Media reports of Chinese President Xi Jinping’s comments on financial reform, calls for more monetary and fiscal policy coordination and the central bank’s buying of government bonds. In combination, these developments have prompted speculation that China may adopt quantitative easing (QE) to revive economic growth. Here’s why we think this would be inappropriate in China.
In the current policy framework, the People’s Bank of China (PBoC) can increase money supply via open market operations (OMO) and facilities such as the mid-term lending facility (MLF) and pledged supplementary lending (PSL). These measures inject liquidity over a time span ranging from overnight to five years into the economy.
To date, such action has been insufficient to revive growth momentum. Some analysts see implementing QE as a solution. Despite the economic logic, we believe they are missing the point about QE in China’s situation.
Why quantitative easing?
Strictly speaking, QE is a form of monetary easing implemented when the policy interest rate hits zero, thwarting the central bank’s ability to stimulate growth via further cuts to official interest rates.
Under such circumstances, the central bank can buy assets from the private sector or even the government and pay for these by creating ‘central bank reserves’. This is referred to as ‘printing money’, though technically the central bank does not actually have to print any banknotes.
Typically, the central bank either sets a target for the quantity of assets it will buy at any price, or it sets a target for the price of an asset and buys however much is necessary to hit that price. The purposes are:
- To flood the economy with money to reduce the term premium and risk-free yield (or, simply put, interest rates) for as long as it takes to revive economic activity
- To signal that interest rates will stay lower for longer to boost aggregate demand.
Conditions in China
China’s interest rates are still far above zero. So, there is still room for the PBoC to cut interest rates before needing to consider QE. When, as it did recently, the PBoC buys government bonds in the open market, it is easing monetary conditions in an economy where interest rates are positive and not close to zero. For us, such a move qualifies as liquidity management, like OMO, and not QE.
Some observers have argued that the expansion of the PBoC’s balance sheet since 2023 (see Exhibit 1) indicates the start of QE. We disagree. Balance sheet expansion has been driven by MLF injections and relending. These are targeted injections for PBoC-designated sectors and banks as directed by Beijing.
What about the central bank trading government bonds directly in the secondary market? In our view, the PBoC can engage in a so-called operation twist – as the US Federal Reserve occasionally does – to sell (or buy) short-term securities and buy (or sell) long-term securities simultaneously to lower (or raise) long-term interest rates. Such trades do not expand the balance sheet and should not be seen as QE.
In fact, we see no evidence that China has suffered from a balance sheet recession (see Chi on China: “Is China Falling into a Balance Sheet Recession?”, 16 August 2023).
If China were caught in an economic quagmire of a spending and investment squeeze as consumers and businesses struggled to cut debt it would typically prompt monetary authorities to implement QE. There are some symptoms of this in China, but we are not seeing massive destruction of wealth or a large-scale breakdown of financial engineering.
Cost versus benefits
We think QE proponents have also overlooked its uncertain economic impact and the hefty cost involved. These could overwhelm the marginal benefits that China may reap.
QE relies on asset price inflation to create a wealth effect, boosting consumption and investment. However, this may not work as intended when the loss of confidence is such that it leads to extreme aversion to risk, destroying appetite for consumption and investment. In this context, the additional liquidity is left idling in the economy – as in the case in China now.
With interest rates remaining positive, we believe traditional monetary policy tools, rather than QE, still have a role to play in resolving China’s economic problems.
QE, the argument goes, also has the benefit of weakening the renminbi exchange rate. This would help boost exports, increase capacity utilisation and end deflation.
For us, this argument is flawed, and the perceived benefits are marginal.
Firstly, the RMB exchange rate is not a major factor affecting China’s competitiveness. This can be seen in the continued increase in China’s global export market share (see Exhibit 2). The resistance among Western economies to surging exports of attractively priced Chinese electric vehicles (see Exhibit 3) is a further indication of China’s competitive strength.[1]
Secondly, contrary to conventional wisdom, China no longer relies on exports to drive growth. Since the 2007-08 Global Financial Crisis, exports have been only a secondary force in China’s economy; in some years, they actually been a drag on growth (see Exhibit 4).
The point is that the RMB exchange rate would have to fall significantly (e.g., by 20% to 40%) to boost China’s exports materially and help GDP growth. However, such a devaluation would exacerbate existing trade tensions and likely cause chaos in global markets.
QE not a solution
China’s monetary transmission mechanism has broken down since the Covid-19 health crisis, reflecting incomplete reforms of the country’s monetary policy framework.
We believe this means Beijing must now ease policy by more and for longer than in previous cycles for it to have the same impact on growth. Longer term, it would have to implement more reforms, reducing its ‘implicit guarantee’ further and truly liberalising interest rates to allow the monetary pricing tools to work effectively (see Chi on China: “Implications of China’s Impaired Monetary Transmission Mechanism”, 5 January 2024).
Beijing also needs to overcome the problems of moral hazard and rent seeking in the financial sector, so that credit can flow to where it is needed most instead of being misallocated to inefficient sectors, as is currently the case. As a result, efficient sectors have been starved of credit, leading to undercapacity (see Chi on China: “The Conundrum of China’s Excess Capacity”, 14 September 2016).
In combination with the loss of confidence that has impaired credit demand, rent seeking, regulatory arbitrage and moral hazard have prevented the credit impulse[2] from sustaining a recovery despite the PBoC’s aggressive liquidity injections since late 2023 (see Exhibit 5).
The most recent regulatory (or interest-rate) arbitrage that has distorted credit flows is the ‘round-tripping’ of bank loans.[3] Here, banks lend to large companies to fulfil the banks’ regulatory requirements for loan growth. The banks then turn around and offer the borrowers a time deposit rate above the loan rate, enticing them to deposit the loan in a time deposit. Those funds then remain idle in the banking system.
QE cannot fix this. Microeconomic and structural policy solutions are, in our view, the solution.
Indeed, Beijing has been implementing regulatory reforms since 2017 to deleverage and de-risk the financial system, and by attacking the various elements of the incentive problem. The most recent measure was to crack down on round-tripping. This was achieved by banning banks from offering borrowers fixed deposit rates higher than the lending rates.
While there is liquidity in the system, it is not taken up due to a loss of confidence. The impaired monetary transmission mechanism only rubs salt into the wound. All this has led some market players to compare China’s post-pandemic economic woes with Japan’s post-bubble plight in the 1990s, when Japan’s economy was plunged into three decades of debt deflation.
In our view, this analogy is inappropriate because China has not fallen into a balance sheet recession as Japan did. However, the sharp change in global sentiment on Japan since early 2024 – expressed in the idea that the Japanese economy is finally transitioning from its long-running debt-deflation spiral to a ‘virtuous’ wage-price inflation cycle – contains lessons about how China can avoid the risk of falling into a debt-deflation spiral.
A lesson from Japan
The biggest lesson is to maintain real interest rates low for long enough to sustain growth in a debt-deflation environment. The logic is simple: it is crucial to rekindle ‘animal spirits’ and revive private sector spending, thus reflating the economy.
In this regard, the Bank of Japan’s persistent monetary easing finally delivered an average nominal growth rate of more than 3.0% in 2022 and 2023 (compared to an average of -0.4% in the 2000s) and turned around market expectations.
However, Beijing has continued to avoid aggressive easing since the pandemic amid concerns over the negative impact on its structural reform and debt-reduction efforts. This stance recalls Japan’s approach in the early 1990s, which kept it from acting forcefully after the country’s property bubble burst. Such policy missteps lay bare the consequences of failing to deal proactively with the loss of wealth and confidence.
More and longer easing needed
We believe China needs to pursue aggressive monetary easing to revive the ‘animal spirits’ that will bolster private investment and consumer spending.
‘Incremental easing’ policy between 2022 and 2023 (see “Chi Time: Still Bearish on China? Indicators for gauging Changes”, 6 February 2024) has diluted the growth impetus.
Arguably, China’s economic problems are self-inflicted and, since interest rates have not hit the zero bound, traditional policy tools remain appropriate. Even though total credit is still growing at around 9.0% annualised, it needs to grow faster and interest rates need to fall further and for longer.
Indiscriminate flooding of liquidity through QE cannot, in our view, fix the incentive problems and structural distortions. It would likely aggravate the misallocation of capital, leading to even more excess capacity in inefficient sectors.
We believe China needs monetary easing. There is a simple Keynesian prescription for getting out of a liquidity trap: when the private sector is not spending, the public sector must pick up the slack.
References
[1] Whether competitiveness is achieved through comparative advantage or government subsidies is irrelevant here. The point is that China’s EVs are super-competitive, with prices 40% to 125% below those of Western brands in various markets.
[2] Credit impulse is defined as the flow of new credit into the system as a percentage of GDP.
[3] For a stylised example of incentive problems creating systemic financial distortion, see “China’s Impossible Trinity – The Structural Challenges to the “Chinese Dream”, pp.115 – 120, Chi Lo, Palgrave Macmillan 2015.
