China is facing a slowing economy amidst an abundance of cash, a scenario that has economists pondering if the country is caught in a liquidity trap. This predicament demands President Xi Jinping’s administration to consider spending its way out of the economic slowdown. However, traditional economic remedies like fiscal stimulus might prove ineffective within the framework of Beijing’s ‘socialist market economy.’
The concept of a liquidity trap, first described by John Maynard Keynes during the Great Depression, refers to a situation where individuals hoard cash due to low bond yields. A similar crisis arose in Japan after the property bubble burst in 1998, leading to a recession and diminished impact of monetary policy. These echoes of past economic challenges resonate in China’s current economic climate. While Chinese interest rates are far from zero, the recent surprise cut in the benchmark one-year loan prime rate to 3.45% highlights the central bank’s efforts to loosen monetary policy. Despite state media’s dismissal of liquidity trap concerns, the parallels between China’s current situation and Japan’s three decades ago cannot be ignored. While Western economies are grappling with inflation, China’s consumer price index has remained stagnant since the beginning of 2023. Just like the Bank of Japan, the People’s Bank of China is loosening monetary policy but failing to influence prices, resulting in an unprecedented surplus of money.
China’s M2, a broad measure of money supply, has skyrocketed, surpassing 300 trillion yuan ($42.3 trillion) in April 2023. This figure dwarfs the combined money supply of the US and Europe and indicates an excessive level of liquidity in the Chinese economy relative to GDP. Further signs of economic stagnation include record-high bank deposits and stalled growth in total social financing. Companies are hoarding cash instead of investing, as evidenced by the widening ratio of interest-paying time deposits to demand deposits in Chinese banks.
Paul Krugman argued for forceful action to combat entrenched expectations of economic decline, suggesting that central banks should credibly promise to be irresponsible. China’s central bank has taken a similar approach, aggressively clamping down on debt trading and threatening to short-sell billions of yuan worth of government bonds. This reflects a waning faith in China’s growth potential and underscores the similarities with Japan’s experience. The yield on China’s long-dated government debt securities has converged with that of Japan’s, indicating a lack of confidence in China’s economy. This is further exacerbated by the recent frenzied speculation in May, which saw the price of a 30-year Chinese bond spike by 25% upon debut, causing its yield to temporarily dip below that of its Japanese counterpart.
Following Keynesian principles, China has embarked on an expansion of fiscal policy. The government’s recent issuance of 1 trillion yuan special bonds this year signifies its willingness to spend, but the question of its effectiveness remains. The government plans to continue issuing these bonds over the next several years, aiming to fill a growing void in the economy. Property developers are struggling with debt, and individuals are repaying home loans early, leading to a significant shrinkage in the mortgage-backed securities market. However, the extent of the central government’s financial commitment remains unclear.
China’s history of using large-scale spending during difficult times is well-documented, as evidenced by the 4 trillion yuan stimulus package implemented during the global financial crisis in 2008. However, the current administration has been hesitant to deploy such a massive fiscal bazooka. This cautious approach suggests either a lack of concern about the economic predicament or fears of unintended consequences from excessive spending. The previous stimulus package, while effective in the short term, led to long-term structural problems such as industrial overcapacity and ballooning local government debt.
The current economic challenge is further compounded by China’s shift towards boosting consumer demand and moving away from property and investment-led growth. One type of spending that could prove effective is the expansion of social security. The recent Third Plenum approved a resolution calling for building a more comprehensive social security net, focusing on areas like medical and education costs. This move could provide individuals with the security they need to spend rather than save for an uncertain future.
Beijing is also making efforts to address the glut of unsold homes by assisting local governments in acquiring them and converting them into public housing. Expanding this program would require increased funding from the central government and a bigger budget deficit than the current cap of 3% of GDP. Furthermore, China could leverage its cash-rich private sector firms, such as Tencent and Alibaba, to invest in sectors like technology, healthcare, and even real estate. This could potentially stimulate private investment and revitalize the economy.
For a sustained economic uptick, Xi might need to reassess the role of the private sector, particularly after years of regulatory crackdowns on entrepreneurs that have dampened the entrepreneurial spirit. While the ruling party has expressed support for the development of the non-public sector, this commitment is juxtaposed with a pledge to consolidate and develop the public sector. Until Beijing clarifies its stance on the relative dominance of these two forces, China’s options for averting a sustained economic slump will remain limited.
