RIETI Report November 2009

China's Reaction to the Global Economic Crisis

As economies across the globe struggle to recover from the global financial crisis, China has recovered more quickly and forcefully than any other major economy thanks to extensive stimulus measures implemented more than a year ago by China's central government. In an attempt to gain an insight into these measures and how the giant economy plans to sustain its growth, RIETI invited prominent Chinese economist Professor YU Yongding to speak at a special seminar, which will be the focus of this month's RIETI Report.

Professor YU takes a look at China's current situation, massive stimulus package, expansive monetary policy, and economic rebound. He also looks at the steps China needs to take to sustain its current growth and the risks it faces with its vast foreign exchange reserves tied to the value of the U.S. dollar.

RIETI Special Seminar


"Global Economic Crisis and China - Structural change and future of renminbi"
  • Speaker: YU Yongding (Professor, Institute of World Economics and Politics, Chinese Academy of Social Sciences / President, China Society of World Economics)
  • Commentator: KWAN Chi Hung (Consulting Fellow, RIETI / Senior Fellow, Nomura Institute of Capital Markets Research)
  • Commentator: GOTO Yasuo (Senior Fellow, RIETI / Chief Economist, Mitsubishi Research Institute, Inc.)

This month's featured article

China's Reaction to the Global Economic Crisis

YU YongdingProfessor, Institute of World Economics and Politics, Chinese Academy of Social Sciences / President, China Society of World Economics

China's current economic situation

China is currently facing three key challenges: maintaining growth, deepening structural adjustments and defining the future role of the renminbi.

During the period of reform with the opening up of the economy, China has been enjoying economic growth at an average rate of 9.8% annually. However, between the second and third quarters of 2008, China's economic situation worsened suddenly and dramatically. After the onset of the subprime crisis, the Chinese government and economists still hoped that the crisis would be contained and the slowdown of the global economy would not be exceptionally bad. But the fall of Lehman Brothers crushed their hope. GDP growth dropped to 9%, 6.8% in the third and fourth quarters, respectively. In the first quarter of 2009, it fell further to 6.1%. The export growth rate fell from 20% in October 2008 to -2.2% in November 2008. Inflation also dropped significantly.

The single most important cause of this situation was the dramatic drop in exports. The fall in the growth of fixed asset investments also contributed to the fall of GDP growth. Contributing factors to the fall in fixed asset investment growth include inventory adjustment, the fall of export-related investment, and investment in real estate. The fall in real estate investment was mainly due to People's Bank of China's monetary tightening aimed at controlling inflation and asset bubbles.

The steel industry was the most seriously affected industry and hence can be used as an example to analyze the causes of the fall of the growth of the economy after the Lehman Brothers fiasco. The total production of steel fell by 3.93% between August and September. More than 53% of the fall of steel production can be attributed directly to the fall in foreign demand. If all indirect impacts of exporting industries which are heavy users of steel, such as the decrease in exports in the container industry and ship-building industry, are included, perhaps some 60-70% of the fall in steel production can be attributed to the fall in external demand.

The same is true of the economy as a whole. The contribution of net exports to economic growth was 3% in 2007. This number declined significantly in 2008 and has turned negative in 2009.

China's expansionary fiscal stimulus packages

The Chinese government's response to the global slowdown is admirable. There was no other country in the world, which has taken action as swiftly and decisively as China.

China's stimulus package amounted to four trillion RMB or $580 billion, equivalent to 14% of the Chinese GDP in 2008. In the package, 1.18 trillion RMB was new expenditures by the government, which would be spent over two years. The stimulus package also included tax reduction and other measures. Among them, were VAT reform, business tax cuts and the rise in the thresholds of individual income taxes. The most of the tax measures of all are the increases in tax rebates. The planned total tax rebates in 2009 are 960 billion RMB, though the final figure could be higher. The 4 trillion stimulus package is expected to add 1-2 percentage points to GDP growth in 2009. While the central government announced its stimulus package, local governments offered their own stimulus packages worth 18 trillion RMB.

The most important component of China's stimulus package is investment in infrastructures, especially in railways, roads, and airports. The government is focusing on these because the Chinese leadership wants to see quick results, meaning to reserve the fall of the economy as quickly as possible so as to avoid the surge of mass unemployment for migrant workers. In fact, more than 20 million migrant workers in coastal areas were under the threat as a result of the collapse of the external demand. The leadership also understands that China is suffering from overcapacity. To invest in infrastructures rather than in manufacturing will not worsen the problem of overcapacity, while increasing demand and creating jobs

The main source of the finance of the stimulus package is the central government. The Central government finances one-quarter of the 4 trillion stimulus package, in the form of direct grants and interest rate subsidies. In the case of central government-sponsored projects, with the approval of the National Development and Reform Commission (NDRC), the Ministry of Finance provides all of the funding for the registered capital. Bank credits are the second most important source of the finance for the stimulus package. Local governments proposed their own stimulus packages of 18 trillion RMB. Central government will issue 200 billion RMB government bonds on behalf local governments. Credits of commercial banks are expected to be the most important resources of the finance for the local government proposed projects.

Very expansionary monetary policy

Regarding China's financial conditions, it must be understood that prior to the financial crisis, China's financial situation was in quite good shape and China was not suffering from a lack of liquidity or a credit crunch and the banking system was sound. Asset bubbles were not serious or were corrected, and monetary policy was generally accommodating. Accommodations included abolishment of credit rationing, lowering reserve requirements, lowering interest rates on banks' loans and deposits, lowering the thresholds of down payments of mortgages, and lessening sterilization.

Since 2009, the Peoples Bank of China (PBOC) has adopted a very expansionary monetary policy to support the expansionary fiscal policy. In the first half of 2009, bank credits increased 7.3 trillion RMB which was above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP (table. 1). As a result, the inter-bank money market has been inundated with liquidity. In contrast, the annual increases in bank credits in 2006 and 2007 were 3.18 trillion RMB and 3.63 trillion RMB, respectively. Previously, corresponding to the rapid increase in liquidity caused by PBOC intervention in the exchange market, which was aimed at offsetting the appreciation pressure on the renminbi created by persistent trade surplus (and capital account surplus), the PBOC sold a large amount of central bank bills to mop up the excess liquidity. Since the fourth quarter of 2008, the PBOC has almost stopped selling more bills. The liquidity has inundated the inter-bank money market and even once made the interest rates in the inter-bank market lower than interests on deposits with commercial banks with same terms of maturity. This phenomenon was described in China's banking circles as "flour being more expensive than bread".

Table 1.The growth rates of major monetary aggregates
Billion RMB, %
Growth of MI
Growth of M2
Growth of credits

Source: PBOC

The rebound of the Economy

As a result of expansionary fiscal and monetary policy, the Chinese economy has rebounded strongly. China's slowdown lasted a quarter or less. In addition, the short-lived slowdown may be explained partially by the fact that, inventory adjustments may have played a very important role during the slowdown, due to the changes in expectations. For example, throughout the first half of 2008 all major Chinese steel mills were stockpiling products and materials on expectations of continued high demand. After the Lehman crash, the mood turned so quickly and hence inventories were cut dramatically.

Perhaps, the Chinese economy may have started to rebound as early as in the later fourth quarter of 2008 or the early first quarter of 2009. In the second quarter, China's official figures showed year-on-year gross domestic product growth of 7.9%. It is certain that China's GDP will grow more than 8% this year. Almost all indicators of real economic activities just released last week show further improvement from July to August. Growths of industrial production, fixed asset investment and retail sales all are better than expected. Just released data such as PMI, property investment and auto sales also are very positive. With regard to auto sales, it is too positive, in my view.

Need for change in the growth pattern

The recovery of economic growth is a done-deal, and hence, the most important question now China is facing is whether China's growth is sustainable. When the Chinese economy was in its worst shape, I had not a shred of doubt about China's ability to continue growth until at least 2011. The reason is simple: China's fiscal position was strong and hence China could spend its way out of slowdown. China's debt to GDP ratio was 18% of GDP, a ratio that is just a tenth of Japan's. China's strong fiscal position and its large domestic market allow China to use expansionary fiscal and monetary policy to stimulate domestic demand to replace rapidly shrank external demand.

However, in the longer run, if China fails to change its growth pattern through structural adjustments, China will not be able to sustain its growth in the next 10-20 years. From a macroeconomic point of view, China needs to lower its investment rate, which is way too high compared with other countries (figure below). Due to the fact that China's investment rate has been increasing steadily, it has caused overheating first and then subsequently overcapacity. Initially, overcapacity was overcome by investing more. However, more investment creates more overcapacity for the future. Since 2005, exports also played an important role in absorbing overcapacity.

Asia Investment

From the figure below, it can be seen that growth in fixed asset investment and exports played a very important role to overcome overcapacity. In fact, from 2003 to 2008 before the breakout of the global financial crisis, the Chinese economy was suffering from overheating rather than overcapacity.

China's Export and Investment grouth

Now, as a result of the stimulus package and expansionary monetary policy, the Chinese economy is rebounding, while China's structural problem has worsened.

First, China's investment efficiency has been falling. With an investment rate of 50% and a growth rate of GDP of 8 %, the incremental capital-output will be as high as or more than 6. In comparison, Japan's incremental capital-output ratio was about 3. From 1991-2003, China's incremental capital-output ratio was 4.1. The fall of investment efficiency will have important negative bearing on China's long term growth.

Second, Infrastructural investment is a long-term investment and will take a long time to create revenue streams. Furthermore, despite the fact that investment in infrastructures has the virtue of avoiding overcapacity, investment in infrastructures without accompanying investment in manufacturing capacity means investment in infrastructures will not bring in returns. Where to get tolls, if there is no traffics in an 8-lane highway? To make things worse, due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous. All these mean not only low efficiency but also possible significant increase in nonperforming loans in the future. Although from the long run perspective, the room for investment in China's infrastructures is still huge, due to China's underdevelopment, compared with developed countries. However, in the medium run, say in the next 3-5 years, China may have to deal with the problems of rising nonperforming loans and a worsening of fiscal position.

Third, despite the fact that China's trade surplus is decreasing (although, this is a result of the impact of external shocks, rather than a result of the initiative aimed at rebalancing), the Chinese government is hoping to stabilize exports through tax rebates on exports and other policies. This allows enterprises that have seen drops in exports to survive, though such enterprises should redirect their products from foreign markets to domestic markets, and if these enterprises cannot compete with non-export orientated enterprises on an equal footing, they should be allowed to go bankrupt. China is still hoping to see the recovery of external demand following the United States' recovery. This wish may come true, if the U.S. government fails to rebalance their economy. However, in the long-run, it is more likely that, the U.S. will eventually achieve the objective of rebalancing. Without the U.S. to act as the last resort of imports, China as well as the rest East Asia will have to cut their current account surpluses.

In short, to achieve sustainable growth and to improve the welfare of the nation, growth should not be achieved at the expense of structural problems such as high external dependence, high investment rates, pollution, energy inefficiency, income distribution gaps, and inadequacies in medical care, education, and other social services. If China fails to tackle these structural problems, growth is likely to see a W-shaped future.

The good news is that adjustment policies are currently underway. The Chinese government has issued instructions to clamp down on investment in eight key industries including steel and aluminum. Also, China has tightened monetary condition. The amount of new credits in July 2009 dropped significantly compared with the first half of the year.

China's foreign exchange reserves face three risks

The safety of China's foreign exchange reserves is another issue. As warned by Paul Krugman, China has fallen into a "dollar trap". In the short run there will not be large upheavals, though in the longer run, China is facing a triple whammy.

First, the devaluation of the dollar is inevitable, which will lead to capital losses of China's foreign exchange reserves. The bulk of China's 2.3 trillion dollar foreign reserves holdings are not held for the purpose of self-protection, rather they are savings in the form of U.S. treasuries. China needs to preserve their value. There is no question whatsoever that the U.S. dollar is on its way to devaluation, which started since April 2002 and, after a short interval, restated again since March 2009. Unless the U.S. economy accomplishes its rebalance, the dollar will fall. As a result, the capital losses of China's foreign exchange reserves are inevitable.

Second, though inflation may not be an immediate threat, the U.S. inflation rate should be around 4% according to U.S. Federal Reserve officials. This would mean that each year China's purchasing power devalues by 4%. Furthermore, due to extremely expansive monetary policy, the dollar has been debased. Unless the Fed implements the exit strategy successfully, which is doubtful, the real value of China's foreign exchange reserves will be eroded. Finally, as a result of dropping money from the sky by Helicopter Ben, serious inflation cannot be ruled out.

Third, due to the huge budget deficit and supply of bonds by America, there is no guarantee that there will be enough demand for the U.S. securities. As a result, the price of U.S. government securities will drop and China's U.S. security holdings will suffer losses.

First of all, China should reduce its current account surplus and capital account surplus. If it cannot reduce the twin surpluses, it has to translate the surpluses into assets other than U.S. treasuries, which include increasing outbound FDI, investing in strategic resources, engaging in mergers and acquisitions, portfolio investment abroad, lending to international organizations, selling panda bonds, engaging in currency swaps, and providing aid to developing countries.

With regard to stocks, the U.S. government should offer more Treasury Inflation-Protected Securities (TIPS)-like financial instruments. This would allow China to convert some of its holdings of U.S. government securities into similar but safer assets. China should be allowed to convert part of its foreign exchange reserves into special drawing rights (SDR)-denominated assets. China should not rule out the possibility of adjusting the composition of its foreign exchange reserves to mimic the composition of SDR. If the U.S. government cannot safeguard the value of China's holdings of U.S. government securities, the U.S. government should compensate China in one way or another.

KWAN Chi Hung
Regarding global imbalances and the renminbi issues, two questions arise. The first is how China's current account surplus can be reduced and the second is whether China should move faster toward a floating exchange rate regime.

Looking at private consumption, China stands at 35% of GDP while the U.S. stands at 70%, implying that there is room for China to expand consumption. China's private consumption has been declining along with the widening income gap between rural and urban areas. Income disparities must be addressed to stimulate consumption. Three policies should be introduced to deal with this problem. The first one is domestic free trade areas. The second one is domestic "flying geese" to promote the relocation of declining industries in high-income regions to low-income ones. The third one is domestic Official Development Assistance (ODA) using Japan's local allocation tax as a model. Since President Hu Jintao came to power in 2002, much has been done along these lines and results are beginning to be seen. For the first time since China's opening up, inland regions are growing faster than coastal regions.

The twin surpluses of both current and capital accounts are a direct result of the government's efforts to maintain an undervalued renminbi. Though China moved to a managed floating system in July 2005, it has returned to being de facto pegged to the dollar as an emergency measure. Moving to a floating rate system is needed to restore monetary independence. Keeping the exchange rate fixed to the dollar will give rise to asset bubbles and inflation.

GOTO Yasuo
While the outcome of the financial crisis must be considered, the causes are also important. Japan and China were also part of the cause and both countries should keep in mind that intervention into foreign exchange markets by governments leads to the buildup of foreign reserves.

China has been conducting operations on a larger scale than those of Japan which leads to certain monetization for the U.S. This will make money control more difficult in the future and will eventually cause unsustainability and a drastic plunge in the U.S. dollar. U.S. treasuries cannot be sold continuously, but the possibility of selling them must be pursued.

Capital losses of private sector-held U.S.-denominated assets must also be considered. This requires reestablishment of the international financial system, and China and Japan must take a leadership role in this debate. Corporate sentiment in Japan prefers a weak yen, but this may not be sustainable.

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