Huang Yiping's Analysis of China's Macroeconomic Framework and Policymakers' Doubts About Stimulus Initiatives

Peking University's National School of Development Dean Urges Government to Shift from "Prioritizing Investment Over Consumption" Policy and set CPI Growth Target at 2%-3%

Hello, my readers. I just had a vacation and stayed in Beijing, where I immersed myself in the Northern Chinese version of bathhouse culture. Similar to Thermae, a bathhouse in Beijing is not just for taking a shower but also a place to socialize; you can have decent Sichuan cuisine plus unlimited fruit supply and even play PS5 with friends. Generally speaking, It’s a very Rome-like experience. That’s also where I write today’s episode.

For today’s episode, I bring Professor Huang Yiping’s analysis of China’s macroeconomic framework. It was initially his speech published on Changan Jiangtan(长安讲坛), named The Macroeconomic Policy Framework with Chinese Characteristics. As one of the foremost experts on China's economy, Professor Huang's work is a must-read for anyone seeking to understand the perspective of Chinese policymakers.

He is the Dean of Peking University's National School of Development. Moreover, since March of this year, he has been a member of the People's Bank of China's Monetary Policy Committee. As China's central bank, the People's Bank of China plays a crucial role in formulating and implementing the country's monetary policy. That’s why I think Professor Huang's explanation of the Chinese macroeconomic structure carries significant weight and deserves our undivided attention. It’s a long talk so that I will summarize the article. For more, you can check the link for the full transcript in Chinese.

Article link：https://mp.weixin.qq.com/s/Eb-eTxcWA86jyEtQsvL5Pw

Three characteristics of China's macroeconomic structure

1. Non-market policy tools

   China's monetary policy tools are more diverse, including policy rates, quantitative tools, and administrative measures. Policy rates are relatively complex, and simultaneously controlling short-term and medium-term rates may affect the shape of the yield curve. However, Pan Gongsheng, the governor of the People's Bank of China, has indicated that the policy tool function of the medium-term lending facility rate may be abolished.

   The monetary policy toolbox also includes some unique quantitative tools, such as "window guidance," where central bank officials use gentle language to convey clear policy requirements. The reason for the emergence of diverse and complex policy tools is that China is still in a transitional period, market-oriented reforms are not yet complete, and the interest rate transmission mechanism is not smooth enough. State-owned enterprises are not sensitive enough to interest rate changes, so quantitative tools and administrative measures are more effective.

   China's monetary policy framework is transitioning from direct control to indirect regulation and from quantitative tools to price tools, but this transition is not yet complete. Currently, it is a hybrid of both quantitative and price rules coexisting. Overall, the current regulatory system is effective, but there is still significant room for improvement in terms of responsiveness and accuracy.

2. Division between the Ministry of Finance and the Central Bank

   Unlike Western countries, China's fiscal authorities and central bank are both part of the government, so theoretically, policy coordination should be easy. However, in practice, this is not always the case. In macroeconomic policy discussions, central bank officials and fiscal officials sometimes engage in cross-discussion of policy choices, which is not a problem in itself, but there may also be considerations of departmental positions.

   Both the central bank and the Ministry of Finance attach great importance to "preserving policy space" for future needs. However, there are sometimes differences between macro and departmental positions. If the goal of "macroeconomic stability" is affected due to "preserving policy space," it may seem like putting the cart before the horse.

   An appropriate balance needs to be struck between "policy soundness" and "economic soundness." The purpose of maintaining "policy soundness" is to leave policy space to support "economic soundness" in the future, but if policies are too conservative and once "economic soundness" is affected, there will no longer be "policy soundness."

   The government attaches great importance to the 3% fiscal deficit rate threshold, but this has led to two potential problems. First, the broad fiscal deficit rate is far higher than 3%, and second, the short-term unwillingness to expand too much may seem conducive to the health of fiscal policy. However, if the economy is inactive, it may instead increase the probability of a deterioration in the fiscal situation in the future.

3. The amplifying effect of local governments on macroeconomic regulation

   In the past, a distinctive feature of China's macroeconomic regulation was the significant role played by local governments. Local governments would intensify their implementation efforts when the central government introduced policies. For example, in the "4 trillion yuan" stimulus policy announced in 2008, the central government was responsible for 1.13 trillion yuan, but the actual amount ultimately reached 30 trillion yuan, with the amplification mechanism mainly coming from local governments.

   Two mechanisms determine the behavior of local governments: First is the "GDP bidding competition" or "GDP beauty contest," which means that under otherwise similar conditions, the faster a region's GDP grows, the higher the likelihood of promotion for that region's leaders. Second, local governments have obtained many resources through land finance and financing platforms.

   These two mechanisms often make local governments amplifiers of macroeconomic policies, especially when policies are relaxed. Local governments have played a crucial role in amplifying the macroeconomic regulation mechanism and stabilizing the macroeconomy.

   This amplification effect is not entirely symmetrical: When the central government implements expansionary policies, the amplification effect of local governments is more significant; when contractionary policies are in place, the amplification effect is less prominent.

   The amplification effect can also have sequelae. For example, after the "4 trillion yuan" stimulus policy, problems such as overcapacity, high leverage, zombie enterprises, real estate bubbles, financial inefficiency, and inflationary pressures emerged. This may be why officials have doubts about excessive stimulus policies, and decision-makers have begun to focus on cross-cycle adjustments.

Macroeconomic policies facing new challenges

1. Overly-moderate macroeconomic policies

   After the pandemic, China's economic recovery was relatively weak. The main reason was that the balance sheets of households and businesses were squeezed during the pandemic, leading to weak overall demand.

   In the case of weak overall demand, macroeconomic policies should have played an expansionary role. However, in 2023 and 2024, the government's stimulus efforts were consistently lower than market expectations.

   The reasons for China's relatively small macroeconomic policy stimulus may include:

   1. Although past stimulus policies had good effects, they also produced side effects such as high leverage, low efficiency, and asset bubbles, causing some people to have reservations about large-scale stimulus.(like the one after the financial crisis)

   2. With GDP growth rates around 5%, some officials may believe that the economic situation is not as bad as many people worry.

   3. Macroeconomic policies are good at supporting supply but not good at supporting consumption, and China currently faces the challenge of overcapacity.

   4. The Chinese government has a strong administrative mobilization capability, and macroeconomic policies are easy to implement but difficult to withdraw, so decision-making departments are relatively prudent.

2. The Function of Macroeconomic Policies in Managing Market Expectations

   In recent years, local governments have begun to be absent from macroeconomic regulation and control due to a lack of fiscal capacity and market discipline constraints, resulting in limited policy effects of the central government's support for economic growth. The traditional macroeconomic policy approach needs to be adjusted.

   Macroeconomic policies change aggregate demand through two mechanisms:

   1. Directly adjusting fiscal or monetary policies to increase or decrease aggregate demand;

   2. Changing the expectations of market participants. The policy force must be strong enough to make market participants believe that the economy will undergo a directional change in order to achieve twice the result with half the effort; otherwise, it is difficult to change expectations and behaviors, and the effect will be twice the work with half the result.

   Nobel Prize winner in Economics, Robert Shiller, proposed "Narrative Economics," believing that forming a credible and persuasive narrative can guide the behavior of market participants. However, influential "narratives" can sometimes create bubbles and risks. An example behind that is in early 2009 after China announced the "4 trillion" stimulus policy, international copper prices soared, mainly because an important project in the policy, updating the national power grid system, would use a large amount of copper.

3. Risk of deflation

   Despite China's GDP growth reaching 5.3% in the first quarter of 2024, which is in line with the annual growth target of around 5%, the perception of market participants differs significantly. One possible reason is the decline in prices. The GDP deflator for the first quarter was -1.1%, implying that nominal GDP growth was only 4.2%, which is directly related to the operating income and profits of enterprises.

   From the fourth quarter of 2023 to January 2024, China's CPI has been in a state of negative growth, and most experts predict that the annual CPI growth rate in 2024 will be below 1%. There are two main reasons for the rise in CPI: the "pig cycle" of pork prices and the rise in oil and energy prices.

   Watanabe Tsutomu, a Japanese price research expert, believes that price expectations are the most crucial factor. If prices do not rise, a vicious cycle of expectations will form between consumers, producers, and investors, leading to economic downturns. Japan's loss of 30 years was largely the result of such a vicious cycle.

   Since 2022, Japan has begun to emerge from the vicious cycle, with consumers starting to accept price increases. Japan's inflation rate has shifted from being an "exception" over the past years to a level roughly the same as that of the United States and Europe.

   China needs to be vigilant about whether it will fall into the "low inflation trap." Currently, China's PPI and CPI growth are sluggish, and the economy has a series of contractionary mechanisms. If China's inflation rate becomes a new "exception," it may cause a downturn in economic activity and deserve high attention.

4. Risk of balance sheet recession

   Japanese economist Gu Zhaoming proposed the concept of a balance sheet recession when analyzing the consequences of the asset bubble burst in Japan in the 1990s. He found that at the time, companies no longer pursued profit maximization but instead sought to minimize debt. This change in behavior could lead to a comprehensive economic recession, rendering monetary policy and structural reform policies ineffective.

   In recent years, there have been frequent debates about whether China's economy will experience a balance sheet recession. Once the balance sheet begins to shrink comprehensively, it will be difficult to maintain the stability of economic activities.

   Currently, the balance sheets of Chinese households, enterprises, and local governments are facing unprecedented pressure:

   • The decline in real estate prices has caused household assets to shrink, and the asset quality of financial institutions is under pressure;

   • The requirements for deleveraging or stabilizing leverage have made it impossible for local governments to support the expansion of economic activities effectively.

   If the balance sheet cannot be stabilized, it will be difficult for economic activities to stabilize truly. In Gu Zhaoming's view, at this time, it is necessary to give greater play to the role of fiscal policy. When there are fewer and fewer high-quality borrowers in the market, the government should play the role of the ultimate borrower.

The problem of macroeconomic policies and policy suggestion

Macroeconomic policies in China should return to their cyclical positioning, focusing on managing the economic cycle. However, several new situations have emerged in China's economy that have undermined the effectiveness of these policies.

Firstly, the perspective of cross-cyclical regulation may weaken the effect of counter-cyclical regulation. While cross-cyclical regulation is a reasonable response to past problems and has strong theoretical innovation, coordinating it with counter-cyclical regulation poses a new challenge. Counter-cyclical regulation should not be abandoned due to concerns about cross-cyclical issues.

Secondly, tight financial conditions have led to the absence of local governments in macroeconomic regulation in recent years, which may be the main reason for the unsatisfactory effect of recent macroeconomic stimulus policies. While it is not necessarily a bad thing for local governments to reduce their participation in macroeconomic regulation, the central government needs to take on greater macroeconomic policy responsibilities.

Thirdly, the pursuit of economic stability goals has been affected by an overemphasis on policy soundness. The soundness of the macro economy is the essence, while the soundness of policy tools is the appearance. For example, when the economy is weak, raising the fiscal deficit rate above 3% may appear to reduce the health of fiscal policy, but if fiscal stimulus policies ultimately stabilize the macro economy, the space for fiscal policy will certainly become larger.

Fourthly, adjustments to industry policies have affected macroeconomic stability. The special rectification policies of the past few years have targeted the most active economic sectors, and although the special rectification has ended, the market has not yet felt a relaxation in the regulatory policy environment. Special rectification is an industry-specific policy, but it has objectively produced a tightening macro effect.

To improve the effectiveness of macroeconomic regulation, China can consider making policy adjustments in the following areas:

1. Guide market expectations by increasing the intensity of macroeconomic policies, giving the market sentiment a sufficiently large shock, and paying attention to the role of "narrative economics".

2. The central government and the central bank should take the main responsibility for macroeconomic regulation, with sufficiently large fiscal expenditures, sufficient budget, and the ability to implement.

3. Prioritize "counter-cyclical regulation" ahead of "cross-cyclical regulation", taking supporting measures to alleviate contradictions and strengthening market discipline through structural reforms.

4. Strengthen the coordination between fiscal, monetary, and industry policies to achieve mutual cooperation and concerted efforts.

Professor Huang also gave three short-term policy recommendations:

1. Elevate the importance of pursuing moderate inflation (2%-3% CPI growth) to the same level as pursuing medium-speed growth.

2. Increase the intensity of macroeconomic policies, especially by promptly implementing fiscal expenditures, and adopt measures to support consumption growth, such as allowing migrant workers to settle in cities and directly giving money to the people.

3. Leverage sovereign credit to reduce vulnerabilities and balance sheet risks, with the central government assuming responsibilities to stabilize the market and boost confidence.

For more of Professor Huang’s analysis of the Chinese economy: