This week China took an unusually strong measure to goose its economy. It lowered the amount of money that Chinese banks needed to hold in reserve. In theory, this should allow the banks to take those sequestered funds and use them for new loans, thereby stimulating the Chinese economy.
The clearest interpretation of the move is that Chinese authorities are seriously concerned about the state of the economy. It followed news last week that China’s economy grew at a 7.0 percent rate in the first quarter of 2015. This was the slowest rate of growth in six years. While that pace of growth would be welcome in most parts of the world, China works on a different scale. For years, the rule of thumb was that China needed a minimum of 8 percent growth just to keep job-seekers satisfied.
There are fewer job-seekers than there used to be, as China begins a serious demographic change, and Chinese officials have lowered their announced economic growth expectations. Nonetheless, the announced number seems to have caused some alarm. This may be, in part, because Chinese economic statistics do not have the same reputation for accuracy that one might see in OECD countries. Chinese officials have a strong incentive to meet their growth targets and, according to their own reports, they do so with striking regularity.
China’s leaders face the same macroeconomic balancing act their counterparts face the world over – overstimulate the economy and you get inflation; underdo it and you get unemployment. But they approach the challenge with a significantly less developed financial system than developed country counterparts. There is also an additional sense of fragility that comes from China’s one-party state. Periods of inflation have traditionally been associated with political unrest (e.g. inflation was one factor leading up to the Tiananmen Square protests of 1989). The prospect of a slowdown poses political dangers as well, since strong growth has largely replaced ideology as a selling point for China’s governing regime.
The underdevelopment of China’s financial system poses real questions about whether the latest effort to stimulate the economy will do more good than harm. In a well-developed financial system, Chinese banks would take in customer deposits and carefully sift through business applications for new projects. They would select the best of those projects and make loans. In this sort of textbook case, a cut in interest rates or reserve requirement will lower the threshold for selecting projects to fund. The newly-funded projects will represent new economic activity and stimulate growth.
In China’s case, banks have played a different role. The government has dictated interest rates that savers would receive and that lenders would pay. Loans often went from large state banks to large state-owned industries. The pre-ordained nature of this ritual meant that bankers rarely honed the skill of distinguishing worthy projects from worrisome ones. Further, with low mandated interest rates in the official banking sector, money often worked its way outside the official sector, either through separate savings vehicles, shadow banking, or investment in asset markets. Over the last year, while the Chinese economy recorded relatively modest growth, the Shanghai stock exchange rose roughly 100 percent. There is real concern that the new infusion of funds could do more to pump up asset bubbles than to stimulate the real economy.
At a Chicago Council event earlier this month, the United Kingdom’s former top central banker, Lord Mervyn King, offered a generally bleak assessment of the current efficacy of monetary policy. This preceded China’s recent move, but his argument was a general one. Monetary stimulus works, he said, by shifting economic activity from the future to the present. If people are reasonably confident about their economic prospects a couple years down the line, then lower interest rates or more abundant loans allow them to cheaply shift some of that future consumption forward in time.
The problem, he noted, occurred when people were not optimistic about the future. If you are wary about both this year and next, then there are no planned splurges to be brought forward via monetary loosening. Lord King argued that data have reflected increasingly weak results from monetary efforts.
Yet this has not deterred major economies around the world from turning to monetary policy again and again, when they do not see any easy alternatives. China now joins the ranks of those favoring monetary hope over experience.
Phil Levy is senior fellow on the global economy at The Chicago Council on Global Affairs. Previously he was associate professor of business administration at the University of Virginia’s Darden School of Business. He was formerly a resident scholar at the American Enterprise Institute and taught at Columbia University’s School of International and Public Affairs. From 2003 to 2006, he served first as senior economist for trade for President Bush’s Council of Economic Advisers and then as a member of Secretary of State Rice’s Policy Planning Staff, covering international economic matters. Before working in government, he was a faculty member of Yale University’s Department of Economics for nine years and spent one of those as academic director of Yale’s Center for the Study of Globalization.
His academic writings have appeared in such outlets as The American Economic Review, Economic Journal, and theJournal of International Economics. He is a regular contributor to Foreign Policy magazine’s online Shadow Government section and writes on topics including trade policy, economic relations with China, and the European economic crisis. Dr. Levy has testified before the House Committee on Foreign Affairs, the Joint Economic Committee, the House Committee on Ways and Mean, and the US-China Economic and Security Review Commission. He received his PhD in Economics from Stanford University in 1994 and his AB in Economics from the University of Michigan in Ann Arbor in 1988.
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