China’s Monetary-Policy Choice

SHANGHAI – China’s economy has followed a remarkable course in recent years: from record-breaking powerhouse to major global risk, at least in the eyes of some. Indeed, with GDP growth this year almost certain not to reach the authorities’ 7% target, the world is now watching closely for signs of crisis and a much sharper slowdown. How did China get here, and can it put its economic growth back on track?

China’s growth has been unsustainable for a while. A stimulus package of less-than-prudent fixed-asset investment, adopted in response to the 2008 global financial crisis, sustained 9% GDP growth for two years. But, after 2011, stimulus turned to macroeconomic tightening, causing investment growth to plummet from a nominal rate of over 30% to about 10% recently. This prevents full utilization of production capacity and resources, and explains why GDP growth above 7% is simply not possible.

Excess capacity and falling growth are mutually reinforcing. Not only does excess capacity have a negative impact on growth; perhaps more important, sharply declining growth also contributes to massive redundancy in some industries (especially resources and the heavy and chemical industries).

The question is why growth continues to slow. One popular line of thinking focuses on long-term structural factors, such as demographic transition. But, so far, few studies have indicated that structural factors are adequate to explain the extent of the decline in China’s potential growth rate over the last couple of years.