China's Three Arrows

Assessing China's latest economic stimulus through the lens of Japan's "Abenomics"

China’s seemingly outsize policy stimulus took most of us by surprise this week. Just when we had gotten used to Beijing’s grudging reaction to increasingly serious economic problems, the financial authorities apparently came to the rescue with their own version of a “big bazooka.”  At least that’s the verdict of the Chinese equity market, with the composite CSI 300 surging some 15% in the final three trading days of the week. With the Politburo sending an emergency-meeting message of more to come, is China’s long economic nightmare now over?

If it were only that easy.  For the past several years, I have become increasingly concerned that China was at risk of falling into a Japanese-like quagmire — a balance sheet recession characterized by stagnation and deflation as an outgrowth of the bursting of a major debt-fueled asset bubble.  The comparison is far from perfect — there are many characteristics of China that are very different from those which led to Japan’s multiple “lost decades.” Other than being a large developing economy with several still untapped sources of future growth — namely, household consumption, urbanization, and insufficient capital endowment of its large workforce — China also benefits from understanding the lessons of Japan as underscored by a provocative warning issued by an “authoritative person” on the front page of People’s Daily back in May 2016.

Being forewarned, however, is not the same as being pre-emptive.   The jury is still out on whether China has succumbed to the Japanese disease. If anything, the preconditions of debt-intensive growth and the excesses of a major asst bubble have gotten considerably worse since the authoritative person sounded a prescient alarm over eight years ago.  Moreover, China has experienced its most severe whiff of deflation of the post-reform period of the 1980s.  Similarly, as the chart below shows, China’s growth shock — a deceleration of six percentage points in GDP growth from the 10% surge from 1980 to 2010 to the IMF’s projected  increase of around 4% over the next five years — is on a par with  that which afflicted Japan for nearly thirty years when its economic growth went from 7 ¼% from 1946-90 to just 0.8% from 1991 to 2023. No matter how you cut it, a once hyper-growth Chinese economy is now experiencing the wrenching impacts of a major slowdown — just like Japan.

Chinese policymakers can ill afford to split hairs between their current economic malaise and the Japanese disease. They should err on the side of acceptance rather than denial and take major efforts to avoid the mistakes that kept Japan trapped  for three lost decades.  It has been said many times that while Japan floundered as a wealthy, high-income nation, China’s problems are occurring when it is considerably less well off — with its per capita income currently less than half that of Japan’s (PPP-adjusted constant dollars). Therein lies the toughest comparison: If China is stymied by Japanese-like problems, it will never reach the high-income status that has been such an important aspirational objective of China’s Party leadership for the nation’s centennial in 2049.

Japan not only provided a template of what to avoid but the “Abenomics” framework of the late Prime Minister Shinzo Abe offered a policy prescription of how to get out of the quagmire.  It was broken down into three buckets, or “arrows” as Abe dubbed them — monetary, fiscal, and structural. The theory was simple: powerful fiscal and monetary stimuli were necessary to provide Japan with the countercyclical escape velocity it needed to break the shackles of a liquidity trap, whereas structural reforms were vital to establish the sustainable traction of enduring recovery.  In the end, Abenomics failed to deliver — not because of a poorly designed plan but because Japan lacked the political will to get on with heavy lifting of structural change, the third arrow.  Could the same fate await China?  Considering the Japanese-like risks now afflicting China, I think it makes good sense to examine the latest Chinese policy package through the three-arrow lens.

From the perspective of the first arrow – monetary stimulus — China’s latest financial stimulus appears impressive.  Large interest rate cuts by the central bank, coupled with major liquidity injections into hard-pressed local governments and a severely beleaguered equity market, strike me as most significant among the many actions.  However, while the outsize response of the CSI 300 index produced as impressive a weekly bounce as China has seen in more than fifteen years, it barley shows up on a longer-term chart, where the September 27 close remains some 36% below its February 2021 high.    Again, the Japanese experience provides some helpful perspective here, as the Nikkei 225 Index bounced four times by an average of 34% on its way to a 66% cumulative drop from December 1989 to September 1998. Oversold markets have long been known to stage dead-cat bounces. It is far too soon to know if that is now the case in China

China’s fiscal arrow is iffier. While the Politburo statement paid lip-service to fiscal stimulus imperatives, these actions were  framed more in terms of broad promises of what is to come rather than as a detailed set of measures to be announced. For example, while the Politburo meeting readout pledged to “stop the decline in the property market,” the policy actions in support of this objective were couched mainly in terms of cuts in mortgage rates, downpayment requirements for second homes, and reduced interest rates on so-called social housing; there was a notable lack of detail in a long-awaited fiscal program to absorb the overhang of unsold homes and convert it into low-income public housing. Like Japan, where fiscal actions in the 1990s were repeatedly constrained by mounting public sector indebtedness, China remains wary of deploying the type of fiscal bazooka that was so effective in sparking its recovery in 2009-10. And perhaps that’s with good reason — with the debt-to-GDP ratio for the Chinese government at 85% in early 2024, nearly three times what it was back then (33% in 2009-10), according to BIS statistics.

Like Japan, an assessment of China’s third arrow structural reform initiatives is most problematic. I have long highlighted three major structural challenges faced by China: demographic headwinds causing a shrinkage of the working age population: productivity challenges faced by an economy now drawing more support from low productivity State-owned enterprises and less support from the high-productivity private sector; and a seemingly chronic under consumption problem of Chinese households. While the recently concluded Third Plenum took some very small steps in addressing some of these issues — mainly in the form of a disappointingly small increase in China’s absurdly low retirement age spread out over fifteen years (raising it from 60 to 65 for males and from 50 to 55 or 58 for females, depending on occupation).  Meanwhile actions in support of the once dynamic private sector are more in the form of rhetorical statements of support from Party leadership than concrete actions aimed at rolling back regulatory and political constraints that have been in place since mid-2001.  Nor has Beijing faced up to what I have long argued is China’s most daunting impediment to structural rebalancing — the need to address social safety reforms (i.e., retirement and healthcare) in order to reduce excessive fear-driven precautionary saving and boost discretionary household consumption.

With the markets roaring their approval of China’s bold policy actions this week, it is tempting to say that the worst  is over for a beleaguered Chinese economy. At best, that conclusion is premature.  At worst, it is a false dawn, strikingly reminiscent of similar  short-lived bursts of euphoria that punctuated Japan’s three lost decades.  At a minimum, this three-arrow accounting exercise warns against cracking out the champagne in response to this week’s pronouncements from Beijing. In other words, it will take more than one arrow to arrest China’s serious growth problems.  Given the severity of the interplay between the country’s cyclical and structural problems, the still beleaguered Chinese economy seems exceedingly unlikely to turn on a dime. In Chinese parlance, the work of the government is far from done.