A couple of months ago, the Xinhua news agency published three articles on ‘stimulus and reform’ to strongly support the government’s mini-stimulus policy. While acknowledging that the term ‘Likonomics’, as Premier Li Keqiang’s economic strategy has been dubbed, demonstrates a commitment to structural reform, the news agency also blamed it for creating the illusion of a tension between stimulus and reform.
China’s current macro-control policy, however, deserves closer scrutiny.
Is it a stimulus policy or a stabilisation policy?
Professor Lu Feng has written a number of articles recently about macroeconomic policy, making two important points. Firstly, policies aimed at stabilising growth should not be labelled ‘mini-stimulus’. Secondly, under the current circumstances, it is probably better not to stimulate the economy. Premier Li has repeatedly said that it was neither necessary nor feasible to adopt a substantial stimulus policy. ‘No major stimulus policy’ were the exact words used to describe the first pillar of Likonomics, ‘no stimulus’, which does not mean ruling out macroeconomic policy aimed at stabilising growth.
But nowadays in China, macro policies always try to accelerate rather than to slow growth. Perhaps this suggests that the official target is too high relative to growth potential?
Another important question is whether the current deceleration in growth is cyclical or structural. The Chinese economy faces significant difficulties for at least three reasons. The first is the slow global recovery and negative consequences from previous stimulus policies. The second is an unsustainable growth model, evidenced by problems such as over-investment and income inequality. And the third is the new middle-income trap challenge. Of the above, only the first factor is cyclical in nature.
Some fundamental changes in the Chinese economy also confirm that current growth deceleration is mainly structural. It is no longer possible for Chinese exports to continue to grow at more than 20 per cent or more a year because of the sheer size of China’s economy.
In the meantime, a slowdown in capital accumulation looks permanent, while the labour force is already shrinking. Lu Yang and Cai Fang of the Chinese Academy of Social Sciences estimate the current growth potential at 7.75 per cent. Liu Shijin of the Development Research Center of the State Council puts it at 7 per cent.
How low can growth go before it becomes intolerable? In order to increase policy flexibility, the government proposed new target bands for growth, replacing previous targets that specified only a single number. The new targets give a range for a growth rate that isn’t so high that it causes major inflation problems or so low that it triggers serious unemployment. This is the trade-off between inflation and unemployment represented by the familiar macroeconomic concept of the Phillips Curve.
The problem is the lower boundary for growth is probably too high. The official growth target was set at around 7.5 per cent. However, when growth slowed to 7.4 per cent during the first quarter, the government almost panicked. Policymakers fear that there could be major problems with unemployment, financial risk and investor confidence should growth slip below 7.2 per cent, although they have not provided any strong evidence for such a fear. If the government is serious about its new target bands, it should reduce the lower end of its target range.
The government also experimented with targeted structural measures. For instance, there has been an increase in investment in the power sector, and the reserve requirement ratio for financial institutions lending to small and medium enterprises has been lowered. These policies may help China to stabilise growth and overcome bottlenecks.
The success of such measures, however, is dependent on the assumption that the government has sufficient information to act appropriately on these structural issues. Unfortunately, the government’s track record in this area has not been satisfactory.
The government has tried some differentiated measures for different industries and regions but most of them have failed. While it is useful to experiment with targeted macro-controls, it is important that this experiment does not turn into new industry policy. New policies should include exit strategies and should not restrict competition.
Is it still possible for China to achieve medium to rapid economic growth in the coming decade? It depends on the policy strategy.
Long-term growth cannot occur via fiscal stimulus. A recent study by Tan Yuyan of Peking University finds that stimulus policies create more zombie firms and inhibit productivity, profitability and job creation in viable firms. Harry Wu’s work detailing the decline in industrial productivity after the previous stimulus package makes the same point.
A more effective strategy for achieving relatively rapid economic growth is through accelerating economic reform, which would stimulate productivity growth in the future. For instance, Lu Yang and Cai Fang estimated that reform of the one-child policy and the hukou system of household registration, combined with improvement in human capital, could raise China’s future growth by 1 to 2 percentage points.
My own joint study with Ji Yang also discovered that more complete financial reforms could lift growth by 1.4 percentage points. And a study by the International Monetary Fund finds that, if a comprehensive reform program is rigorously implemented, Chinese growth may be lowered by 0.2 percentage points in the near term but may be increased by 2 percentage points by 2020.
All these studies suggest that it is possible for China to continue with relatively rapid economic growth. But the government has to both accelerate structural reform and tolerate some growth slowdown in the near term.
This article was originally published at East Asia Forum. Reproduced with permission.