China’s export to GDP ratio in 2007 was 35 per cent. Compared with a growth rate of 25 per cent in September, exports shrank by 2.2 per cent in November. This fall in exports may have cut GDP growth by 3 per cent. If its indirect impact is included, it may have shaved more than 5 per cent off China’s 2008 growth rate.

China’s high export dependency is a result of its export promotion policy. But from a macroeconomic perspective, China’s high export dependency is partly attributable to overcapacity caused by over-investment. In 2007, the combined contribution of fixed asset investment (FAI) and net exports to GDP growth was more than 60 per cent. FAI and exports are the engine-room of Chinese growth.

Importantly, FAI growth has been consistently higher than GDP growth. This has equated to rising investment rates since 2001. How is China’s growth drama being played out in this unsteady environment?

The potential growth rate rises because FAI is higher than the other components of aggregate demand. Excess demand (overheating) will shift to overcapacity as a result. In China’s case, sustainable growth is not possible because the growth rate of FAI is higher than the growth rate of other components of aggregate demand.

If the growth rates of components of aggregate demand other than FAI fail to rise, overcapacity can only be absorbed by a further rise in the growth rate of FAI. This feedback loop leads to acceleration of FAI to absorb overcapacity.

Eventually the growth rate of FAI will hit a ceiling imposed by social, environmental, natural resource, ecological or other constraints. Deflation then sets in and the growth process will break down.

To prevent the collapse of the growth process, either FAI growth can be slowed, or the growth of the other components of aggregate demand can be accelerated. The equality of the growth rate of FAI with that of other components of aggregate demand is a necessary and sufficient condition for maintaining steady, sustainable growth in the long term.

When signs of overcapacity began to surface in 2004 the Government tried to clamp down on new investment projects. The steel industry was a case in point. In 2004, China’s steel production was about 400 million tons. Concerned about overcapacity, the government clamped down on construction of new steel mills. But strong demand for steel, attributable to real estate development and strong export demand, meant new steel mills continued to appear. China’s steel production rose to more than 600 million tons in 2007.

Growth was sustained temporarily, but at the cost of economic equilibrium. Investment fever and strong external demand from mid-2007 meant China’s inflation rate worsened rapidly. The strong external demand delayed the surfacing of overcapacity for many years.

But export demand is highly unstable. In the second half of 2008, export demand collapsed due to the global financial crisis. Long-postponed overcapacity surfaced suddenly. The sudden shift from inflation to deflation, in September to October 2008 was truly stunning.

With or without the GFC, overcapacity and the need for correction were inevitable. The global economic crisis merely exposed the vulnerability of China’s growth pattern in a dramatic fashion.

The Chinese government moved quickly to mitigate falling GDP growth after the GFC through a stimulus package and monetary expansion.

In November 2008 the government introduced a 4 trillion Yuan stimulus package (14 per cent of 2008 GDP) for 2009 and 2010.

The success of China’s stimulus package is unsurprising. Over the past decade, China’s budget deficit was so low that after the stimulus China’s debt should only be about 20 per cent of GDP. There is plenty of room for the Chinese government to use expansionary fiscal policy to supplement the lack of export demand.

The central government is financing one-quarter of the 4 trillion yuan package, in the form of direct grants and interest rate subsidies. Bank credit is the second most important source of finance for the stimulus package.

Local governments proposed their own stimulus packages of 18 trillion yuan. The central government will issue 200 billion yuan in government bonds on behalf of local governments, but commercial bank credit is expected to be the most important source of finance for the proposed local-government projects.

Monetary expansion since 2009 has also been important to China’s recovery. The People’s Bank of China (PBOC) has adopted a very expansionary monetary policy to support the expansionary fiscal policy. In the first half of 2009, bank credit increased by 7.3 trillion RMB, already usurping the yearly target.

As a result, the inter-bank money market has been inundated with liquidity. This led to the phenomenon described as ‘flour being more expensive than bread’, with interest rates in the inter-bank market lower than interest on deposits with commercial banks.

China’s banking system was relatively safe when the Western banking system was on the edge. Thus, the increase in liquidity in the inter-bank money market has been translated into an increase in bank credit and broad money. What are the long term effects of these two responses to the GFC?

The expansionary fiscal and monetary policies may have succeeded in arresting a fall in growth, but the medium and long-term impacts of the expansionary policies are concerns.

First, the most important feature of China’s growth pattern is investment overdrive. The investment rate has increased from 25 per cent in 2001 to 50 per cent as a result of the stimulus package. This means that China’s overcapacity will become more serious in the future.

Second, investment efficiency has been falling as a result of the stimulus package. The government knows that the economy has been suffering from overcapacity. Therefore, the stimulus package was concentrated in infrastructure, rather than new factories. But there are still problems with an infrastructure-centered stimulus package. The fall of investment efficiency will have an important negative bearing on China’s long-term growth.

Third, infrastructure investment is long-term investment and will not reap immediate benefits. There must also be investment in manufacturing capacity. Where will tolls come from, if there is no traffic on an eight-lane highway? Also, due to hasty implementation, waste in infrastructure construction is rife.

Fourth, the over-enthusiasm of local governments for local investment may create big problems. Most of the local stimulus packages will be financed by commercial loans guaranteed by local governments. As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources.

Finally, as already mentioned, China’s monetary policy has been too loose. There is no need for such low interest rates. Interest rates are an important screening device in developing countries. With tiny interest rates, small and middle-sized private and innovative enterprises suffer discrimination relative to state-owned monopolistic enterprises. The progress made in enterprise reform may be undone.

In sum, if the government fails to tackle structural problems head on, the negative impact of the measures taken to manage the crisis could be serious. But it is also notable that the Chinese government is aware of the problems and has begun to take measures to put structural adjustment back on the agenda.

Hopefully, the Chinese government will both succeed in reviving the economy, and also in reversing the worsening structural problem. Only then will there be a strong foundation for China’s future growth.

Yu Yongding is Professor and immediate past director of the Institute of World Economics and Politics in the Chinese Academy of Social Sciences (CASS). This essay is an abstract of his Richard Snape Lecture to the Australian Productivity Commission in Melbourne last November.