The most prominent problem facing the Chinese economy is low prices, which have made it difficult for enterprises to increase revenues and profits.
In the labor market, new jobs are limited, and the growth rate of residents’ income is slow. If corporate profits and residents’ labor income remain at low levels, then confidence in both consumption and investment would become weak.
Currently, the main problem is a lack of demand, not the supply side. Seen from another perspective, nominal, not real, variables — such as price, profit and wages — are the main problem facing the Chinese economy.
What has caused the lack of demand? Why do nominal variables perform poorly? Why is it difficult for incomes to increase?
The growth of these nominal variables originates from the growth of nominal purchasing power, which in turn mainly comes from the creation of broad credit, such as extension of loans or issuance of bonds, which will create corresponding financial assets, bringing about an increase in nominal purchasing power.
For example, if one borrows 5 million yuan ($690,800) from a bank to purchase an apartment, the money would transform into new corporate and resident deposits, thus bringing about an increase in nominal purchasing power.
During the past decade, the growth of credit in China has mainly come from local government financing platforms and real estate-related loans. Therefore, when major problems in real estate occur and local financing platforms are tightly regulated, credit and demand will nose-dive.
The weakening credit growth will in turn lead to slowing growth of financial assets and nominal purchasing power, because financial assets here mainly refer to various debt-based financial assets, such as deposits and bonds. When the growth rate of these assets slows significantly, people will feel that they have less money on hand.
Some have argued that China already has a lot of money, and the lack of demand is not due to a lack of money. Statistics show that the financial assets of a Chinese household on average are valued at $60,000. In comparison, the figure is more than $1 million in the United States, and $200,000 in Europe and Japan. Therefore, Chinese people’s “wallets” are not big, and the slow growth of the “wallets “has led to a weakening of purchasing power in the past two years.
Others have argued that what counts is not the amount of money, but its distribution. Although there have been some changes to our income distribution during the past decade, it has been functioning quite stable and cannot lead to the sudden intensification of the lack of demand in recent years.
The main reason is still the slowing growth of overall credit. The growth rate of total social financing has dropped from 12-13 percent in the past to 9-10 percent, and further down to 8 percent this year. In recent quarters, the growth of total social financing has continually declined to hit historical lows, unable to bolster the country’s nominal purchasing power.
Willingness to spend
The main solution to the problem of lack of demand does not lie in reform. The purpose of structural reform is to improve production efficiency, optimize resource allocation and increase productivity. However, lack of demand does not reflect a problem of productivity but inadequate nominal purchasing power.
What we need to do is to make people have more money in their pockets and more willing to spend. We can solve the problem by making full use of standardized countercyclical policy tools.
In terms of monetary policy, the most effective, flexible and targeted policy is to significantly reduce the policy interest rate.
China currently has about 300 trillion yuan of debt. If the policy interest rate is reduced by 100 to 200 basis points, debtors would save 2-3 billion yuan a year in estimated debt interest payments. Meanwhile, it will add to financial assets worth at least 10 trillion yuan, which would help keep real estate prices stable.
By significantly reducing the policy interest rate, the entire residents’ “wallets” would increase by tens of trillions of yuan, including savings on debt interest payments and increasing valuation of financial assets. It would also increase consumption propensities and reduce savings.
It would be the most flexible policy, with policy interest rate able to be adjusted any time. It would also be the most targeted policy.
Compared with other countercyclical policies, policy interest rate adjustment works by expanding the “wallets” of individuals and enterprises to optimize the relative price environment.
Some people are worried about the potential effect of the policy, in terms of reducing bank profits or affecting the renminbi exchange rate.
As the policy interest rate drops, however, the total demand and nominal income level would increase, the nonperforming loans ratio of financial institutions will decline significantly, and loans of banks would increase markedly, helping improve the balance sheets of financial institutions.
In terms of the exchange rate of the renminbi, its fundamental support comes not from unchanged interest rate differentials, but a brisk economy, which would increase demand for renminbi assets. If reduction of interest rates can revitalize the Chinese economy and improve the prospects for corporate investment and profits, it would provide strong support for renminbi assets.
In terms of fiscal policy, the focus in the short term should be on ensuring that the budget is fully implemented. But the boosting effect of the fiscal policy on GDP growth is limited.
In the first quarter of this year, the combined growth of general public budget and government fund expenditures was a minus 1.5 percent, which was a drag on GDP growth. Government spending is important because it is equivalent to nongovernment sector revenues. Insufficient growth in government spending will have a significant impact on the incomes of businesses and residents.
Regarding local government debt, the tempo of local government debt reduction is very important. At a time when the private sector is unwilling to increase leverage, the government should be cautious in deleveraging; otherwise, it will create a vicious cycle leading to a spiraling decline in spending and incomes.
The views don’t necessarily reflect those of China Daily.
The writer is deputy director of the Institute of World Economics and Politics, Chinese Academy of Social Sciences. The article is a translated version of a speech by the writer at a meeting held by the China Macroeconomy Forum, a think tank.