Author: Guonan Ma, Fung Global Institute
There’s a debate going on about the appropriateness of monetary easing in China. Monetary policy was excessively tight in 2014 but started loosening more meaningfully from late 2014, in an attempt to cushion slowing growth, facilitate rebalancing, support reform and mitigate financial risk. This shift in policy stance was warranted, desirable and will serve the economy well in the short and long term.
Monetary policymaking can be tough and controversial. In mid-2014, debates in China began heating up. They centred on whether monetary policy was excessively tight and thus ought to ease in a timely and meaningful way.
There are two competing schools of thought on Chinese monetary policy. On one side, the anti-easing — or ‘no pain, no gain’ — camp believes that monetary accommodation hampers economic reform, worsens structural imbalances and promotes short-term pseudo-growth at the expense of sustainable long-term development. Reforms and structural adjustments, the logic goes, are necessarily painful and monetary easing undermines these goals.
Less ideological arguments point to China’s still buoyant labour market in spite of weaker growth as evidence of an economy near its lower growth potential. A shrinking Chinese labour force, a possible Lewis turning point, a bigger job-intense service sector and the attendant slower total productivity growth might all combine to trim underlying growth potential consistent with non-inflationary full employment. Thus, slower headline GDP growth can still be compatible with an economy operating at or near full capacity, questioning any need for monetary accommodation.
The pro-easing camp thinks that sensible, nimble monetary easing complements economic reform, cushions growth, facilitates structural adjustment and mitigates financial risk. Reform, while imperative, is not a sacred cow but a means to improve living standards. And economic reform calls for a sensible shift in the monetary policy stance in response to business cycles. The Chinese economy is unbalanced, but one does not need to strangle it in order to rebalance it. On the contrary, an excessively tight monetary policy could aggravate structural imbalances.
This controversy in China looks odd. In the United States, the euro area and Japan the consensus view among policymakers is that aggressive demand-support policy measures and strong structural reforms on the supply side should go hand-in-hand. And why not? The puzzling question is why one should have to make a stark choice between them instead of sensibly combining the two. A healthy Chinese economy needs both structural reforms on the supply side to enhance potential growth and a nimble monetary policy to exploit potential and mitigate possible cyclical headwinds on the demand side.
From late 2014, the People’s Bank of China (PBoC) started to act more decisively to ease its monetary policy — most notably, its three rate cuts and another broad reserve requirement ratio (RRR) cut. Did the PBC make a big policy mistake, perhaps by succumbing to political pressure from vested interests?
The short answer is no. Contrary to the views of the anti-easing camp, there are several reasons justifying this shift in China’s monetary policy stance.
There is evidence that the Chinese economy has been operating below its potential capacity. This can be seen from the marked growth deceleration, intensifying disinflationary pressure, rising inventory, declining corporate earnings, slowing credit and high real interest rate. Furthermore, among the big five economies of China, the US, euro area, Japan and UK, both China’s monetary policy stance and its broader financial condition tightened the most in the wake of the global financial crisis (GFC). This weighed on Chinese domestic demand. A mix of accommodative monetary policy and neutral fiscal policy would serve China the best now, as the country opens up its capital account and moves away from its dollar peg, while restructuring its local government finance.
Prompt monetary relaxation, not tightening, supports domestic demand, reduces the headwinds from de facto fiscal contraction emanating from local government deleveraging, eases the relatively tight Chinese financial conditions and deflects global deflationary shocks. It helps mitigate adverse demand shocks, which have been non-trivial, and as a minimum, avoids rubbing salt into the wound.
China’s monetary policy accommodation can actually help accelerate liberalisation, by winning both broader political support and gaining greater headroom for implementing difficult reforms. While monetary policy is neither a magic bullet nor a substitute for the necessary institutional and structural reforms, monetary easing could provide the reform-minded PBoC a window of opportunity to accelerate financial liberalisation. In contrast, maintaining tight monetary and fiscal policies is an ill-advised tactic to force through tough reform programs, which could ultimately be counterproductive, if not reckless.
A timely relaxation should also help cushion an orderly slowdown of the Chinese economy, in turn facilitating the structural rebalancing task. The credit binge witnessed during the GFC was partially the consequence of the unmistakably late monetary policy response to collapsing domestic and external demand at that time. And this rapid credit expansion mostly funded local government investment, likely worsening domestic imbalances. Moreover, most of the credit allocation and industrial policy responsibilities burdening the PBoC should be decommissioned, because monetary policy is not an adept instrument with which to address such structural issues.
Financial stability concerns have likely come to figure more prominently on the PBoC’s agenda because a key challenge is how to manage the legacy of excess leverage and increased financial imbalances in China. One sensible response is measured monetary accommodation to maintain steady nominal growth. This would help pre-empt a potentially vicious debt deflation cycle and dampen excess volatility in the financial system, while facilitating the tricky deleveraging process, not vice versa.
Guonan Ma is a senior fellow at Fung Global Institute, Hong Kong.