How China’s Keynesian experiment paid off

In the aftermath of the GFC, Beijing and Washington both unveiled large stimulus packages - the results of which could not have be more different. Why was China's package so much more effective?

Graph for How China’s Keynesian experiment paid off

Chinese 100 yuan (RMB) bank notes being counted at a bank in Huaibei, in eastern China's Anhui province. (CHINA OUT AFP PHOTO)

Seven years after the onset of the global financial crisis, Australia still remains divided over the wisdom of the Rudd’s government’s stimulus package. The current Coalition government believes it was wasteful and contributed to the country’s debt problem.

The criticism remains despite the fact that some of the world’s most pre-eminent economists --  including Nobel Laureate Joseph Stiglitz -- regard Australia’s stimulus package as one of the best designed and most effective programs.

In China, there is also a heated debate taking place over the country’s monster four trillion yuan ($700 billion) stimulus package, which is credited with saving not only China’s economy, but also the economies of many commodity exporting nations -- including Australia’s.

Many leading economists and policy-makers in China have criticised the after-effect of the stimulus package. Wu Jinglian, the doyen of the economics profession and a leading reformer, said the country must not repeat that mistake and should focus on improving efficiency and competiveness.

The 4 trillion yuan stimulus package is widely believed to have contributed to problems such as the quick accumulation of local debt, large excess capacity in many industrial sectors such as steel and cement and the strengthening of the state sector at the expense of the private sector.

For example, China’s local government debt increased nearly 20 per cent every year for the last three years. The collective debt of local governments increased nearly 3.9 trillion yuan ($720 billion) to 10.6 trillion yuan by June 2013.

However, there are many who believe Beijing’s bold and decisive action saved the day. The latest instance of praise has come from two economists from the US Federal Reserve Bank of St Louis, who argue that Beijing’s stimulus not only saved China from recession, but it was also much more effective than government intervention in the US and Eurozone.

In the aftermath of the global financial crisis, Beijing and Washington both unveiled large stimulus packages that were as large as 5 per cent of GDP in both countries, according to data from the International Monetary Fund.

But the results could not be more different. China quickly rebounded to its double digit pre-GFC level in late 2009 and overtook the US as the world’s largest manufacturing country, a title held by the US for more than a century.

On the other hand, the US is still slowly recovering from the global financial crisis. GDP levels in developed economies has declined permanently since 2008 by as much as 10 per cent below their respective long-run trends, according to the two Fed economists in their paper “Withstanding Great Recession like China.”

This begs the trillion dollar question: what is so special about China’s stimulus package and how come it worked so much more effectively than the US package?

The key to understanding the effectiveness of Beijing’s program is the country’s state-owned enterprises -- the much derided villains of China’s reform narrative.

If we can rewind the clock and go back to the time when Hank Paulson begged Congress for the $700 billion bank rescue package, one of the biggest problems facing the former US Treasury Secretary was the unwillingness of American banks to lend, despite the fact that Ben Bernanke, the former Fed Chairman, was throwing money at them.

By 2013, the total monetary injection into the US financial system reached $US 3.5 trillion but banks responded by increasing reserves rather than increasing bank loans which in turn led to a substantial collapse in consumption and investment.

However, when China’s central bank started to expand the money supply, they told big state-owned banks to open their purses. The response was immediate and there was no holding back. The real growth rate of loans increased from 5 per cent a year in mid-2008 to 12.49 per cent a year in December 2008 and shot to 32.5 per cent a year in June 2009, the historical peak since 1978.

China’s state-owned enterprises heeded Beijing’s call and ramped up their production as well. There was a massive increase in industrial capacity across many sectors including steel, cement, solar panels and ship building.

“The Chinese government cleverly used its state-owned enterprises as a fiscal instrument to implement its aggressive stimulus programs in 2009, consistent with the very Keynesian notion of aggregate demand management through increased government spending and the fiscal multiplier principle” say the two Fed economists.

China’s central bank governor Zhou Xiaochuan compared the role of a central banker during a financial crisis with that of a gatekeeper of a dam during a drought. He said the gatekeeper should not flood the entire field when only selected patches need water.

In the US, the Fed flooded the entire field while China aggressively channelled money into the country’s state-owned enterprises with immediate effect. To be fair to Bernanke, even the most powerful man in the international banking system can’t tell American bankers to lend when they don’t want to.

China’s authoritarian system has its advantages when dealing with crises. However, it will prove harder to deal with its aftermath.

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