The Necessary Demand-Side Supplement to China’s Supply-Side Structural Reform: Termination of the soft budget constraint

China in the news in the first half of 2016

After uncharacteristically low real gross domestic product (GDP) growth in 2015 (6.9 per cent—below the official target of 7 per cent), 2016 began with much international media attention drawn to the weakness of China’s economy. In an interview, for example, George Soros proclaimed that ‘a hard landing is practically unavoidable for China’, and added that this was also the root cause of global financial market turmoil (Bielski 2016). The International New York Times then ran worrisome China-related stories on its front page on three consecutive days: ‘Fears about China’s economy fester at Davos’ (Stevenson 2016), ‘China’s woes deflate hopes for economic rise in Africa’ (Onishi 2016) and ‘Investigation fuels doubts about growth data in China’ (Bradsher 2016).

The Wall Street Journal (2016a) and the Financial Times (Wildau 2016) also stoked investors’ concerns about China’s internal weakness and external belligerence by running front-page stories with the headlines ‘China faces dilemma over yuan’ and ‘China mouthpiece warns Soros against shorting renminbi’, respectively. The same issue of the Wall Street Journal also ran, on page two, the alarmist story headlined ‘China’s working-age population sees biggest-ever decline’ (Burkitt 2016).

Pessimism about China’s economic outlook deepened in January 2016 when the World Bank lowered its growth rate projections for China and the rest of the world from January 2015 for 2016–17. This unexpected slowdown in the growth rates of most countries (for example, the anticipated US growth rate for 2016 was reduced from 3 per cent to 2.7 per cent) also reduced the room that would allow Chinese policymakers to induce growth through exports in the 2016–17 period.

The sense of doom and gloom about China also revived attention to earlier allegations that the real situation in the country was in fact far more negative again, but had been hidden by official manipulation of economic data. Investment houses Capital Economics and Lombardi Street disputed the official growth rates for each quarter of 2015. Their alternative estimates for the annual growth rate in 2015 were about 4.3 per cent and 3.1 per cent, respectively, compared with the official figure of 6.9 per cent (Russell and Lai 2015).

In the first quarter of 2016, China started further easing of its monetary policy to counter the widely perceived dire picture of its economic growth. In response, the Wall Street Journal (2016b) editorialised on the danger of ‘China’s bond bubble’, and Nobel Laureate Paul Krugman announced in an interview:

China scares me. China has a huge adjustment problem. They have an economy that is based upon unsustainable levels of investment and needs to radically shift from investment to consumption. They don’t seem to be managing it. They have a large internal debt problem and a government that doesn’t seem to be thinking clearly about it. At this point their response to economic difficulty seems to be to crack down on the financial press and to tell them to write happy stories. (Martens 2016)

Foreign media concerns about the course that China’s economy was taking and the nature of its economic management found their domestic counterparts in China itself, on the front page of the People’s Daily on 8 May 2016. The article quoted an unnamed ‘authoritative’ official as ‘saying that boosting growth by increasing leverage was like growing a tree in the air and that a high leverage ratio could lead to a financial crisis’ (Xin 2016a). The South China Morning Post interpreted the article as heralding an impending ‘big economic policy shift’.

This prediction was validated the following day when the People’s Daily ran on its front page an article written by Xi Jinping that expounded on the need for ‘supply-side structural reform’:

China could not rely on ‘stimulating domestic demand to address structural problems such as over-capacity’, he said. ‘The problem in China is not about insufficient demand or lack of demand, in fact, demands in China have changed, but supplies haven’t changed accordingly,’ Xi said. He gave the example of Chinese consumers shopping overseas for daily products such as electric rice cookers, toilet covers, milk powder and even baby bottles to show that domestic supply did not match domestic demand. Xi said [that China] faced ‘outstanding problems of unwieldiness, puffiness and weakness’. ‘The main symptom is limited innovation, and that’s the Achilles heel of China’s [macro] economy,’ Xi said. (Xin 2016b)

We agree with the assessment that supply-side structural reform is the most effective way to address China’s present economic problems. In this chapter, we will identify some of the major structural reforms that would entrench dynamism in China’s economy and also seek to emphasise that better demand- side management is required for this entrenchment to be successful. Specifically, on the demand side, China needs to expunge the soft budget constraint from the economic system (or greatly reduce its frequency and size) if supply-side structural reforms are to generate the desired outcomes.

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