Debate Room Part 2: Should China have Another Stimulus Package?

No. Some Pain is Necessary in the Short Run

The slow recovery of the US economy and the deep recession in the eurozone have cast a long shadow on the global economy. Given the strong headwinds faced by China’s exporters and the weak domestic demand, many have advocated another stimulus package to arrest the impending economic slowdown. I am against any stimulus package that does not include much-needed structural adjustments.

After more than 30 years of breakneck growth, the Chinese economy is experiencing growing pains. Although the current downturn is triggered mainly by economic weaknesses in China’s trading partners, China cannot maintain its high growth rate by relying on ever-increasing investment demand and export demand. Currency appreciation and higher inflation at home has significantly eroded the price competitiveness of Chinese exports. The high investment rate is unsustainable in the long run and potentially wasteful. China’s existing growth model may, therefore, have reached its natural limits. Without making meaningful structural adjustments, an economic slowdown is inevitable. The global economic downturn may be the trigger, but should not be seen as a structural cause of China’s economic slowdown. To continue to raise productivity and to increase gainful employment opportunities, China needs to reengage in structural reforms that enlarge the role of the private sector and competitive markets.

An economic stimulus that focuses mainly on investment will likely be ineffective, if not wasteful. China’s infrastructure, especially in urban areas, already rivals that of some developed countries in multiple dimensions. And there are already signs of excess capacity in many key industrial sectors, such as steel, cement, solar panels and heavy equipment.

If a stimulus such as the 2008 RMB 4 trillion-package focuses once again on investment, the gross domestic product (GDP) will rise in the short run. But without strong effective demand both at home and abroad, it will simply worsen the existing structural problems by stockpiling more inventories and expanding industrial capacity. With nearly 50% of China’s GDP going towards investment in the last 10 years, we have to ask whether we can expect to earn the required socioeconomic returns from yet more investment directed by the government. A possible silver lining is that employment would increase, but that too, would likely be unsustainable.

China should instead focus on reengaging in structural reforms: enlarge the role of the private sector, expand the role of competitive markets, and offer structural tax cuts to raise disposable income and to lower the tax burdens on consumers and producers. It is good to note that the government has rolled out some such reforms and is expected to do more.

In 2008, the Chinese economy was undergoing policy-induced adjustments. The onset of the global recession in the last quarter of 2008 further exposed many structural problems that China faced. For example, many firms and individuals that borrowed short-term funds to invest in longer term projects or to speculate in the housing market faced the risk of bankruptcy when market liquidity dried up and they found it difficult to refinance. The 2008 stimulus rescued many of them. This, however, cannot be a viable policy in the long term. By providing a safety net for risk-taking firms and individuals, we encourage them to take more risk than is socially optimal. When we say we encourage market competition, we should embrace the disciplinary functions of markets.

The economy is like an only child being raised by overprotective parents and grandparents. Shielding the child from the stumbles and scrapes of everyday activities does not make him stronger. Rather it robs the child of his chance to learn from his own mistakes when most of his mistakes are rather harmless. Would we expect such a child to make good judgments later in life?

To avoid the so-called middle-income trap and to restore high and balanced growth, we need to implement structural reforms sooner rather than later. The moment of reckoning is now and we should seize it. It is better to experience a growth rate of 5% and start the process of structural adjustment now than to delay it and face a truly hard landing in the future with potentially negative growth and longer lasting recessions.

China has transitioned from a poor economy barely able to feed its population to a relatively prosperous middle-income economy in just 34 years. This stunning transformation is a testament to the ingenuity of the Chinese policymakers in reforming economic institutions that allowed entrepreneurship to flourish and encouraged families to better the next generations by investing in education and market-oriented skills. For China to graduate from the middle-income class, further economic liberalization will be necessary to create a fair and level-playing field for individuals and firms to compete both domestically and globally. Only through this new round of institutional reforms can China see sustainable rising wages and rising productivity – and steady, balanced growth in the long run.