Is monetary stimulus the appropriate policy choice in China?


Jordi Rof

China is on a clear deceleration path. Most activity indicators support the idea of a soft slowdown. GDP, the wider measure of economic activity, is growing at the lowest rates since 2008. Other sector-specific gauges of economic activity are registering similar trends. Industrial production is growing at 5.9 percent YoY, also the lowest level since 2008. Fixed asset investment growth, a crucial growth engine, is at its lowest level in 15 years. This is resulting in clear signs of overcapacity in the Chinese industry.
Our estimates of capacity utilization, based on OECD discontinued indicators, show a substantial decline, from a peak of 88 percent in 2007 to 81 percent in the last quarter of 2015. Activity readings suggest that the country is not producing at its full potential, a phenomenon known as negative output gap.
The concept of output gap can be defined in different manners. The notion of sustainability, understood as maintaining output levels without creating imbalances, is central in most definitions. Resource misallocation (a disproportionate weight of construction in real estate booms, for instance) or excessive reliance on credit are the most relevant examples of economic imbalances. In the case of China, authorities responded to the 2008 slowdown mainly through monetary stimulus. Credit growth increased, from an average of 16 percent YoY in 2008 to an average of 28 percent and 23 percent in 2009 and 2010.
Lending growth moderated since then, but remained consistently above GDP growth, contributing to worsen debt to GDP ratios. For instance, bank credit to GDP ratios increased from 100 percent of GDP in 2008 to 154 percent in 2015, and their balance sheet rose from around 200 percent of GDP to almost 300 percent in the same period. The evolution of credit suggests overheating, and that slower growth is a structural phenomenon that the accumulation of debt is not fully offsetting.
The traditional measures to overcome economic slack are expansionary fiscal and monetary policies. However, these policies are only fully adequate if there is enough fiscal space and credit can be expanded without becoming a threat. Chinese authorities chose to intensify their reliance on monetary stimulus in 2015. So far, this loose policy option is contributing to manage the deceleration and to avoid a hard landing scenario.
However, that comes at a cost of raising imbalances, and therefore, increases the likelihood of a much larger correction in the future. Assessing whether debt-fueled growth is the right policy option for China is not straightforward. Several information gaps, such as bank’s asset quality and the actual size of the informal financial sector, make any analysis extremely inaccurate, but in any case this model always has a limited validity. Eventually, only fundamental increases in productivity and accumulation of productive capital ensure long-lasting growth.
Does China have any other options other than monetary stimulus? A slowdown in lending would lead to a large growth correction. The incentives to avoid this option are clear and justified. However, Chinese authorities should be aware of the limitations of their credit-fueled model. China will converge with developed economies in terms of growth as the country gets closer to the technological frontier, and looser policies will be unable to alter it.

— Jordi Rof is economist at Asiya Investments Company.


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