Relax control better than release liquidity, Zhang Jun says on China's economy
Fudan economist highlights China's economic slowdown is inevitable and market-oriented structural reform is urgently needed.
Zhang Jun believes that China's economic slowdown, often referred to as "L-shaped," is not a short-term recession but an inevitable, prolonged trend of slowing growth. Consequently, the focus should be on sustaining productivity growth and maximizing China's growth potential.
While acknowledging the government's resolve to transition from unsustainable growth practices through, most notably, "Supply-Side Structural Reform," Zhang remains concerned about the absence of consensus on implementing marketization to address the deep-seated issues. The primary reasons behind the economic slowdown include reduced growth in productivity, inefficient capital allocation, and resource misallocation, Zhang Jun explains, and all are related to overinvestment and overcapacity caused by government intervention.
Today's newsletter is the translation of Prof. Zhang's interview with Guancha. cn [literally Observer, a Shanghai-based online news site]. It is also available on 底线思维 Redline Mentality, a WeChat account under Guancha. cn and 张军说 Zhang Jun Talk, Prof. Zhang's personal WeChat blog. Prof. Zhang has agreed to the publication of this translation.
Understanding the Core Factors Behind China's Economic Slowdown: A Pathway to Breakthrough
Recently, many economists, including yourself, have referenced the "authority' opinions" of the Chinese economy published in the People's Daily in May 2016, especially one statement, "China's economic trajectory will not follow a U-shaped or V-shaped pattern, but rather an L-shaped trend. This L-shape represents a phase that can not be resolved within a year or two."
Generally speaking, L-shape refers to an "L-shaped recession," implying a prolonged downturn, but the current Chinese economy is neither in recession nor depression. How do you think we should understand and summarize the current economic situation in China?
It's the job of economists to define evolving economic phenomena, hence the introduction of new concepts for new trends. For most developed economies, crises or external shocks in the short term would often result in negative economic growth, which is called a "recession." If the recession is not reversed for an extended period, it may evolve into what is called a "depression." Thirty years ago, after Russia and some Eastern European countries implemented radical Shock Therapy, their economic output declined significantly, resembling an L-shape. Therefore, at that time, some economists defined this phenomenon as an "L-shaped" recession. But looking at China, it still has economic growth of around 5%-6% each year, which cannot be called a recession. Compared to ten years ago, China's GDP growth rate has come down, but not sharply, rather slowly.
Therefore, the "L-shape" in the Chinese context merely indicates a trend of slowing growth, and the current growth of about 5% is also due to the pandemic. Three years ago, China's economy grew by more than 6% per year, which was roughly in line with expectations. Regarding the past few years, the slowdown of China's economic growth from a high level, forming an "L-shaped" slowdown trend, seems to be related to the government no longer continuously stimulating investment as before. But it is also important to see the reasons for doing this, and whether these reasons are convincing. Had the Chinese government not recognized that maintaining a high growth rate incurs considerable costs and could lead to unsustainable financial risks, it is unlikely that they would have altered their previous practices.
Based on my observations and thinking over the years, I increasingly feel that the growth slowdown has a certain inevitability. It cannot be simply understood through the framework of macroeconomic analysis, nor should it be interpreted as a lack of sufficient intervention in total demand. Over the years, the continuous slowdown in economic growth has profound reasons.
The period of negative growth in the Producer Price Index (PPI) and the low-level operation of the Consumer Price Index (CPI) are primarily consequences of the economic slowdown, particularly due to the impact of the pandemic over the past three years, rather than indicators of slowing demand. In fact, the emergence of an "L-shaped" slowdown in growth is not something new. This phenomenon is typical for most high-growth economies in East Asia, although it does seem highly unusual when viewed through the lens of Keynesian macroeconomics. If one insists on adhering to the total demand-total supply framework, the continuous slowdown in growth can be interpreted simply as a situation where the increase in total supply is outpacing total demand.
I remember in the winter of 2003, at the 2nd [sic. should be the 3rd] China Economic Annual Conference held at Fudan University, Professor Justin Yifu Lin discussed similar topics in his keynote speech, employing concepts akin to those I've mentioned. [Just in case you are interested: Prof. Lin has repeatedly discussed the failure of shock therapy and the subsequent need for a new economic theory, as evidenced in his papers in 2002, 2014, and 2017, etc.] At that time, China also experienced moderate tightening in macro terms, but its GDP still grew at slightly more than 8%, although it had slowed down significantly from the previous growth of over 10%. The key difference now is that China's current economic slowdown exhibits a "long tail phenomenon," indicating an inability to revert to previous growth levels. In the current economic climate, this suggests limited prospects for a U-shaped reversal.
This is indeed a very interesting phenomenon. We need to pay attention to how this "L-shaped" trend is formed. What deep-seated reasons behind the slowdown in growth do you think need to be studied and explained?
In my view, the specific growth rate figures may not be that important. In the short term, a little more or less does not explain the problem. What needs attention is that, in the medium and long term, China's GDP growth rate is indeed slowing down. This slowdown is a trend, not a short-term downturn phenomenon, so I don't think it's just a simple demand contraction or a problem with the so-called "three driving forces of the economy [investment, consumption, export]."
Of course, the economy has come down more in the past three years under the impact of the pandemic, but that is a different discussion. Like the other East Asian economies, the slowdown in growth is a step-down, a trend. The factors that fueled the previous high growth have undergone significant changes and can no longer sustain such a high potential growth rate. The future bottom of this trend will depend on the potential of the Chinese economy and whether the conditions necessary to unlock this potential are present, etc., which is an issue of more significance and can be discussed further.
Simply put, ensuring a reasonable growth in overall productivity in the future is crucial. As for whether a growth rate of 6% or slightly higher one is attainable in the future, I think it is possible, considering that China's economic growth rate exceeded 6% before the pandemic. If conditions allow for a better economic recovery, China should be capable of resuming its previous growth trajectory.
The problem is, it is extremely difficult to prevent the overall productivity from dropping in the next few years, which would drag down the potential growth rate. If you have been paying attention to economists' research papers recently, you will notice that after 2008, China's productivity growth indeed entered a slowdown, a clear slowdown. Some studies have also confirmed that this slowdown in productivity is largely the result of a high investment-driven growth model. Of course, this assessment is not focused on the GDP growth data of individual years, but rather on a trend observed over several years.
Some might argue that the slowdown in productivity is a global phenomenon, with worldwide productivity also experiencing a deceleration. On one hand, the emergence of new technologies has still not escaped the "Solow Paradox" [where productivity decreases despite rapid development in information technology]. On the other hand, as new technologies become more widespread, technological innovation in developed countries has reached a plateau, leading to a pulse-like deceleration in the momentum of productivity growth.
The slowdown in China's productivity is not solely due to the deceleration associated with technological advances. A significant contributing factor is the long-term inefficiency in capital allocation. Many economists have highlighted that the Chinese economy has long suffered from inefficient capital allocation and resource misallocation. However, short-term prosperity often obscures these substantive issues, making them hard to see. Think about it, the prosperity stimulated by investment encourages many loans to be allocated to many low-productivity infrastructure projects, and even those projects that do not have substantial productivity growth will be launched. Moreover, this issue appears to become increasingly severe at the grassroots level.
Is it because the systemic financial risks are too high that they had alerted the central leadership, prompting the Central Financial Work Conference to emphasize the need to comprehensively strengthen financial regulation and effectively prevent and resolve risks? That is, they had no choice but to hit the brakes and regulate and rectify finances?
Regulation and rectification of the financial sector have been a part of China's macroeconomic regulation and have occurred multiple times in the past. Over-investment, due to its tendency to accumulate substantial risks in the financial sector, would also direct the top leadership to the macroeconomic issues.
However, the statement from the central leadership in 2015 marked a departure from previous assessments. It suggested that China's previous growth model was unsustainable and needed correction, leading to the proposal of "Supply-Side Structural Reform." This was a significant change. This change indicates that the top leadership also believed that the economic slowdown in the preceding years was not merely cyclical but possibly structural. Lowering the growth expectations at that stage and not encouraging the pursuit of high speed was an important signal to the market. The "authority' opinions" published in the People's Daily in May 2016 explicitly expressed the central government's determination to change the economic growth model.
Of course, this is also controversial in the field of economics because there is no consensus on how to transform the growth model. Whether administrative intervention is necessary to restrict traditional economic activities and investments is a complex issue. Theoretically, marketization is the fundamental solution to overcoming inefficiencies and misallocation of capital distribution, but there was no breakthrough in reaching a consensus on implementing marketization to address these issues.
On a side note, the concept of a "new normal" was first introduced at the Central Economic Work Conference in 2013. Since then, I have noticed that the top leadership has gradually accepted this narrative, believing that the country's economic development was facing "三期叠加 three simultaneous challenges" [first proposed by Xi in 2013 during a CPC Politburo Standing Committee meeting], namely, having to "deal simultaneously with the slowdown in economic growth, making difficult structural adjustments, and absorbing the effects of the previous economic stimulus policies." Although the growth rate would be slower, there was a consensus that as long as efforts were made to cultivate new drivers of growth, the Chinese economy would still maintain medium-to-high-speed growth.
In my view, the top leadership has indeed shown unprecedented determination and resolve on this issue and has been making comprehensive policy adjustments based on this logic, a stance that appears to remain unchanged to this day. However, the challenge lies in the inadequacy of marketization, which has not become the decisive force in structural adjustment. In the shift towards new growth drivers, the government has paradoxically intensified the implementation of industrial policies. This is highly concerning, and I fear it might lead to new complex problems later on.
For instance, overinvestment still prevails in many areas, such as the photovoltaic industry in recent years and currently in lithium batteries, new energy vehicles, green carbon peaking and carbon neutrality, and energy storage. The government has guided or intervened in resource allocation through industrial policies, which is problematic. In any field that becomes a hotspot, the government will guide the market to increase investment in that area, attracting a large influx of capital in the short term and rapidly accumulating capacity. Excessive capacity will ultimately lead to a deterioration in the industry's profitability, R&D capabilities, and overall investment returns, creating substantial debt for banks. Therefore, although China has limited excessive investment in traditional areas, overcapacity in new energy sectors might still become a significant problem.
You believe that the fundamental reason for the economic slowdown in the past seven or eight years is the slowdown in productivity, which in turn, is closely correlated with overcapacity.
I noticed that Mr. Yu Yongding [Academician of the Chinese Academy of Social Sciences (CASS), former Member of the Monetary Policy Committee of the People's Bank of China] recently mentioned a point of view that overcapacity is a structural and industrial problem. At the macroeconomic level, when considering the total quantity, the issue is one of insufficient total demand rather than overcapacity; or, overcapacity that is a result of insufficient effective demand. He believes that the primary challenge facing China's economy over the past decade has been a lack of sufficient total demand, rather than an issue of "overcapacity." What is your view on this?
I have already said enough about my understanding. Superficially, insufficient demand and excessive supply are two sides of the same coin, but their economic meanings are different. Additionally, I believe there's no need to overly focus on whether China's economic challenges are short-term total volume issues or long-term structural problems, as most of these challenges are inherently long-term.
If China is already facing excessive ineffective capacity and deteriorating capital returns, more policy stimulation targeting investment demand will naturally lead to the accumulation of more ineffective capacity, at least in the context of China.
As for the current monetary and fiscal policies, apart from the sudden impact of the pandemic in the past three years, China's GDP growth rate has hovered around 6%, with a nominal growth rate of about 8%, which is not significantly different from expectations. Moreover, in recent years, including this year, the amount of money injected into the economy, both in total and in terms of growth rate, has been substantial, outpacing the growth of nominal GDP. This indicates that liquidity is not in short supply, and policies may not be as tight as perceived. Nonetheless, there is still pressure to stabilize the economy.
Therefore, the crux of the problem is not whether to further stimulate infrastructure investment by releasing more liquidity, but rather about concentrating on enhancing China's potential growth rate trend. Significant improvements are needed in this area. Looking ahead, if China's policies do not prioritize addressing systemic issues and increasingly rely on marketization to rectify inefficiencies in capital distribution, the persistent problems of investment waste and misallocation will continue to trouble its economy. Without these reforms, stabilizing the potential growth rate will remain challenging.
A few years ago, I expressed the view that "relaxing control is better than releasing liquidity", advocating for reducing the intervention of industrial policies and relying more on the market in many areas to gradually restore the vitality of the economy. The overall macroeconomic policy in recent years has adopted a strategy of mildly stimulating demand, aiming to ensure basic job creation and prevent the short-term GDP growth rate from deviating too far from expectations.
I understand very well the objectives of the authorities with their macroeconomic policies. Currently, the Chinese economy faces many uncertainties and challenges, and under these circumstances, it is prudent for macroeconomic policies to maintain a cautious approach, steering clear of the risks associated with over-adjustment and volatility. More critically, however, is the need for a swift consensus on tackling structural and deep-rooted issues, to advance systemic and institutional reforms, broaden the scope of the economy, and unlock the potential for Chinese growth.