China’s economic rise over the past four decades has been nothing short of remarkable. Economic growth has averaged nearly 10% annually since 1980. Throughout this entire time, Chinese policymakers have proved adaptable and successful at maintaining both strong economic growth and financial stability. This was facilitated by China’s state-capitalist economic system, which provides policymakers with more policy levers and greater autonomy than in more market-oriented economies. A closed capital account, extensive state ownership and the prominent, even dominant position the government occupies in the financial system allow the authorities to intervene forcefully and in a timely manner to safeguard financial stability and maintain high economic growth.
After the economic disasters of the Maoist era, China adopted a gradualist and pragmatic approach to economic policy-making. Deng Xiaoping, the reform-minded leader who took the reins following the Cultural Revolution recommended that China “ford the river by feeling the stones”. Policy-making was to be gradual, cautious and guided by trial and error. Deng also opined that it does not matter if the cat is black or white as long as it catches mice. Policy-making was to shun ideology and focus on generating prosperity.
Gradualism and pragmatism have served China well. What is one then to make of China’s present economic policies, which have drawn criticism for not acting sufficiently forcefully in view of slowing economic growth, a potential slow-motion financial crisis and the risk of Japanese-style deflation? China’s post-pandemic economic growth has disappointed and most economists have downgraded China’s growth potential to well below 5%. China also appears to be on the verge of sliding into deflation, while recent defaults of major real estate developers have raised concerns about financial stability.
Current economic policy needs to be understood in the context of a broader rebalancing of the economy, which aims to stave off even greater economic and financial problems in the future. While it would be a mistake to underestimate the substantial risks involved in rebalancing, policy-makers do have the tools to manage the rebalancing while avoiding a broader financial crisis. But it is far from clear what is to replace China’s very successful, but now defunct economic model in the coming years and decades. Let me explain.
The problem of excess savings
To get a sense of how good or poor a job the Chinese government is doing, it is necessary to understand the policymakers’ goals as well as the constraints they face. At the macro level, China suffers from excess savings and bad investment. This is the problem policymakers are tackling. But tackling it also increases risks to short-term economic growth and financial stability.
Why are excess savings a problem? China’s economic model has been characterized by high savings rates. A high savings allows for a high investment and strong economic growth. As a relatively capital-poor country, China has benefited greatly from massive productivity-enhancing infrastructure investment, for example. At 45% of GDP, China’s savings rate remains very high, although it is much lower than the 51% of GDP it reached in 2008, the year the global financial crisis erupted and Beijing launched a major infrastructure investment program. By comparison, America’s savings rate has not exceeded 20% of GDP once in the past two decades.
While large savings can help finance rapid economic growth, they become a problem if they are channeled into relatively unproductive investment projects. In national accounting terms, savings is the share of national income that is not consumed. Savings can be converted into investment or they can be exported in the form of current account surpluses. Since peaking at a massive 10% of GDP in 2007, China’s current account surplus has declined to around 2% of GDP or less. This then leaves domestic savings worth 43% of GDP (savings minus current surplus) to be converted into investment. A substantial share of this investment takes the form of real estate and infrastructure investment. In other worlds, China channels savings into a sector where financial returns are diminishing fast.
Overinvestment in this sector has led to a buildup of financial risks. If debt-financed real estate investments are not sufficiently profitable, creditors will take losses. In addition, the relatively unproductive nature of real estate investment weighs economic growth, relative to more productive, alternative investment elsewhere in the economy. China’s increasing inability to convert part of its savings into profitable investment represents major medium- and long-term economic and financial risks. China is getting less economic and financial bang for its investment buck. Chinese policymakers want to avoid a further buildup of financial risks and channel savings into more profitable investments to support medium-term economic growth and limit future financial risks.
The problem of over-investment
The excess savings/ bad investment problem is particularly significant in the real estate sector, not least owing to the size of the sector and its importance for the economy and the financial system. By some estimates, real estate accounts for 25% of GDP. This makes the challenge of reducing investment and growth in such a significant economic sector a risky undertaking, financially and economically.
Financially, overinvestment in real estate has increased financial risks. If a debt-financed investment does not generate sufficient financial returns to repay related liabilities, somebody will incur financial losses. In other words, the current economic model, or at least the part that relies on excessive real estate investment to drive economic growth, has been largely exhausted. Put differently, who needs all these apartments in tier 3 and tier 4 cities? If nobody ends up occupying them, financial losses will occur and unused real estate will not increase the productive potential of the economy. This does not mean that China will not need real estate and infrastructure investment in the future, but simply that present high levels of investments are economically wasteful and financially problematic.
Although the Chinese government announced its intention to rebalance the economy away from investment and exports to consumption under President Hu more than fifteen years ago, it has only been moderately successful. It has been more successful in terms of reducing China’s export dependence than in reducing its reliance on investment to support economic growth. In 2020, Chinese policy makers introduced the so-called three lines policy, which forced real estate developers to reduce their financial leverage, which in turn aimed to reduce the macro-financial risks related to the construction sector and ultimately shrink investment in the sector. This policy has pushed many large developers into default, which points to the accumulation of financial risks prior to the introduction of the policy. With real estate representing such a large share of the economy, a significant slowdown in construction activity is now weighing on economic growth. With large amounts of lending to the real estate sector, the sectoral slowdown and bankruptcies is leading to financial losses, and it has begun to weigh on real estate prices, which, via wealth effects, impacts domestic demand and economic confidence.
Rebalancing policy has created economic and financial risks
Economically, rebalancing is weighing on economic growth, and this is not taking into account second-round effects, such as stagnating or falling real estate prices and financial losses incurred by banks and individual investors as well as local governments. But from the perspective of Chinese policymakers this is the price to pay to reduce a further build-up of financial risks and the continued misallocation of savings, which would sooner or later have proved unsustainable and led to even more significant financial losses and foregone growth. The risks are further exacerbated by a highly interconnected and often opaque financial system. Interconnected, because local governments have been in for the financial ride by benefiting from real estate construction. Opaque, because financial information related to the shadow banking system and local government finances often lacks transparency, making it difficult to assess the aggregate level of financial risk as well as where exactly the risks sit and whether creditors and the financial system can absorb the losses related to the rebalancing policy.
Financially, the default of real estate developers translates into losses among creditors, whether they be banks, shadow banks or households that paid for apartments before completion. The economic slowdown in real estate construction and mounting financial losses also affects local government finances due to a sharp reduction in housing related income from land sales. In addition, the poor financial performance of real estate and infrastructure investment will also have a negative impact on local government finances through their off-balance sheet funds, so-called in local government financing vehicles (LGFVs). If LGFV-related investment in real estate and infrastructure go bad, local governments will incur further financial losses.
Purposefully, the central government in Beijing has so far refrained from bailing out the real estate companies, local governments or other creditors, such as banks and shadow banks, to avoid moral hazard (forcing creditors to internalize risk and improve risk management), to limit the financial impact of bailout on on central government finances and to bring about the desired reduction of real estate investment. (Defaults of real estate developers will impact their capacity to build real estate and their financing costs will increase.) But the government is forced to tread a fine line between rebalancing the economy away from real estate over-investment, while not blowing up the financial system and limiting the negative impact of lower real estate activity on economic growth. This requires a carefully calibrated policy where various objectives need to be balanced, including the goal of maintaining short-term and systemic financial stability as well as of rebalancing the economy away from real estate investment over the medium- to long-term.
Short-term, a consumption-oriented fiscal stimulus is best option to support growth
To counteract the short-term slowdown in economic growth, the government has three primary policy levers: monetary policy, fiscal policy and exchange rate policy. Until now, the government has refrained from deploying these tools forcefully, instead appearing to focus on microeconomic reforms, such as financial reform and reforms aimed at facilitating private consumption, without deploying more effective macroeconomic tools aimed at stimulating domestic demand or exports. Should the short-economic growth outlook deteriorate further, policymakers’ preferred option will be to opt for increased central government fiscal stimulus targeting household consumption, accompanied by more modest support from an expansionary monetary policy. Here is why:
An expansionary fiscal policy is the most direct way to stimulate domestic demand, and especially private consumption, while also reducing aggregate savings. As savings are too high and profitable investment opportunities are limited, a policy aimed at lowering savings (increasing consumption) would help tackle the problem of excess savings as well as generate greater short-term demand to stabilize economic growth. Fiscal measures would need to be targeted to limit the negative impact on government finances and to maximize the so-called fiscal multiplier (or the extent to which the fiscal stimulus raises economic growth in the future). The stimulus would need to be financed by the central government, as local government finances are already weak due to their reliance on (falling) real estate related revenues and their prospective financial losses related to LFGVs.
Alternatively, the government could cut interest rates more forcefully. In the past, the government resorted to this playbook, most notably in the wake of the global financial crisis in 2008. To the extent, however, that lower interest rates also stimulate unprofitable investment in sectors like real estate, this would be less desirable and a less targeted measure and fuel investment rather than consumption. Lower interest rates would also slow down the deleveraging of the real estate sector. Moreover, the authorities may be reluctant to reduce interest rates in order not to reduce banks’ net profit margins, thereby undermining bank profitability and their ability to absorb credit losses directly or indirectly related to the real estate crisis. However, if the risk of a recession and the risk of the economy sliding into deflation increases substantially, policymakers will have little choice but to deploy more forceful monetary measures.
A policy geared towards weakening the exchange rate could in principle support economic growth. But not only would this require a substantial weakening of the currency, which might undermine domestic financial confidence, it would also be unlikely to have a significant impact on economic growth, given that China is far less dependent on external demand than in the past (and economic growth in its major export markets is declining). Beijing is unlikely to resort to forceful policy of currency depreciation, not least because it would be accompanied by significant interest rate cuts.
Longer-term, China needs to create more profitable investment opportunities or sharply increase consumption (or both)
But what about the medium and long term? China’s economic growth potential remains considerable given that its per capita income is less than a third of the United States. This points to what economists call catch up potential, essentially the scope to adapt advanced technology, improve human capital and increase the capital stock to support faster economic growth and higher per capita incomes.
From another perspective, China is squarely facing the so-called middle-Income trap. The middle-income trap refers to the increased likelihood of fast-growing emerging economies to experience a substantial downshift of economic growth once their income reaches middle-income levels. The challenge then is to figure out what policies can help exploit their growth potential going forward. This issue is closely related to the macroeconomic and structural challenge China faces in reducing savings (increasing consumption) and creating conditions for excess savings to be converted productively and profitably into domestic investment.
With respect to the second issue, China would need to introduce wide-ranging structural reform aimed at ensuring greater competition, a less privileged position of the state sector, and a greater role for markets (as promised a decade ago at the Third Plenum) to improve productivity and economic growth. This is at least what liberal economists would propose. Excess savings mean that financing is not a constraint, but finding or creating financially profitable and economically growth enhancing opportunities may.
With respect to the first issue, if a more productive use of excess savings cannot be found, the government will need to take measures (easier said than done) to stimulate private consumption by increasing the share of household income. It can also attempt to reduce households’ precautionary savings by providing government-financed health and pension benefits. If necessary, the government can try to finance all or some of these measures through deficits or through higher taxes on the corporate sector, thus reducing corporate savings and hence overall savings.
Rebalancing is as challenging as it is necessary
The goal of China’s present economic policy is to rebalance the economy while avoiding both systemic financial distress and economic stagnation (including deflation). Due to long-standing tradition, Chinese policy-makers have opted for a gradual approach to rebalancing the economy, hoping to be able to avoid a messy, large-scale financial restructuring as well as a potentially massive government-financed bailout. The former might bring about the very disruption policy-makers want to avoid in case a policy gradual economic adjustment and “controlled default” fails. The latter would be costly and would undermine the goal of economic and financial rebalancing, unless it were accompanied by a state-imposed restructuring of the real estate sector. But even then it would let other creditors off the hook and leave moral hazard unpunished, which may encourage future excessive risk-taking elsewhere in the economy. The macro-imbalances and the system of political economy that brought them about would reset, but similar problems would reappear in the future.
The risk is that doing nothing or doing too little too late pushes the economy into deflation, where prices begin to fall and domestic demand begins to stagnate even more in expectation of future price decline while capital investment becomes very unattractive due to falling prices. If such a scenario were to become a serious risk (and it would require more than a month of two or deflation), the government could opt for large-scale, if targeted fiscal stimulus, as it would have been best to avoid deflation. More generally, greater (targeted) fiscal support would also help facilitate a smoother rebalancing by offsetting the economic drag related to diminished real estate sector activity and limit the financial losses that would occur elsewhere in the economy if the Chinese economy were to enter into prolonged deflation and economic stagnation.
If the excess savings hypothesis is correct, however, stimulating consumption will require much more than a simple, one-off fiscal stimulus. Instead, policies need to increase consumption structurally by raising the household share of national income. Ideally, such a policy should be accompanied by reforms that allow for more productive investment opportunities. Chinese policy-makers understand all this. But designing and implementing well-calibrated policies to balance short-term risks and long-term adjustment is a difficult task, even for decision-makers who control powerful economic tools and benefit from significant autonomy.
Of course, excess savings come in degrees, and once policy-makers remedy over-investment in the real estate sector and succeed in mitigating the related financial risks that come with over-investment, China may just gently settle on to lower growth trajectory (underpinned by high investment) in the context of more, but sustainable financial returns on investment. In this scenario, deflation caused by a lack of consumption and an inability (in the aggregate) to find reasonably profitable investment opportunities will not occur. But even in this scenario, China would greatly benefit from an economic policy that shifts the economy towards greater consumption and a policy that creates more attractive investment opportunities.