>The Sustainability of China’s Recovery from the Global Recession

China’s policy response to the global financial and economic crisis was early, large, and well-designed. Although Chinese financial institutions had little exposure to the toxic financial assets that brought down many large Western investment banks and other financial firms, China’s leadership recognized that its dependence on exports meant that it was acutely vulnerable to a global recession. Thus they did not subscribe to the view sometimes described as “decoupling,” the idea that Asian countries could passively weather the financial storm that originated in the United States and other advanced industrial economies. They understood that absent a vigorous policy response China inevitably would suffer from the backwash of a sharp economic slowdown in its largest export markets—the United States and Europe.

While it is now widely understood that China was the first globally significant economy to begin to recover from the crisis, critics nonetheless increasingly charge that the stimulus program has substantial flaws and that China’s early economic recovery cannot be sustained. One prominent critic has gone so far as to suggest that the stimulus has created a debt-fueled bubble that will collapse, causing China’s growth to plunge to only 2 percent.1 But the analysis below suggests these criticisms are exaggerated.

China and the Crisis
In the fall of 2007, just before the global crisis, the Chinese authorities tightened monetary policy and took steps to curtail an incipient property bubble. But when the global crisis intensified in the fall of 2008 the authorities reversed economic course by launching a policy of monetary easing in order to offset the additional drag on China’s growth caused by the sharp slowdown in global trade. First, they cancelled the lending quotas that had previously restricted the ability of
banks to fully meet the demand for loans from their customers. Second, to ensure that a sufficient supply of funds would be available to meet this demand, the government repeatedly
reduced the share of deposits that banks had to place with the central bank. Banks were not necessarily forced to expand their lending in 2009, as has often been asserted. It was in their economic self-interest to do so since the interest rate that they could charge on loans was several times what they earned either on funds they were required to place with the central bank or on funds lent in the interbank market.3 Thus, the government’s first step in monetary easing was to increase the supply of loanable funds.

Shortcomings of the Stimulus?
China’s growth in 2009 was impressive compared with the absolute downturns in economic output in the United States, Europe, Japan, and many other developed economies and was the fastest growth of any emerging market. But 2009 was the second consecutive year of slowing Chinese growth and 8.7 percent was the slowest pace of expansion recorded since 2001. Moreover, critics, both in China and abroad, argue that growth recovery in 2009 was unsustainable since it relied on a burst of investment financed largely by an unprecedented increase in bank lending.11 According to the critics, the massive stimulus program would have several adverse consequences.

First, in the short run it created bubbles in the property and equity markets as funds lent for investment leaked into these markets. Second, in the medium term the massive investment program financed with the expanded supply of credit would inevitably lead to excess industrial capacity and thus, with a slight lag, would put downward pressure on prices and firm profits.12 That, in turn, would impair the ability of firms to amortize their bank debt and thus likely lead to a large increase in nonperforming loans. Potentially this would require the state to recapitalize the banks once again, with adverse consequences for the government’s fiscal position.

Third, the critics argue that the stimulus undermines China’s strong fiscal position. China’s budget deficit barely topped 2 percent in 2009, a small fraction of the deficits recorded in the United States and some other advanced industrial countries. This meant China’s outstanding government debt remained stable at only 20 percent of GDP, again a small fraction of most high-income economies. But, the critics charge, this obscures a massive increase in hidden government debt.

Finally, the critics charge that the stimulus program exacerbated China’s structural imbalances and set back the effort to transition to growth that would rely more on the expansion of private consumption expenditure rather than the growth of investment and exports.

Excessive Lending and a Property Bubble?
The charge of excessive lending growth, for example, fails to take into account that the authorities initiated steps to slow lending growth as early as mid-2009. Increased window guidance and other initiatives slowed lending dramatically in the second half of the year. Although lending spiked upward in January 2010, the China Banking Regulatory Commission (CBRC) announced that month that it would take tougher measures to moderate the pace of lending over the balance of 2010. It reinstated mandatory lending quotas on individual banks and imposed tougher regulations to prevent banks from disbursing most of their lending quota in the first quarter or two of the year.14 It also raised the required reserve ratio by 50 basis points in both January and February, cutting banks’ excess reserves and further signaling the transition away from the “moderately loose monetary policy” of 2009 to the “moderately loose monetary policy implemented flexibly” policy of 2010.

Second, the CBRC has taken other steps to curtail the expansion of bank credit. In October 2009, in what he described as a “historic decision,” Chairman Liu Mingkang ruled that banks would no longer be able to count subordinateddebt and hybrid capital as part of their tier-two capital.

Contrary to repeated criticisms,
this stimulus had a substantial
consumption component and focused
on investment in infrastructure
rather than expanding capacity in
traditional industries such as steel.

Creation of Excess Capacity?
What about the assertion that the investment boom in 2009 created excess capacity that will lead to downward pressure on prices and thus on firm profits, perhaps leading to defaults on the loans that financed the capacity expansion? This argument too seems not well founded. In a high-growth, high investment economy, such as China’s, some product sectors inevitably have at least temporary excess capacity. The issue, however, is whether this excess capacity is so widespread and enduring that it could contribute to deflation, putting downward pressure on the profits of a large number of firms across many sectors. Such a situation would not only impair the ability of individual firms to repay their loans but also potentially lead to large-scale losses in the banking system.

To read the full report: CHINA'S RECOVERY