Squaring the Circle: How China Can Combine Growth with Deleveraging

In a new Paulson Policy Memorandum, Bloomberg economists Tom Orlik and Fielding Chen begin with China’s increasingly fraught economic situation. China, they note, has pushed into 2016 facing multiple challenges: Supply side reforms and shrinking exports threaten to throw growth and employment off course. A torrid expansion of lending has added to financial risks and raised larger concerns about the medium-term growth path. The People’s Bank of China, China’s central bank, has stabilized the yuan but the larger goal of a more market-set exchange rate has receded farther into the distance.

Orlik and Chen argue that, in the past, Chinese monetary policy has always done the bulk of the work to support growth. And while this has proved to be effective, it has come at a cost. Indeed, they describe an increasingly precarious financial situation in China: bank assets have tripled since 2008 and non-performing loans at 1.3 trillion yuan ($200 billion) are now equal to 2 percent of China’s GDP. Businesses and local governments in China carry a heavy burden of debt. Repayment has been made more difficult as overcapacity has dented prices and profits.

In this context, Orlik and Chen propose policy action across three fronts:

First, they argue for a fiscal stimulus targeted at expanding public services and raising the spending power of China’s low-income households. This, they say, would provide a boost to growth and employment but without the downsides of another credit-fueled splurge.

Second, they recommend a step change in transparency that would enable China’s financial markets to operate more efficiently. By channeling more funds to high return private and services sector firms, the Chinese financial system could generate more output bang for less credit buck.

Third, they suggest steps to revive faith in China’s short- and medium-term growth prospects, combined with greater transparency of both economic data and policy thinking. These, they say, would boost confidence, creating the conditions for the People’s Bank of China to move toward a more market-determined exchange rate.

Orlik and Chen’s memo looks at each of these measures in turn, concluding with some more granular recommendations that flow from their three arguments.

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