China goes to the stimulus well again — with a twist

If anyone looks back at its reported budget deficit in 2009 and 2010, it would seem like China had decided to sit out the globally coordinated stimulus needed to offset the slowdown that followed the crisis. 

According to the International Monetary Fund (IMF), China’s budget deficit stayed under 2 percent of its GDP in 2009, and its budget was more or less back in balance by 2010. Even Germany — a country known for its extreme commitment to fiscal discipline — briefly ran a fiscal deficit of 4 percent of its GDP.

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In this case, though, looking at a narrow measure of stimulus — the central government’s budget balance deceives. China actually loosened massively: freeing up local governments to borrow, relaxing formal curbs on bank lending and allowing loosely regulated “shadow banks” to develop.

This broader stimulus allowed China to sustain relatively rapid growth even as Europe and the United States experienced a deep recession, and it allowed the Chinese economy to pivot away from its previous reliance on exports toward a new growth model based on high levels of domestic investment.

China could have responded to the global shock of 2008 differently. It could, for example, have ran a larger formal budget deficit and relied less on flooding the economy with bank credit.

Or it could have sought to do more to raise consumption and reduce China’s high level of national savings — by spending more on social insurance for example — rather than relying on a high level of investment to carry its economy through.

China’s decision about how to stimulate back in 2009 has defined its course ever since. China’s economy became dependent on rapid credit growth and threatened to stall whenever the government clamped down on credit.

After the global crisis, investment rose to over 45 percent of its GDP, an incredibly high level. For comparison, a high-growth/high-investment emerging economy rarely invests more than 30 to 35 percent of its GDP, and a typical advanced economy invests 15 to 20 percent of its GDP.

Keeping its economy moving has required the accumulation of debt by local governments, local infrastructure financing vehicles and many state-owned firms.

China’s growth — and the investment that keeps its current account and trade surplus down — rests on a fragile base. When China’s financial regulators start to worry about the pace of this debt accumulation and try to scale it back, the economy tends to slow.    

We have now been through three cycles of leverage and restraint in the last 10 years. China pulled back on its initial credit stimulus in late 2010 and 2011, only to reverse course in 2012 as Europe’s financial crisis deepened and put strain on many emerging markets.

China then tightened from 2014-15 only to reverse course as evidence mounted of a deeper-than-recognized domestic slump and a major slowdown in domestic property investment. Then in 2017 and 2018, China pulled back on its 2016 stimulus, dialing down the off-balance sheet borrowing of local governments and cracking down on shadow banking.    

Now China’s leaders again faces the risk that that their last round of tightening has led to a bigger slowdown than they really want. Many measures of activity suggest that growth in the fourth quarter was far below the announced pace.

Infrastructure investment had slowed in the first part of the year; auto sales fell off a cliff; and it looks like trade war-related uncertainty will cut substantially into growth in the first part of 2019. Not surprisingly, China is again looking to stimulate its economy.

But China is trying to avoid opening the floodgates by allowing credit to flow unhindered through its economy. Its stimulus has been more targeted:

  • certain taxes have been cut (though the impact of these cuts will be muted by cuts in some parts of the government budget);
  • some but not all local infrastructure projects have been approved; and
  • the government is encouraging the banks to lend more to small, private business without completely walking away from the measures that made it harder for the shadow banking system to continue its previous breakneck growth.

The question, of course, is whether this more targeted approach to stimulus will work.

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The rest of the world has a stake in China getting its macroeconomic management right. If the stimulus fails, pressure to cut interest rates below those of the Fed and allow the yuan to depreciate in order to help China export its way out of domestic trouble will intensify.

Remember that the China exchange rate shock of August 2015 came after a period of domestic economic weakness. 

The rest of the world also has a stake in those reforms that would allow China to be able to maintain an acceptable pace of growth without relying either on domestic stimulus or massive exports. That ultimately means China needs to get serious about putting in place policies that strengthen Chinese consumption.

High savings have allowed China to finance a high level of investment internally, but these is such a thing as too much of a good thing.

Brad W. Setser is the Steven A. Tananbaum senior fellow for international economics at the Council on Foreign Relations.