HONG KONG – In March, meetings of the G-20, the Chinese National People’s Congress, and multiple think tanks all reflected a growing awareness of the risks to the global economy posed by deflation and intensifying financial instability. In mitigating these risks, the path that China takes will be particularly important. But avoiding a hard landing in China is a necessary but insufficient condition for global recovery.
Contrary to the advice of many Chinese economists, the country’s policymakers have opted not to follow the conventional Western approach of using flexible exchange rates as the main shock absorber for volatile capital flows and thereby freeing monetary policy to provide liquidity for domestic structural adjustments. This satisfied both Western economists and global financial markets, which breathed a collective sigh of relief when Chinese leaders reaffirmed their commitment to maintaining a stable renminbi.
The fear was that, if China sought a weaker exchange rate to escape deflation, the result would be another round of global competitive devaluations and even more deflation. Fortunately, China’s leaders recognize that, if the world remains mired in a balance-sheet recession, the lack of aggregate demand, by continuing to weaken trade, will drag down their own country’s growth.
But, of course, China still needs to find a way to cope with capital outflows, while pursuing the structural reforms that are needed to place its economy on a sustainable long-term growth path. As we recently argued, the key will be to maintain an annual growth rate of roughly 6.5%, while pursuing a multifaceted short-term stabilization plan that aims to stimulate job creation to offset the losses from restructuring inefficient industries and eliminating excess capacity.