Long-term Excessively Loose Monetary Policy at the Root of China’s Economic Woes: Wang Xiaolu
Do China's unique experience with inflation warrant reconsideration of traditional monetary policy?
A leading Chinese economist says the implementation of excessively loose monetary policy by the People’s Bank of China (PBOC) lies at the root of the deep-seated structural challenges faced by the Chinese economy.
In article published by China Newsweek, Wang Xiaolu (王小鲁), Vice President of the Beijing National Economic Research Institute (北京国民经济研究所), said that growth in China’s money supply has outpaced growth in the real economy since the start of 2023.
From last year until the first two months of 2023, the year-on-year (YoY) growth in China’s M2 broad money supply has been significantly higher than the actual GDP growth rate or the growth rate for the added value of industry over the same period.
According to Wang, this indicates that China is currently at risk of implementing excessively loose monetary policy, which could have dire ramifications for the broader economy.
“Excessively loose monetary policy is not conducive to stable economic development and does not stimulate consumption,” Wang wrote. “In the absence of effective investment opportunities, it chiefly stimulates inefficient and ineffective investment, which will further expand financial risks.”
According to data from the National Bureau of Statistics (NBS), China’s real GDP growth rate was 3% in 2022, but YoY growth in the broad money supply (M2) was 11.8% – 8.8 percentage points higher than the actual GDP growth rate and 6.5 percentage points higher than the nominal growth rate.
During the same period, YoY growth in total social financing was 9.6%, while YoY growth in renminbi lending was 11.1%, both significantly higher than GDP growth.
NBS data further indicates that January-February of this year, YoY growth in the added value of industry was only 2.4%, while during the same period, the operating revenues of industrial enterprises above designed size did not increase, but instead decreased by 1.3%. YoY growth in the M2 money supply was 12.9%, however, at least 10.5 percentage points higher than industrial growth.
Loose monetary policy will drive inefficient investment
Wang argues that excessively loose monetary policy is not conducive to stable economic development at present, because Chinese enterprises are still at the stage of sluggish recovery after the Covid pandemic and their confidence has yet to recover. This means the demand for funds from Chinese businesses remains weak.
According to Wang, the slow recovery of the real economy is not due to insufficient funds but instead the result of lacklustre market demand, and in particular weak consumer demand.
In January-February of this year, the total retail sales of consumer goods only increased by 2% when adjusted for inflation. Room for enterprises to expand production remains limited, while there remains a lack of effective investment opportunities due to overcapacity.
Given these conditions, loose monetary policy is poorly positioned stimulate consumption, but will instead serve to spur inefficient investment by China’s state-owned enterprises.
“Experience shows that private enterprises face hard budget constraints and are less motivated to make blind investments,” Wang writes.
“Under sluggish market conditions, most enterprises prefer to adopt a conservative business strategy and wait for appropriate opportunities to expand their operations. This is rational enterprise behaviour and also a necessary condition for the market mechanism to regulate supply and demand and promote the restoration of equilibrium.
“State-owned enterprises with soft budget constraints and certain government investors are more likely to invest blindly without considering costs or the risk and return for investments. A few private enterprises that can easily obtain low-cost funds may also have the same behavior.
“Therefore, under the condition of insufficient space for effective investment, expanding the money supply and credit scale can easily stimulate inefficient and ineffective investment, expand financial risks, and lead to the ineffective allocation of resources and the expansion of economic bubbles and non-performing debts.
“Past experiences have repeatedly shown that in this situation, excessive loose monetary policy can only cause funds to flow into inefficient areas.”
Excessively loose monetary policy a long-term challenge for China
A core principle of traditional monetary theory is that monetary policy should maintain basic neutrality, meaning that the growth of money supply should be kept roughly on par with economic growth, otherwise it will lead to inflation.
Wang points out that in China, however, growth in money supply has been higher than economic growth since the start of the reform and opening period at the end of the 1970’s, but has yet to cause severe inflation because of the country’s unique circumstances as it transitioned towards a market economy.
“During the transition from a planned economy to a market economy, China experienced a transformation from product commoditization to factor capitalization,” Wang writes.
“In the 1980s and 1990s, products allocated according to plans gradually became commodities sold on the market, and their prices changed greatly. Subsequently, the funds and land previously allocated by the government became capital, gradually forming markets for factors of production, such as the capital market and the land market.
“The additional demand for money generated by these two processes of transformation absorbed excess money, which suppressed inflation for a period.”
The phenomena of money supply significantly outpacing growth in the real economy without triggering burdensome inflation has continued in China since the start of the new century
During the 20 years from 2002 to 2022, real GDP increased 3.97-fold, while the M2 money supply increased 13.40 fold, with the average annual growth rate of the money supply exceeding the GDP growth rate by 5.9 percentage points.
During this period, however, the average increase in the annual consumer price index (CPI) was just 2.5%, while for the producer price index (PPI) it was just 1.9%, for very mild levels of inflation.
According to Wang, this phenomenon has “led to widespread misunderstandings in academic and political circles, and the belief that traditional monetary theory is outdated and that faster money growth than economic growth will not cause serious harm.”
Wang points out that rates of inflation for different sectors of the economy have varied greatly since the start of the 21st century, depending on their rooms for capacity growth as well as their dependence on natural resources.
Loose monetary policy did not lead to price increases in industries where investment could achieve about rapid expansion in productive capacity. This included most manufactured goods, such as clothing, footwear, textiles,, home appliances, daily necessities, cosmetics, automobiles and computers.
According to Wang, the average annual price increase for these products over the past 20 years has mostly been between -1% and +1% – essentially meaning there have been no price gains as a result of monetary expansion. Some products even experienced an average price decline of 2% to 4%, with sectors such as steel and cement, which suffered from severe overcapacity, experiencing continuous price declines prior to large-scale capacity reduction.
“These manufacturing industries share a common feature,” Wang writes. “Their production scale is not limited by natural resources. Under conditions of loose monetary stimulus, it is easy to make capacity investments and expand the scale of production continuously.
“The continuous expansion of supply without a corresponding increase in demand often leads to oversupply. Prices naturally do not rise, and in some cases, continue to fall.
“This phenomenon is actually caused by excess productive capacity, and does not indicate that the money supply is not excessive, nor does it indicate that ‘deflation’ has occurred.
“The widespread excess capacity has restrained enterprises from raising prices, and even forced them to compete on price and promote sales. The reason for the excess capacity is precisely the excessive investment caused by continuous monetary stimulus.”
Inflation caused by loose monetary policy confined to resource-scarce sectors
Wang points out that for sectors constrained by a scarcity of natural resources that are unable to increase productive capacity arbitrarily through investment, monetary expansion is more likely to lead to inflation because it is not possible for them to achieve excess production capacity
“The mechanism by which excessive money supply leads to inflation still exists, but the differences between industries are significant,” Wang writes.
“Due to the improved efficiency of modern investment and faster construction speeds, monetary stimulus can easily cause rapid expansion of production capacity and excess production capacity in some fields, suppressing price increases.
“Price increases that accompany monetary expansion often only occur in sectors where production capacity is not in excess.”
The sectors include agricultural products that rely on land or water resources, such as grains, vegetables, fruits, and aquatic products. According to Wang, the average annual price increase for these products over the past 20 years has in general exceeded 5%.
They also include land and real estate, which have seen “unusually sharp” increases over the past two decades, despite moderate gains in CPI and PPI.
“From 2001 to 2021, the average land transfer income per hectare in China rose from 1.43 million yuan to 23.93 million yuan,” Wang writes. “Land prices have increased by 15.7 times in 20 years.
“During the same period, the average price of commercial residential buildings per square meter sold by real estate companies in China rose from 2017 yuan to 10,396 yuan, for a 4.2 fold increase.
“This data clearly underestimates the rise in housing prices, as in recent years, housing development and sales in large cities has gradually shifted from urban areas to suburbs with lower housing prices. If first-tier cities are measured in the same locations as urban areas, housing prices have generally increased by more than 20-fold.”
According to Wang, the inflation caused by excessively loose monetary supply in these sectors has had more of an adverse impact upon the living standards of the average Chinese household.
“The rise in housing prices is directly related to excessive money supply, leading to low- and middle-income residents in large cities being unable to afford to buy or live in houses, and facing enormous pressure in their lives.
“Agricultural products are essential to people’s lives, and their price increases have to a certain extent offset the nominal income increase of the vast majority of low- and middle-income groups, lowering their actual standard of living.”
Chinese economy proves monetary policy theory needs a rewrite
Wang contends that the disparate impact of long-term loose monetary policy on different sectors of the Chinese economy means that traditional monetary and inflation theories require reconsideration.
“The traditional monetary theory that excessive monetary supply will lead to overall inflation needs to be revised…excessive monetary supply can lead to overcapacity in many sectors, which actually suppresses price increases.
“However, in sectors where production capacity is constrained, the traditional mechanism of monetary expansion leading to price increases still exists. Excessive monetary supply still has serious negative effects, but the form of expression has changed.
“The current situation in countries such as the United States is a good example. Their current problem of overall inflation is precisely the result of continuous quantitative easing in the past.
“Unlike China, the United States has been shifting its economy from the real to the virtual in recent years, and the role of monetary easing in stimulating investment in the real economy has been limited, and has not caused manifest overcapacity.
“Similarly, monetary easing has brought about overall inflation in the United States, and overcapacity and structural imbalances in China, with the same harm but different manifestations.”
Is excessively loose monetary policy at the root of China’s economic problems?
Wang believes that excessively loose monetary policy – particularly since the Global Financial Crisis – lies at the root of many of the economic challenges faced by China today.
“Structural imbalances such as widespread overcapacity, difficulties in enterprise sales, declining production efficiency, abnormal housing price increases, excessive debt accumulation, and significant financial risks that have occurred since the large-scale dual loosening policy in 2009 are precisely the result of the sustained and sizeable expansion of the currency supply,” Wang writes. “The severity of these impacts is no less than that of widespread inflation.”
Wang firstly points out that Keynesian expansion policies can only expand demand in the short term, but will expand supply in the medium and long term.
For this reason, long-term currency expansion will exacerbate overcapacity and supply-demand imbalances, leading to more sluggish economic growth subsequently. Non-productive and inefficient investment projects will not increase capacity, but instead lead to resource mismatches.
Wang also points out that investment demand spurred by monetary expansion cannot replace consumption demand, and instead exacerbate structural balances in China, where capital formation rates have long been too high.
In recent years China’s capital formation rate has remained at around 43%, which is still nearly 20 percentage points higher than the world average and nearly 10 percentage points higher than before 2000. The consumption rate is only 54%, nearly 20 percentage points lower than the world average, and nearly 10 percentage points lower than the period prior to 2000.
“China’s recent growth weakness is mainly due to structural imbalances, with the key being the imbalance between investment and consumption,” Wang writes.
“Monetary stimulus is not only useless for this, but actually harmful as it will exacerbate structural imbalances and hinder healthy economic growth.
“Currently, the demand side urgently needs to improve people’s livelihood, improve public services and social security, and solve the problem of insufficient consumption demand. The key to the supply side is to improve the business environment, achieve fair competition, and boost the confidence of private enterprises.”