Bal­ance stim­u­lus and sup­ply-side re­form

China Daily (Canada) - - LIFE -

Since lastNovem­ber econ­o­mists and the me­dia alike have been hail­ing sup­ply-side struc­tural re­form as a ground­break­ing so­lu­tion to China’s eco­nomic woes. The logic goes, de­mand-side poli­cies, in the form of Key­ne­sian stim­u­lus mea­sures, are use­ful only for re­solv­ing short-term and ag­gre­gate prob­lems. But since China’s prob­lems are long term and struc­tural, the country should fo­cus on sup­ply-side struc­tural re­form, even if it means ac­cept­ing slower GDP growth. Is this the right ap­proach?

GDP growth is gen­er­ated via the in­ter­ac­tion be­tween the sup­ply side and the de­mand side of the econ­omy. For ex­am­ple, in­vest­ment in hu­man cap­i­tal en­ables in­no­va­tion, the prod­ucts of which cre­ate de­mand and, in turn, eco­nomic growth. De­mand-side pol­icy and struc­tural ad­just­ment are not mu­tu­ally exclusive. In ag­gre­gate terms, growth of sup­ply de­ter­mines growth po­ten­tial, and growth of de­mand de­ter­mines the use of that po­ten­tial. To change the eco­nomic struc­ture and growth pat­tern, first the struc­ture of de­mand must be changed.

For China, the sup­ply side should be driven more by in­no­va­tion and cre­ation, rather than by in­creas­ing in­puts. On the de­mand side, it should be driven more by do­mes­tic con­sump­tion, in­stead of in­vest­ment (es­pe­cially in real es­tate) and ex­ports. But this shift is prov­ing dif­fi­cult, as struc­tural fac­tors cause China’s long-term po­ten­tial growth rate to fall; the econ­omy now seems set to fall be­low that lower rate this year.

All of this sug­gests that con­tin­ued struc­tural ad­just­ment is needed in China. But the re­al­ity is that China has been en­gaged in such ad­just­ment for a long time, with un­sat­is­fac­tory re­sults, in­di­cat­ing that com­ple­men­tary de­mand­side poli­cies may be needed. More­over, while slower growth is un­avoid­able be­cause of ad­just­ment, there is a limit to how low a growth rate China can ac­cept. With China’s growth hav­ing al­ready reached a 25-year low in 2015, that thresh­old may not be far off.

To be sure, many be­lieve that China’s growth rate will sta­bi­lize in the sec­ond half of 2016. If it does, China’s lead­ers could prob­a­bly con­cen­trate on struc­tural ad­just­ment with­out con­sid­er­ing ad­di­tional stim­u­lus. But there is good rea­son to be­lieve that China’s growth rate will con­tinue to de­cline this year.

The fact is that China re­mains in the grip of de­fla­tion, with prices and out­put in a downward spi­ral. De­spite a slightly pos­i­tive consumer price in­dex, the pro­ducer price in­dex has been fall­ing for 47 months in a row. More­over, the GDP de­fla­tor has been neg­a­tive since the be­gin­ning of 2015.

Two types of de­fla­tion spi­rals are cur­rently at work in China. There is the over­ca­pac­ity-de­fla­tion spi­ral, in which over­ca­pac­ity pushes down the pro­ducer price in­dex, lead­ing to fall­ing cor­po­rate prof­itabil­ity. Then there is the debt-de­fla­tion spi­ral, in which fall­ing pro­ducer price in­dex causes real debt to rise, again weak­en­ing cor­po­rate prof­itabil­ity. In both cases, firms are driven to delever­age and re­duce in­vest­ment, a re­sponse that leads to more over­ca­pac­ity and fur­ther de­clines in the pro­ducer price in­dex. Fur­ther­more, given that China’s cor­po­rate debt is al­ready very high, the in­crease in real debt may have dev­as­tat­ing con­se­quences for fi­nan­cial sta­bil­ity.

Com­pound­ing the chal­lenge con­fronting China is the fact that the econ­omy’s ma­jor de­mand-side driver, real-es­tate in­vest­ment, is de­clin­ing more rapidly than the al­ter­na­tive source of de­mand, do­mes­tic con­sump­tion, is ris­ing. In 2015, the un­sold res­i­den­tial floor space for China as a whole was 700 mil­lion square me­ters, while the av­er­age an­nual sale of floor space in nor­mal times was 1.3 bil­lion square me­ters.

Faced with dou­ble-digit growth in in­ven­tory, real-es­tate devel­op­ers slashed in­vest­ment. By the end of 2015, real-es­tate in­vest­ment growth dropped al­most to zero. This year, though in­vest­ment in­creased some­what in Jan­uary and Fe­bru­ary, that rate is al­most cer­tain to fall sig­nif­i­cantly fur­ther. Be­cause real es­tate in­vest­ment ac­counts for more than 10 per­cent of China’s GDP, the im­pact of this trend on over­all eco­nomic growth will be con­sid­er­able.

In this con­text, China is not fac­ing a choice be­tween Key­ne­sian stim­u­lus or sup­ply-side re­form, but rather a chal­lenge in bal­anc­ing the two. In or­der to avoid a hard land­ing that would make struc­tural ad­just­ment ex­tremely dif­fi­cult to im­ple­ment— not, it should be noted, to prop up growth— an­other stim­u­lus pack­age that in­creases ag­gre­gate de­mand through in­fras­truc­ture in­vest­ment is needed. Given that China’s fis­cal po­si­tion re­mains rel­a­tively strong, such a pol­icy is en­tirely fea­si­ble.

But the new­stim­u­lus pack­age should be de­signed and im­ple­mented with much more care than the 4 tril­lion yuan ($586 bil­lion) pack­age China in­tro­duced in 2008. With the right in­vest­ments, China can im­prove its eco­nomic struc­ture while help­ing to elim­i­nate over­ca­pac­ity.

The key will be to fi­nance projects mainly with govern­ment bonds, in­stead of bank credit. That way, China can avoid the kinds of as­set bub­bles that swelled in the last sev­eral years, when rapid credit growth failed to sup­port the real econ­omy.

And to ac­com­mo­date this ap­proach, the Peo­ple’s Bank of China should ad­just mon­e­tary pol­icy to lower govern­ment-bond yields. Specif­i­cally, it should shift the in­ter­me­di­ate tar­get of mon­e­tary pol­icy from ex­pand­ing the money sup­ply to low­er­ing the bench­mark in­ter­est rate. Need­less to say, in or­der to up­hold the in­de­pen­dence of its mon­e­tary pol­icy, China has also to re­move the shack­les from the yuan ex­change rate.

Struc­tural ad­just­ment re­mains ab­so­lutely crit­i­cal to China’s fu­ture, and the country should be pre­pared to bear the pain of that process. But, un­der cur­rent cir­cum­stances, a one-di­men­sional pol­icy ap­proach will not work. Ex­pan­sion­ary fis­cal pol­icy and ac­com­moda­tive mon­e­tary pol­icy also have an im­por­tant role to play in plac­ing China on a more stable and sus­tain­able growth path.

The author, a for­mer pres­i­dent of China So­ci­ety ofWorld Eco­nom­ics and di­rec­tor of the In­sti­tute ofWorld Eco­nom­ics and Pol­i­tics at the Chi­nese Academy of So­cial Sciences, served on theMone­tary Pol­icy Com­mit­tee of the Peo­ple’s Bank of China from 2004 to 2006. Project Syn­di­cate


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