Editor's note: This is the second installment of a three-part series about China's economic rebalancing. Part one analyzed the problems Chinese policymakers are trying to solve, as well as those China's evolving economic model is causing. Part two offers potential solutions to these problems.
China's economic rebalancing is creating a host of issues. Most pressingly, government attempts to discourage overinvestment in the real estate and infrastructure sectors are slowing economic growth. Several short-term strategies are available to ease this transition, most promisingly an expansionary fiscal policy that increases private consumption. However, China will also need to make longer-term strategic changes to support its rebalancing, namely by creating alternative outlets for excess savings. Above all, these outlets will need to include more productive investment opportunities.
Short-term solutions: Consumption-oriented fiscal stimulus
To counteract the short-term slowdown in economic growth caused by reduced investment in the real estate and infrastructure sectors, the Chinese government has three primary policy levers: fiscal policy, monetary policy and exchange rate policy. Until now, Beijing has refrained from deploying these tools forcefully, instead focusing on microeconomic reforms aimed at facilitating private consumption. However, if the outlook for China's short-term economic growth deteriorates further, signaled by several months of deflation, policymakers would likely opt for a more expansionary fiscal policy to stimulate household consumption.
An expansionary fiscal policy would raise government spending and transfers and/or cut taxes, making it the most direct way to stimulate domestic demand, especially private consumption. Additionally, as private consumption rises, savings rates will decline, which will decrease overinvestment. In this way, an expansionary fiscal policy would help solve China's short-term issue of an economic slump while also supporting the government's longer-term goals of shifting away from overinvestment. The central government would need to fund this stimulus, as local government finances are already weak due to their reliance on falling real estate-related revenues and their prospective financial losses.
If an expansionary fiscal policy proves insufficient, policymakers could resort to altering China's monetary policy by cutting interest rates more forcefully. However, this option is not ideal, as lower interest rates would also increase unprofitable investment in sectors like real estate, slowing the deleveraging of the sector. Lower interest rates would also reduce banks' net profit margins, undermining bank profitability and their ability to absorb credit losses directly or indirectly related to the real estate crisis. Moreover, this strategy would widen the gap between Chinese and U.S. interest rates, which would put downward pressure on the yuan and lead to increased capital outflows. These constraints mean the government would likely only lower interest rates if the risks of recession and deflation are particularly high.
Lastly, the government could try to stimulate the economy by adjusting its exchange rate policy. In this scenario, a weaker exchange rate would make China's exports comparably cheaper, thereby increasing foreign demand for Chinese goods. However, this strategy would be unlikely to significantly kickstart economic growth, given that China is far less dependent on external demand than it was in the past (and economic growth in its major export markets is declining). Additionally, this option would require a substantial weakening of the yuan, which might undermine domestic financial confidence. If that were not enough, weakening the exchange rate would require the government to cut interest rates, which, as stated previously, might compound the issue of overinvestment and lead to a host of undesirable knock-on effects. Therefore, Beijing is unlikely to resort to a policy of currency depreciation.
Longer-term solutions: Profitable investment opportunities and consumption
To ensure that China's short-term economic slowdown does not become a long-term stay in the middle-income trap, policymakers must create new outlets into which the country can pour its excess savings. By putting these savings to work, China's economic growth potential, which is already considerable, would increase. This is evidenced by the fact that China's per capita income is less than a third of the United States', pointing to what economists call catch-up potential, a country's ability to adopt advanced technology, improve human capital and increase capital stock to support faster economic growth and higher per capita incomes.
To tap into this potential, China needs to create profitable investment opportunities. This would require policymakers to introduce wide-ranging structural reform aimed at ensuring greater competition, a less privileged position of the state sector, and a greater role for markets to improve productivity and economic growth. Beijing's decision in March to relax controls on the technology sector may reflect early moves in this direction. However, finding or creating financially profitable and economic growth-enhancing investment opportunities will be challenging.
If the government fails to create more productive investment opportunities, China will still need an outlet for its excess savings. Policymakers would likely attempt to solve this issue by continuing to stimulate private consumption. However, this would require much more than a simple, one-off fiscal stimulus. Instead, policies would need to increase consumption structurally by raising the household share of national income, which would be fiscally costly and may be difficult to achieve politically. Even if such a stimulus succeeds, a large share of savings would need to be shifted to consumption, which would be a long-term process. A gradual transfer of income from the government and the corporate sector would be preferable. The government could support this stimulus by providing government-financed health and pension benefits, thereby reducing households' precautionary savings. If necessary, the government could also try to finance all or some of these measures through deficits or through higher taxes on the corporate sector, thus reducing corporate savings as well.
Chances of success
Chinese policymakers will face many challenges in the next few years, but they also benefit from several advantages. First, China's state-capitalist economic system enables policymakers to intervene forcefully and quickly to maintain economic growth and preserve financial stability. Second, China learned much from observing the Japanese and U.S. financial crashes in 1991 and 2008, respectively.
As a result, Chinese policymakers will continue to remedy overinvestment in the real estate sector and mitigate its related financial risks. In this scenario, China would gently settle into a lower growth trajectory (underpinned by continued high investment) in the context of more sustainable financial returns on investment. After all, the economy has plenty of catch-up growth potential left.
However, if policymakers fail to act forcefully enough, they could lose control of China's economic rebalancing. If this happens, China could be forced to implement disruptive large-scale financial restructuring in the real estate and infrastructure sectors, and even costly government bailouts. It might also push the economy into more sustained stagnation that could lead to deflation. As we will see in part three, this failure could impact China's political stability and have far-reaching implications for trade partners around the world.
