The economic new normal and China’s financial policy

The world economy is still recovering from the global financial crisis of 2008. But while there is still much work to be done, things could have been worse. The Chinese government played a key role in helping the global economy regain its footing following Lehman Brothers' collapse. The launch of its 4 trillion yuan fiscal stimulus programme in 2008-09 benefited not only China, but also trading partners dependent on Chinese imports and investments.

As China's economy slows, however, such anchoring effects are becoming less powerful, exacerbating structural weaknesses in both emerging markets and advanced economies. This ultimately leads to spillback effects in China, by depressing demand for Chinese exports in a sustained manner.

Time for a rethink

Thus, it is no surprise that a reassessment of global economic prospects is currently underway. Some leading economic thinkers, most prominently former US Treasury Secretary Larry Summers, have advanced the idea of ‘secular stagnation', hypothesising that sluggish growth expectations lead to low private investment and excess savings, in turn making it difficult to achieve full employment. Massive interest rate cuts and large fiscal stimulus programmes are generally put forth as the solution that would allow the global economy to escape this trap.

Advanced economies, however, have used up a considerable amount of monetary and fiscal space already, with many pushing the envelope even further, employing unorthodox policies like quantitative easing. Alas, these measures have not jumpstarted private activity sufficiently enough to restore economic growth to pre-crisis levels. Rather, growth in advanced economies is anaemic and likely to remain so for the foreseeable future.

In emerging market economies, the secular stagnation hypothesis remains less relevant; there is still room for catch-up growth. Fiscal and monetary space has not been fully exhausted. Long-term trends, including the demographic outlook, remain relatively favourable compared with the advanced economies. With the right policy mix, these countries can still provide the appropriate incentives for firms to invest, create jobs and generate strong growth.

Emerging markets need to improve their infrastructure, reduce rigidities in labour and product markets and pursue financial market reforms to enable the efficient allocation of savings – while ensuring adequate risk management practices remain firmly in place.

China is an excellent example. Large infrastructure investments in the wake of the financial crisis enabled goods and people to travel faster, contributing to the near-doubling of the country's economy during the past seven years. With average real income in China still less than one quarter of US levels, there remains ample room for China to catch up.

New growth model

To realise economic convergence, however, China will need to shift its growth model away from depending on export-oriented manufacturing and heavy investment. Instead, it will need to focus more on services, innovation, and total factor productivity growth – in short, to combine resources and technology inputs more efficiently.

By any standard, China's growth record during the past 30 years has been striking, with average annual GDP growth close to 10%. As a result, China is now the world's second largest economy as well as its largest manufacturer and exporter.

Millions have been lifted out of poverty and economic opportunities have created a vibrant middle-class. It is worth noting that the United Nations' year 2000 Millennium Declaration goal to reduce world poverty by half during the next 15 years was achieved in 2010 thanks singlehandedly to Chinese growth.

Moreover, it is widely accepted that greater international integration, including the milestone accession to the World Trade Organization in 2001, has provided an impetus for Chinese leaders to speed up reforms and to open up the Chinese economy further.

Which way to turn?

China is at a crossroads once again. Continuing the process of liberalising its capital account and financial markets while striving towards full convertibility of its currency, the ambition of Chinese policymakers is to turn the renminbi into a potential international reserve currency in the near future. If achieved, this objective will likely be considered yet another milestone for the Chinese economy in the coming decades.

Financial sector reform will be instrumental in improving the overall efficiency of the Chinese economy and help China avoid falling into a middle income trap. It is also necessary to prevent asset price bubbles, seen most recently in the equity market and, potentially, the bond market.

By any standard, China’s growth record during the past 30 years has been striking, with average annual GDP growth close to 10%
Han Seung-soo, former prime minister, Republic of Korea

Five specific areas of the financial sector merit attention:

First, completion of the move to a price-based monetary policy framework with interest rates as the main instrument. Getting the prices right is critical for the success of all market economies. This will help improve the pricing of financial assets and the efficiency of credit allocation, ensuring that savings get channelled to their most productive uses. The recent completion of interest rate liberalisation, and allowing banks to price deposits and loans as they see fit, are important elements of this process.

Second, strengthening of regulation and supervision. Dismantling the web of implicit guarantees on financial instruments and introducing an explicit bankruptcy resolution framework for failing financial institutions, as well as allowing investors to bear losses when defaults do take place, will encourage investors to differentiate between risky and risk-free assets and ensure the pricing of financial instruments reflects underlying risks. The recent introduction of a deposit insurance scheme is a major step in the right direction, enabling depositors to distinguish between insured bank deposits and other financial products when choosing where to place their savings.

Third, promoting capital market development to reduce reliance on bank funding. Deepening capital markets will help diversify the sources of funding available to firms and also provide insurance and pension funds with more long-term investment options.

Fourth, achieving greater exchange rate flexibility and reducing official intervention in order to manage exchange rate fluctuations.

Fifth, further capital account liberalisation. Plenty of progress has already been made on this front, particularly in the area of direct inward investment. Further easing of restrictions on the channels for cross-border portfolio investment will allow Chinese firms to access foreign savings to finance their expansion plans. It will also give Chinese households more options to diversify their portfolios and secure higher returns on their savings, as well as encouraging Chinese financial institutions to become more competitive and efficient in providing financial services.

Gradual transition

These reforms will need to be introduced gradually and carefully. Domestic financial liberalisation and exchange rate flexibility should precede full capital account liberalisation. Provided that they are implemented successfully, these reforms will further strengthen domestic macro-financial stability in China and enhance the international appeal of renminbi-denominated assets – in line with Chinese authorities' aim of turning the renminbi into an international reserve currency.

The reforms will also help achieve China's transition from a middle income economy to a high income economy. Nonetheless, downside risks persist. The transition could be bumpy, as suggested by events during the past year, and will need to be carefully managed. The turbulence in stock and foreign currency markets points to several immediate lessons. These include the need for a coordinating mechanism or financial stability committee to manage situations of financial stress and the imperative of communicating policies in one voice to ensure markets understand policy objectives. Moreover, an integrated, system-wide approach to financial sector regulation and better understanding of inter-linkages in the financial system remains crucial.

Transparency in information-sharing is another important factor that should not be ignored. Views about the state of the Chinese economy often differ substantially, partly due to a lack of reliable and high quality economic data. As financial markets have a tendency to assume the worst, Chinese policymakers would certainly benefit from disseminating information in a more transparent and timely manner. It would also allow them to maintain confidence in China's economy and financial system during the current structural growth transition.

Securing a stable and successful transition from a middle to high income economy is important not only for China but for the global economy as a whole.

Chinese authorities are well aware of this. Based on the country's impressive track record during the past three decades, China's government must make the right decisions to ensure a smooth transition to a stable and sustainable growth model and, eventually, high income status. In achieving that goal, authorities will at the same time ensure the rest of the world continues to benefit from China's rising prosperity.