China’s Narrowing Policy Horizons

BEIJING – Back in the last quarter of 2011, when the decline in China’s investment growth accelerated, concerns about a hard economic landing intensified, particularly given the authorities’ reluctance to pursue new expansionary policies. By May 2012, however, the government had changed its mind, with the National Development and Reform Commission approving ¥7 trillion ($1.3 trillion) in new projects. That, together with two ensuing interest-rate cuts by the People’s Bank of China (PBOC), guaranteed an end to the economic slowdown in the third quarter of 2012.

The Chinese economy’s performance has thus maintained the cyclical pattern familiar from the past two decades: rapid investment growth, supported by expansionary policy, drives up the economic-growth rate. Inflation follows, so policy is tightened and growth slows. But inflation remains high or rising, so more tightening is imposed. Inflation falls at last, but growth slows more than desired, owing to the overcapacity that resulted from excessive investment in the earlier phase of the cycle. At this point, policy becomes expansionary again, and the cycle begins anew: led by investment growth, the economy rebounds.

Thus, the acceleration of economic growth since the third quarter of 2012 should come as no surprise. With the government still having room to wield expansionary monetary and/or fiscal policy, the economic revival was only a matter of time.

There is no reason to doubt that the Chinese economy in 2013 will follow the old growth pattern. But China’s decision-makers should bear two things in mind. First, in the past, short-term macroeconomic stability was often achieved at the expense of structural adjustment and rational allocation of resources. To achieve sustained growth, a balance between short-term and long-term objectives must be struck. Striking that balance is the biggest challenge facing China.