Expansionary fiscal policy need of hour

China ended its dynamic zero-COVID-19 epidemic response policy late last year, and by January-end, the sales revenue of various consumer sectors nationwide had climbed by 12.2 percent year-on-year during Spring Festival, or Chinese New Year.

A total of 308 million tourist trips were undertaken across the country during the holiday period, 23.1 percent higher than during the corresponding period in 2022.

Though there have been high hopes of a robust economic recovery, the nation has not yet witnessed the anticipated momentum even after seven months.

China's gross domestic product grew 4.5 percent and 6.3 percent, respectively, in the first and second quarters. The relatively high growth in the second quarter has largely been attributed to the low base effect during the same period last year.

The already modest year-on-year growth rate of the consumer price index, a main gauge of inflation, in the first seven months of this year edged down continuously until it eventually dipped into negative territory of — 0.3 percent in July.

The producer price index (PPI), which measures the costs of goods at the factory gate, has also been declining since October last year. The index decreased by 2.5 percent year-on-year in July, hitting a new low for the current round of depressed growth.

Several domestic and foreign economists have asserted that China has entered a phase of deflation because both the CPI and PPI has reached a range of negative growth.

It is in fact questionable whether China's current economic position can be classified as one that is deflationary as there is no clear definition of deflation and the CPI has only been negative for one month. In my most recent piece, I used the term "quasi-deflationary" to avoid causing controversy.

Past lessons

Actually, this isn't the first time that the Chinese economy has encountered such a similar situation.

Through a 4-trillion-yuan ($547.8 billion) stimulus package, China was able to successfully combat the effects of the global financial crisis from 2008 to 2009 and achieve a V-shaped rebound.

China's GDP growth rate quickly recovered to 12.2 percent in the first quarter of 2010 from 6.4 percent the year before, with consumer and asset prices both increasing sharply at the same time. In March 2010, the CPI went beyond 3 percent, and it rose even further, reaching 4.9 percent in February 2011.

The government set the CPI control target at around 4 percent for 2011. In fact, the government's macroeconomic policy orientation for 2011 had shifted to prevention of asset bubbles and inflation rather than promotion of economic development.

Infrastructure investment declined 2.36 percent year-on-year in February 2012 as a result of the tightening of fiscal and monetary policies in 2011 and a raft of real estate control measures had been implemented since 2010, and the growth rate of real estate investment also gradually decreased since May 2010 after reaching a record high of 37 percent.

Meanwhile, in 2012, there occurred considerable overcapacity, particularly in the steel sector, where profit margins plunged to about 0.04 percent from 2.55 percent in 2011. Most economists at the time believed that excess capacity was the primary issue facing the economy and that it needed to be reduced.

There was significant overcapacity in the steel industry, to be sure, but this was mostly attributable to the severe decrease in the growth rates of industrial, real estate and infrastructure investment.

Since the symptoms of both excess capacity and insufficient effective demand are largely the same, the two are frequently conflated in policy analysis. The path of macroeconomic policy is determined by different assessments of whether the economy is experiencing insufficient effective demand or excess capacity.

Excess capacity generally stems from overexpansion of investment by firms that are overly optimistic about the economic outlook. On the other hand, a lack of effective demand typically results from businesses having an extremely negative view, which causes an overly compressed investment.

Overcapacity is generally a structural problem with the economy, whereas lack of effective demand is typically a macroeconomic issue. A key factor in deciding whether there is surplus capacity or inadequate effective demand is the differing nature of external shocks.

For instance, in 2012, China's overcapacity was linked to a swift change in macroeconomic policy from one of expansion to one of austerity. In reality, China's budget deficit ratio dropped from 2.7 percent in 2009 to just 1.5 percent in 2012, and new loans from Chinese financial institutions peaked in 2009 at 9.6 trillion yuan before falling to 7.95 trillion yuan in 2010 and 7.47 trillion yuan in 2011.

Despite increasing to 8.2 trillion yuan in 2012, fresh lending was still less than what it was in 2009. To put it another way, China's overcapacity in 2012 should be mostly attributed to the lack of effective demand brought on by the abrupt change in macroeconomic policy from loosening to tightening.

In hindsight, the government rushed to the "normalization" of macroeconomic policy from 2010 to 2011 as it overestimated the risk of inflation and asset bubbles. As a result of this, China's GDP growth quickly fell below 9 percent and then 8 percent.

In 2012, the Chinese government and the economic community came to the conclusion that China's potential growth rate was less than 8 percent, a result that the country should have been happy to accept.

However, after falling below 8 percent, GDP growth continued to drop.

While the CPI was kept at a level of roughly 2 percent and the PPI was in negative growth mode since March 2012, GDP growth dipped below 7 percent in the fourth quarter of 2015.

In light of this, I'm starting to worry that China's economy might be about to spiral into a debt-deflation vicious cycle.

In my essay, I wrote: "China must pursue an expansionary fiscal policy to promote effective demand through government-supported infrastructure investment in order to avoid a hard landing of the economy and to lessen the discomfort of adjustment."

Finding solutions

The pandemic-induced shocks have significantly slowed China's GDP development. Long-term evidence of insufficient effective demand in China's macroeconomy is provided by low inflation and persistently negative PPI growth.

The conclusion reached by the central government that "insufficient aggregate demand is the major problem facing the current economic operation" is correct. Given this, the basic path for resolving China's current economic issues is clear.

Local government debt and real estate firm blowouts have emerged as the two main problems threatening China's socioeconomic stability. China still has a lot of room for fiscal and monetary policy to deal with these two problems.

Problems of real estate companies that may pose a systemic financial risk can be addressed by curbing further declines in asset prices, and providing sufficient liquidity, while local government debt can be dealt with through debt swaps and other strategies.

In addition, the government should encourage infrastructure investment through expansionary fiscal and monetary policies in order to boost economic growth. Higher economic growth will boost people's and businesses' confidence, as well as create solid conditions for resolving the debts of real estate companies and local governments.

Fiscal policy should play a leading role in macroeconomic policy, and if expansionary fiscal measures cannot be taken, China's economic growth would continue to trend downward. Stabilizing economic growth through fiscal policy entails boosting fiscal spending, which calls for a corresponding increase in the fiscal deficit-to-GDP ratio.

Western countries have long abandoned the so-called Maastricht Treaty requirements, which state that the fiscal deficit-to-GDP ratio should not exceed 3 percent and the national debt-to-GDP ratio should not surpass 60 percent.

The quantitative easing and zero-interest-rate policies of the United States have been criticized as irresponsible, but it is precisely because of the implementation of such policies that it has set a historical record of 120 consecutive months of positive growth.

It should be noted that this essay solely addresses the short-term macroeconomic situation and macroeconomic stabilization policies. In the long run, whether China's economy can shift from one driven by real estate investment and exports to one that is driven by innovation will determine if it can retain a high growth rate.

Indeed, there is positive momentum in many industries, and innovation-led firms are flourishing across the country. China will be able to maintain a high rate of economic growth over the next decade or two as long as it persists in innovation, and will eventually realize its century-old ambition of the great rejuvenation of the Chinese nation.

The writer is former president of the China Society of World Economics and former director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. He served on the Monetary Policy Committee of the People's Bank of China from 2004 to 2006.

The views do not necessarily reflect those of China Daily.