(II) Xu Gao's case for Beijing to spend: stimulus now doesn't hinder structural reforms
(II) Xu Gao's case for Beijing to spend: stimulus now doesn't hinder structural reforms
Chief Economist of Bank of China International continues with the sustainability and necessity of stimulus.
This is Part II of Xu Gao's case for stimulus, addressing China's challenges of insufficient demand and excess supply.
In today's part, the Chief Economist of Bank of China International Co. Ltd. and an adjunct professor of the National School of Development (NSD) at Peking University challenges the commonplace notion that stimulus measures impede and divert resources away from structural reforms.
Xu explains that both demand and supply must be considered when analyzing China's economy. On the demand side, the key structural issue is weak consumption, which leads to insufficient domestic demand. On the supply side, the industrial structure remains suboptimal, with critical bottlenecks in some sectors—problems that no policy, including stimulus, can quickly resolve. China's current economic pressures—shrinking demand and slowing growth—are largely driven by demand-side issues, precisely where stimulus measures can provide relief.
Mr. Xu has kindly reviewed our translation.
IV. The Sustainability of Stimulus Measures Depends on the Macro Environment
Understanding that the real constraint on stimulus measures lies in a country's supply capacity allows us to evaluate their sustainability. The sustainability of stimulus measures depends on two factors: First, whether the positive effects of the measures can be sustained or if they will quickly lose effectiveness—similar to how the human body can develop resistance to a drug under its continued use, rendering it ineffective. Second, whether the cost of implementing such measures quickly becomes prohibitive, making them no longer worth the expense.
Both factors are shaped by the macro environment in which the stimulus measures are applied. When an economy faces insufficient supply and excess demand, the main constraint is on the supply side, which cannot be relaxed by demand-side stimulus measures. In this scenario, stimulus measures will fail to improve the economy and instead result in rising inflation and a deteriorating balance of payments. In such cases, the disadvantages outweigh the benefits, let alone sustainability.
However, when the economy faces excess supply and insufficient demand, stimulus measures can boost output and employment without imposing significant costs in terms of inflation or balance of payments. It's important to note that while stimulus measures may indeed lead to higher government debt and accelerated monetary growth, these consequences do not undermine their sustainability.
People who lack macroeconomic thinking might mistakenly equate a country with a corporation, fearing that increased debt and money supply will, sooner or later, lead to crises such as debt defaults, inflation, or uncontrolled asset bubbles. However, the principles of macroeconomic operation cannot be fully understood through micro-level experience alone. In a macro environment with excess supply, both government debt (primarily domestic debt) and monetary expansion can be sustainable. In my article "A Comprehensive Correction of Perceptions on China's Debt," published on June 28, 2023, I provided a detailed analysis of the sustainability of China's debt, so I will not elaborate further here.
Concerns about the overall money supply are only part of the broader concerns regarding the sustainability of stimulus measures. Many are particularly worried about the sustainability of investment-focused stimulus. Domestic demand consists of consumption and investment, and macro policies aimed at stimulating demand must prioritize one or the other. Consumption depends not only on consumers' current income but also on their expectations for future income. While stimulus measures can boost short-term income, they often fail to significantly improve consumers' expectations of future earnings, making consumption less responsive to stimulus. In contrast, investment is more sensitive to such measures, which is why it is often the preferred target for stimulus. Since the 2008 subprime mortgage crisis, China's stimulus has primarily focused on investment for this reason.
After a prolonged period of high-intensity investment, China's overall return on investment (ROI) has significantly declined, making it increasingly difficult to find high-return projects. The combination of a relatively high investment-to-GDP ratio and a continuously falling ROI has raised concerns about the long-term sustainability of this investment-driven growth model.
However, does a declining ROI necessarily indicate that the investment-driven model cannot be sustained? For micro enterprises, this is often the truth. Companies face an exogenously determined capital cost that they cannot control. If a firm's ROI falls below the capital cost, it may struggle to pay the debt taken on for investment, facing default risks on its debt. But the same is not necessarily true of macroeconomics. Even when the macroeconomic ROI declines, the expected ROI for savers (which influences the macroeconomic capital cost) may still be lower.
In the article "Three Potential Policy Responses for the Chinese Economy," [translated and published by The East is Read in two parts: I & II] published on March 28, 2024, I argued that in an overinvested economy, the most effective form of investment is actually to reduce investment and redirect the income originally intended for it towards consumption. This requires transferring income from the corporate sector, which typically invests, to the household sector. However, in China, inefficient mechanisms for distributing dividends from companies to consumers obstruct this income transfer. As a result, income remains rigid within the corporate sector and does not automatically flow to consumers, despite a falling ROI, to be converted into consumption.
In this case, China's corporate sector becomes a saver that is insensitive to the rate of return on savings—since few dividends are distributed to consumers, the corporate sector's income has no other way out except to save and invest. This is the primary reason behind China's excess savings, investment, and supply.
Thus, although the domestic ROI in China is relatively low, choosing not to invest does not mean that income will automatically flow to consumers and be converted into consumption. Instead, the income would remain as idle purchasing power in the form of excess savings, exacerbating the problem of insufficient effective demand. In other words, in a macro environment with insufficient demand, those who argue that investing with a low ROI is a waste of national income and therefore unsustainable must also recognize that refraining from such low ROI investments won't lead to a more efficient use of national income. On the contrary, it would lead to greater waste of income, potentially pushing the economy into recession or crisis due to insufficient demand, making the situation even less sustainable. Therefore, given China's current economic structure—where insufficient demand stems from flaws in income distribution—high investment is not only sustainable but also crucial for maintaining economic stability.
In Chapter 10 of The General Theory of Employment, Interest, and Money, Keynes introduced the analogy of hiring people to "dig holes" as a way to create demand and stimulate the economy. While "digging holes" yields little real return, it serves as an effective policy response during periods of insufficient demand. Those who do not understand the macroeconomic operation may, from their own micro-experience, dismiss Keynes' theory. However, those with macroeconomic thinking can recognize the counter-micro-intuitive wisdom behind the concept. Applying this wisdom helps explain the rationale and sustainability of China's current high levels of investment.
Finally, let's address the side effects of stimulus measures. Everything has two sides—where there are benefits, there will inevitably be drawbacks. In the current complex economic environment in China, where various economic contradictions are intertwined no macro policy can be purely beneficial without negative consequences. Stimulus measures will inevitably bring about some side effects. The key is to assess both the positive and negative effects together and comprehensively evaluate the pros and cons of such measures. In practice, the side effects of stimulus measures can be managed through careful optimization of policy implementation. When the economy faces excess supply and insufficient demand, the benefits of stimulus measures clearly outweigh the drawbacks. Rejecting stimulus measures solely due to potential side effects would be akin to giving up eating for fear of choking.
V. Stimulus Measures and Structural Reforms Are Not Contradictory
Many object to stimulus measures, believing they may delay or even obstruct economic structural reforms. In recent years, China's stimulus measures have primarily targeted investment in infrastructure and real estate—two traditional drivers of growth. Some worry that directing resources into these sectors could reinforce the existing investment-driven growth model and divert resources from the necessary economic transformation, thereby impeding structural reforms. However, this concern is unfounded.
The belief that stimulus measures conflict with structural reforms may seem reasonable but misinterprets the cause-and-effect relationship. Stimulus measures are not the cause of economic structural issues; they are a response to them. It is precisely because the economy has structural problems that stimulus measures are needed to stabilize it—not that structural issues arise due to the use of stimulus measures.
When discussing China's economic structure, it is important to consider both the demand and supply sides. On the demand side, China's main structural issue is insufficient consumption, which leads to insufficient domestic demand. On the supply side, the problem lies in an industrial structure that is not yet fully optimized, with critical supply choke points in some sectors. China's current economic pressures—shrinking demand and slowing growth—are primarily driven by structural issues on the demand side. These demand-side challenges are exactly where stimulus measures can serve as an offset.
I have already provided a detailed analysis in my article "Three Potential Policy Responses for the Chinese Economy," explaining that China's long-standing issue of insufficient consumption and weak domestic demand arises from the low proportion of total household income in GDP. The best scenario for China would see a successful adjustment of the income distribution structure and an increased share of household income and consumption in GDP, which would unblock internal economic circulation and fundamentally resolve the problem of insufficient domestic demand.
Until significant progress is made in income distribution reform, China's suboptimal scenario would be to stimulate domestic demand through stimulus measures. These measures can only target consumption and investment, the two components of domestic demand. Within the investment sector, the options are limited to infrastructure, real estate, and manufacturing investment, which are the three main pillars of investment. From a policy effectiveness standpoint, infrastructure and real estate investments are the best choices for stimulus measures. Stimulating manufacturing investment directly expands capacity, exacerbating the problem of excess supply and insufficient demand. At the same time, the consumption sector, constrained by household consumption, cannot be significantly boosted in the short term.
In addressing China's demand-side structural issues, the best scenario of adjusting income distribution and the suboptimal scenario of stimulating investment are not mutually paradoxical. In fact, the suboptimal scenario—used to stabilize demand and boost the economy—is necessary precisely because progress on the best scenario has been insufficient. In the current context of weak domestic demand, such stimulus measures do not divert resources away from economic transformation; instead, they can help drive household spending. Without these measures, more resources in the economy would remain idle and underutilized. It is unrealistic to expect demand-side structural issues to resolve themselves as growth slows without pursuing either the best scenario or the suboptimal scenario.
As for China's supply-side structural issues, while stimulus measures cannot substitute for structural reforms, they can help create a stable macroeconomic environment that is essential for supporting industrial transformation and upgrading. The upgrading of industrial structures depends primarily on enterprises' spontaneous investment and R&D. Without a stable macro environment, companies may reduce investment and R&D spending due to weakened confidence and uncertain future expectations. Rapid industrial transformation and upgrading cannot occur when many companies are struggling with bankruptcy. Therefore, during periods of sluggish economic growth driven by insufficient demand, stabilizing growth through stimulus measures can boost the incomes and confidence of various economic entities, thereby supporting supply-side structural reforms.
The belief that an economic slowdown or crisis will jumpstart supply-side structural reform is more likely to end up with widespread industry downturns, ultimately delaying or even obstructing China's supply-side transformation and upgrading.
In conclusion, stimulus measures and structural reforms do not contradict one another but can be effectively combined. For instance, when implementing stimulus measures, the government can place greater emphasis on boosting consumption by both increasing consumer income and breaking through supply chain blockages that limit consumption. In stimulating infrastructure investment, efforts can focus on "new infrastructure" projects that address critical bottlenecks in China's economic development. In the case of boosting real estate investment, adopting a land supply system with greater price elasticity can better align land and housing supply with population shifts, ensuring that real estate investment not only stabilizes growth but also enhances people’s satisfaction with housing.
The idea that stimulus measures hinder structural reforms, or that structural reforms can be achieved without stimulus measures, is counterproductive to the economy.
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