The Chinese government’s reluctance to unveil a massive stimulus package despite the ongoing economic slowdown has puzzled foreign observers and the Chinese public alike. One possible explanation for the Chinese leadership’s cautious approach could be the huge debt overhang from the 2008 crisis.

SHANGHAI – China’s aggregate demand has weakened significantly over the past three years. In addition to the enduring effects of China’s anti-COVID policy, the country has also been weighed down by the decrease in global demand. Exports fell by 14.5% year on year in July, a stark contrast from the robust 17.2% export growth recorded in July 2022. Given these downturn pressures, the government’s reluctance to announce a massive stimulus package, as many had anticipated, has left foreign and Chinese observers deeply perplexed.

While China’s leaders are certainly aware of the ongoing economic slowdown, they may be estimating that the risk of a bailout is worse than the risk of inaction. Or perhaps they have more confidence in the domestic economy’s resilience against a global recession and believe that the economy will recover quickly on its own.

Regardless, China seems to have chosen not to take further action. In fact, China currently faces significant roadblocks to any additional economic intervention. After all, the accumulation of massive debts, particularly among local governments, has left China with limited room for maneuver. Moreover, the external environment has become increasingly unfavorable to China since at least 2018,  presenting challenges unlike any it has faced over the past 40 years

Consequently, China has adopted an increasingly cautious approach to macroeconomic management. Monetary policy is an interesting case in point. At the onset of the COVID-19 pandemic in March 2020, for example, the US Federal Reserve immediately cut interest rates to near zero. By contrast, the People’s Bank of China lowered interest rates by only 0.2 percentage points. Similarly, while the Fed has raised interest rates rapidly in response to surging inflation, hiking rates by five percentage points since March 2022, the PBOC has pursued a series of modest rate cuts to accommodate GDP growth and reduced demand.

This approach is also the main reason why China has avoided runaway inflation over the past two years. This was made clear in an April speech by former PBOC Governor Yi Gang during his visit to the Peterson Institute for International Economics in Washington, DC. During his speech, Yi highlighted the PBOC’s adherence to the so-called “attenuation principle,” which suggests that central bankers should refrain from taking drastic actions under uncertain circumstances. While this well-known concept was first introduced by Yale economist William Brainard in 1967, Yi’s speech offered valuable insights into the shift in China’s economic-policy thinking in recent years.

In theory, a more conservative monetary policy could better align short-term measures and long-term goals. To this end, central banks should set real interest rates as close as possible to the potential growth rate of output. Nobel laureate economist Edmund S. Phelps’s pioneering work on the golden rule savings rate illustrates the benefits of this approach.

To the extent that Yi’s speech reflects current ways of thinking and changed policy style among China’s top policymakers, it helps explain why China’s economy has become less volatile in recent years. With the scaling back of countercyclical policies, China has managed to sustain growth even without a demand surge. This may align with the government’s development plan, which aims to minimize the huge costs associated with achieving unbalanced growth, such as the rapid pile-up of short-term financial risks.

Indeed, China’s move away from aggressive macroeconomic policy could be attributed to the leadership’s recognition of the threat posed by the country having reached a critical threshold of systemic financial risk a few years ago. Given the nature of the Chinese political system, such risks would be deemed to pose an unacceptable threat to social and political stability.

As a result, China launched a comprehensive “de-risking” effort in 2016. Policymakers adopted de-risking as a guiding principle, shifting from aggressive macroeconomic policies to a more prudent approach. To mitigate risk and address the excessive financialization of the real economy, China initiated a wave of deleveraging and targeted financial interventions, cracking down on the asset-management industry and triggering a correction in the heavily leveraged financial and real-estate sectors.

Risks and uncertainties increasingly stem from external pressures as well. Two decades ago, when the Chinese economy was relatively small and had a fixed exchange rate, its domestic policy was largely insulated from external influences. But the Chinese economy has become too large and its relations with the world’s economies have changed dramatically, prompting China to adopt a more cautious approach in response to uncertainty. The PBOC, for example, must now closely monitor shifts in the US-China interest-rate differential and assess the potential impact on China’s capital markets and the renminbi exchange rate.

Having said that, China’s move away from aggressive macroeconomic policy should not come as a surprise. De-risking policies might have proved effective in preventing a financial or debt crisis, but the pandemic and subsequent COVID-19 policies have hampered the economy’s capacity to rebalance and rebound, resulting in further demand reduction.

Bringing aggregate demand back to pre-pandemic levels is crucial for accelerating China’s economic recovery. To this end, China’s fiscal and monetary policies can be more proactive, given that de-risking policies have remained in place for so long. While policymakers face a delicate balancing act, the growing risk of a protracted downturn underscores the need to find more effective solutions to the pressing challenges facing the Chinese economy.

But China could still do more to rebalance its economy. By committing to carrying out structural reforms, removing barriers to entry, and opening up sectors that are currently closed to foreign competition – such as education, training, consulting, and health care – China could create numerous market opportunities for the private sector and move closer to achieving long-term economic stability.

Zhang Jun, Dean of the School of Economics at Fudan University, is Director of the China Center for Economic Studies, a Shanghai-based think tank.

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