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Deja vu? Old policy tools, old risks in China

Reading Time: 5 mins
Bullet trains nose-to-nose at Yantai station, Shandong province. Infrastructure projects have contributed significantly to China’s economic performance in recent decades, but some commentators believe the marginal return on such investments has turned from positive to negative (Picture: China Daily/Reuters).

In Brief

The communique of the Chinese Communist Party Politburo meeting, held on 31 July 2018, identified maintaining economic and social stability as the top policy priority. China’s real GDP growth rate edged down from 6.8 per cent in the first quarter of 2018 to 6.7 per cent in the second quarter, and is expected to soften further in the coming quarters due to increasingly difficult external and domestic conditions.

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At the same time, infrastructure spending has accelerated. According to one count, by mid-2018 realised expenditure on mega-infrastructure investment projects in 13 provinces alone already totalled 3.4 trillion RMB, very close to the planned investment total for the entire year. This development reminded many people of the 4 trillion RMB stimulus package that the Chinese government announced nearly 10 years ago in response to the global financial crisis.

That policy played a major role in stabilising economic activities in China and some neighbouring economies during the global financial turbulence. But the aggressive fiscal spending and the accompanying monetary expansion also had serious side effects, such as excess capacity, high leverage ratios, asset bubbles and low productivity.

Today, containing systemic financial risk is the first of the three economic policy battles that the government confronts. Many of the financial risk factors that exist today can be traced back to the stimulus package from 10 years ago. The high aggregate leverage ratio is a result, for instance, of an extraordinary expansion of the money supply. And the high local government debt burdens are a consequence of reckless borrowing by local government investment vehicles.

Soon after introduction of the stimulus package ten years ago, policy circles in Beijing reached a clear consensus that the government should tolerate more moderate economic growth and should not engage in aggressive monetary and fiscal policy expansion. And even if it became necessary to adopt some fiscal expansion, it would be better to spend the money on household welfare and structural upgrading, rather than building more infrastructure.

Yet whenever growth softens, the government can’t resist going back to the old policy tools. It seems that this year is no exception. The politburo meeting suggested that active fiscal policy would not worsen the local government debt problem at this time, since the infrastructure projects will be financed by issuing local government special bonds. But the real consequences are yet to be seen.

In the past decade China has struggled to keep a balance between short-run growth targets and structural reforms. Hitting the growth targets were closely tied to maintaining short-run stability. The extremely low degree of tolerance for economic volatility associated with the goal of doubling the size of the economy by 2020 has often encouraged the leadership to sacrifice or postpone reforms whenever the economy experiences uncertainty and downward pressure on growth. The approach Beijing has adopted for stimulating growth has been large-scale fiscal stimulus, paired with accommodating credit conditions.

This was the case in 2008, in 2012 and once again now. According to the National Bureau of Statistics of China, the average annual growth rate of infrastructure investment in the past decade stands at 20 per cent. By 2017, total fixed investment reached 63 trillion RMB, accounting for 76 per cent of GDP, and infrastructure investment reached a value of 14 trillion RMB, accounting for 17 per cent of GDP.

These infrastructure projects used to contribute significantly and effectively to economic performance, but some believe that the marginal return of infrastructure investment in China has now turned from positive to negative due to underestimating actual construction costs and the deteriorating efficiency of some of the infrastructure projects, among other problems.

Investing in unproductive projects may lead to a boom during the initial stage, but in the longer term it becomes a source of inefficiency, inducing problems of debt build-up and economic fragility. This is especially relevant to the local government debt issue that the leadership has tried to rein in during the past few years. Introducing large-scale infrastructure stimulus now will only make the debt problem worse, even with the issuing of special bonds.

Another problem associated with the policy choice of fiscal stimulus is its impact on the pace of domestic structural reform, especially financial reform. Implementing fiscal policy requires stronger government power in the market. This means a retreat of market mechanisms in the decision-making process and a reversal of the market-oriented reform processes.

More importantly, it comes at the expense of reform efficiency. Large-scale infrastructure investment in unproductive or duplicated projects worsens the efficiency of capital allocation, which in turn is detrimental to effective financial resource allocation. Steering through financial reforms even in difficult times, such as now, would reduce the costs of resource misallocation in the longer term, boost economic growth along a sustainable path and build up market confidence during bad times.

Financial reform has a central place in the leadership’s work agenda. Over the past few years, there have been significant achievements in the financial sector, such as inclusion of the renminbi in the Special Drawing Rights basket, increased exchange rate flexibility and the removal of a ceiling on deposit interest rates. And throughout, the Chinese government has emphasised its determination to prevent the accumulation of systemic risks and sudden breakdown of the financial system. This has motivated the implementation of a macro-prudential policy framework and the establishment of the National Financial Stability and Development Committee in 2017. But there remains a lot left to do.

As Zhou Xiaochuan, former governor of the People’s Bank of China, wrote in an article published at the beginning of 2018, there is no ideal sequence for reform, so every window of opportunity to push forward structural reform needs to be seized. A difficult time with growth pressure is an ideal opportunity for reform. The future of growth relies on structural reform and industrial upgrading, underpinned by effective risk management. No more fiscal stimulus deja vu, please.

Jiao Wang is Research Fellow at the Melbourne Institute of Applied Economic and Social Research, Faculty of Business and Economics at the University of Melbourne.

Yiping Huang is Professor and Deputy Dean of the National School of Development at Peking University.

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