. The economic return to infrastructure is low and China needs to spread the financial burdens to the future generations.

Private debt does pose a risk to the economy. Yet, again, its increase is a consequence of recession and restricting credit supply would make things worse because it would kill struggling companies. Also, the rise in private debt is partly fictional. While interest rates in the banking sector are still regulated, those in the shadow banking sector have been liberalised. This gives banks huge incentives to move businesses off their balance sheets through multiple financial transactions that artificially increase debt.

The Chinese authorities are overly shy in offering more accommodating monetary policies. Now, too much emphasis is put on lowering the official interest rate. Rates in the shadow banking sector are very high and hardly affected by official rate changes. Thus banks are induced to divert their businesses to the shadow sector. In the end, prevailing market rates do not change, but the reserve ratio is still high. At 17 per cent, it is more than double the rates between 1998 and 2003. A drastic downward adjustment is necessary to increase credit supply to the real economy.

Yao Yang, dean, National School of Development and director, China Center for Economic Research, Peking University
source: Financial Times