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Macro imbalances to blame for cooling economy

By Lu Feng | 2015-08-13
(Chinese Social Sciences Today)

A man yawns when trying to recruit staff. Labor shortages have spread across many Chinese cities, bringing down the growth of potential supply in the economy.

 

From double-digit growth in the early years of the 21st century to the recent rates of around 7 percent, China’s economy seems to be trapped in a downturn, drawing constant attention from the international community. To some extent, this downward trend is to be expected after years of high growth, but it can also be attributed to adjustments to macroeconomic imbalances.
 

As the growth of the labor force has peaked, the transfer of agricultural labor has scaled down and the effect of the late-mover advantage has weakened, the Chinese economy has seen slowing growth in potential supply. The economic performance these years is inseparable from problems generated by the macroeconomic disequilibrium.


Macro imbalances
In the first years of the 21st century, China achieved amazing results in economic development and opening-up. However, a lag in institutional reform and distortions of factor price fanned the overexpansion of money and credit. In addition to robust momentum in fundamentals, the economy, while running in high gear, was injected with excess speed and heat.

 

Featuring a heavy reliance on multiple industrial-quantitative instruments, extensive macro regulation is insufficient when it comes to eradicating factors causing inflation and asset bubbles, thus gradually bringing about macroeconomic disequilibrium.


Triggered by distortions of factor price, the disequilibrium is primarily caused by an overwhelming amount of money, causing runaway inflation, prodding the government to roll out extensive macro-control policies and adding difficulty to deepening reforms.
 

In the second decade of the century, China suddenly realized that its economy has been beset by a warped system and macroeconomic imbalances, along with an urgent need to rectify the disequilibrium. Only through a period of adjustments can the economy get back onto the track of sustainable growth.


The basic task during this period is to, while maintaining growth at an acceptable rate, regulate previous factors that tipped the macroeconomic balance through market clearing mechanisms and by rebuilding financial and economic disciplines, and create institutional conditions for autonomous growth through structural reform.


Facing renewed inflation in the wake of the 4-trillion-yuan stimulus package, the previous government, led by Hu Jintao, made partial adjustments to a few outstanding problems amid imbalances. As a result, those overstretched sectors and regions were the first to feel the pressure from changes in policy and the economic environment.


At that time, however, the necessity and profoundness of a new round of rebalancing were not fully recognized, making ongoing adjustments passive. Moreover, the demand for another stimulus package had lingering effects.
 

Proactive rebalancing
After the 18th Communist Party of China (CPC) National Congress, the new leadership, led by Xi Jinping, with the attitude of “holding accountable to history and the people,” sized up the situation and weighed the overall situation to reprioritize economic and macro-control goals, ushering in a new era of all-round reform deepening and proactive rebalancing.

 

Since early 2013, when the central government was reshuffled, Chinese decision-makers, when studying and planning for economic development, stressed the “Three-Should” theory: “macro policy should be stable, micro policy should be flexible and social policy should support the bottom line.”


This carefully considered “Three-Should” theory clearly represents the new concept of the new leadership in steering and managing the economic situation and makes explicit the general orientation of economic policy in the rebalancing period.
 

Consistent with the “Three-Should” theory, the overarching goal of China’s economic policy in recent years has been to push ahead with overall reform deepening, in a bid to activate the micro impetus for growth.


On the macro level, relevant policies reflect two basic orientations.
 

First, the government strives to maintain the neutral state of neither loosening nor tightening monetary and fiscal policy, and on this basis, utilize market clearing and regulation functions to resolve contradictions caused by imbalances.
 

Second, in an attempt to maintain the bottom line of 7.5 percent growth, it has adopted two targeted regulation measures: infrastructure investment to boost people’s livelihoods and credit financing for bond issuing to stabilize growth.
 

Despite lowering growth, rebalancing moves taken since the 18th CPC National Congress have made substantive progress in many aspects. First, part of historic excess capacity has been soaked up. Second, overexpansion and inflated prices in such sectors as real estate have been brought under control. Third, shadow banking and overexpansion of local debt have been regulated. Fourth, market entities have changed their expectations for a big bailout by the government when the economy heads downward.
 

Given the process of “expansion-imbalances-rebalancing” and what has happened these years, it is expected that this round of rebalancing will go through three stages. Currently, China is transitioning towards the third stage characterized by deepening adjustments.


At the third stage, there are multiple tasks ahead. First, it is necessary to, amid economic slowdown, digest imbalance factors in the upstream industrial sectors and the property industry to unleash accumulated overcapacity and piled-up inventory.


The second task is to, with the help of market clearing and policy adjustment functions, control and progressively eliminate risks of high leverage and high debt in the financial sector.
 

Third, it is imperative to combine structural reform with short-term macro-control policy to transform the macro-control architecture into a more scientific one. After these adjustment tasks are fulfilled, it is hoped that China’s economy will embrace a new round of autonomous growth.


Policy suggestions
Based on the above-mentioned points, here are a few policy suggestions.

 

First, it is necessary to further define and stick to the policy orientation of reform and adjustment. During the adjustment deepening period, all kinds of inner contradictions and risks will appear and bring mounting pressure for big stimulus. The risk remains that the rebalancing moves will end in failure. It is therefore essential to hold fast to the priority of structural reform and take active actions to strive for success.
 

Second, the bottom line of the economic growth rate should be moderately lowered. When defining the bottom line, the government should consider possible factors behind changes in potential growth and unconventional factors in the rebalancing process.


Since the economy will unavoidably slow down due to the absorption of overcapacity and reduction of too much leverage, real growth should be allowed to be lower than potential growth to some extent during the rebalancing period.
 

All things considered, it is advisable to lower the target growth rate to 7 percent. To adapt to the new environment of the market economy, the government should introduce the growth target from predicative and guiding perspectives to dissipate previous instructional effects.
 

Third, in terms of monetary policy, quantity tools, especially extensive reduction of the reserve ratio, should be employed to maintain the stable growth of money and liquidity. This not only aims to phase out abnormal regulation of reserve requirements, but is also a reasonable market-based move towards steady growth that can help trim the balance sheet of the central bank and provide supporting conditions for the reform of interest liberalization.


Fourth, measures should be coordinated to rectify the imbalanced financial market and latent risks within. Departments concerned should permit defaults on certain shadow banking products, allow some insolvent financiers to emerge from bankruptcy through reorganization and beat rigid cashing expectations to raise the awareness of market risks.
 

Last but not least, it is imperative to plan ahead following small probability events. Good fundamentals and stable, prudent guidelines are a solid guarantee for the smooth completion of the rebalancing. However, possibilities of unexpected, unfavorable changes in the external and internal environment cannot be ruled out. High heed should thus be paid to some regions and departments that have suffered from severe imbalances and might face the risk of “local piping” after the “flood.” Meanwhile, vigilance against changes in the external environment is also necessary.
 

Lu Feng is a professor of economics from the National School of Development at Peking University.