China's 'zero-Covid' exit has raised economic hopes that will only be met through more domestic consumption. Image: Screengrab / HBO

China’s gross domestic product (GDP) growth rate has been falling since the first quarter of 2010. After more than 40 years of breathtaking growth, it is not surprising that China’s economy has lost some steam.

Having fallen steadily from 10.6% in 2010 to 6% in 2019, it remains to be seen whether China’s growth will continue to decline and at what level it will stabilize.

Some in China argue that the decline in economic growth was an inevitability caused by long-term structural factors. Others argue that to avoid a financial crisis, China prioritized lowering its debt leverage ratio, even at the expense of growth.

But, while recognizing the role played by structural problems, the continuous decline in China’s GDP growth rate is to a large extent attributable to China’s premature abandonment of expansionary fiscal and monetary policy due to the overblown fear of financial instability.

The steady decline in the growth rate does not demonstrate the inevitability of China’s economic decline. It is actually a self-fulfilling prophecy. A lack of resolve to implement counter-cyclical policies will cause permanent damage to China’s growth potential — in turn weakening its financial stability.

At the beginning of 2022, Covid-19 abated in China. The consensus is that China’s macroeconomic policy should aim to stabilize GDP growth. For the first time in many years, the Chinese government set a GDP growth target of 5.5% for 2022. The economy was off to a good start at the beginning of 2022, until the Omicron variant struck Shanghai in March.

China’s consumer expenditure, measured by total retail sale of social goods, increased 6.7% year on year in the first two months of 2022. But it declined by 11.1% and 6.7% in April and May. The growth of China’s fixed assets investment also slowed down significantly.

The only comfort came from international trade. In May 2022, the growth rate of exports was 16.9% while that of imports was 4.1%, implying that the growth rate of net exports was very high. But this growth pattern was neither sustainable nor desirable.

China’s trade with the US has boomed through the pandemic. Photo: DTN / Chris Clayton / Screengrab

In the first quarter of 2022, China registered a growth rate of 4.8% year on year, which is rather disappointing. The GDP growth rate for the second quarter is an even more disappointing figure of 0.4%.

Compared with other economies, China’s inflation rate is still moderate. The consumer price index (CPI) rose just 2.1% in May. China’s producer price index (PPI) in May was 6.4%. Although this figure is still concerning, it has decreased by half from its peak in October 2021.

The main challenge to China’s economic growth is recouping the loss in growth since March and achieving a growth rate not far off the 2022 target of 5.5%. China has no choice but to use expansionary fiscal and monetary policy to stimulate the economy. Statistics just released show that this is just what the government is doing

Given the weak consumption and investment demand and the difficulties that small- and medium-sized enterprises are facing, the Chinese government may need to adopt even more expansionary fiscal and monetary policy. But implementing this policy will involve a series of challenges.

The implementation of expansionary fiscal and monetary policy is constrained by the pandemic and China’s strategy for combating Covid-19. Supply chain disruption cannot be solved by fiscal and monetary policy alone, no matter how expansionary. The most acute challenge for China is how to balance Covid-19 pandemic control with economic growth.

While the People’s Bank of China (PBOC) continues to loosen its monetary policy, the US Federal Reserve is accelerating its monetary tightening. The narrowing of China–US benchmark interest rates has led to the increase in capital outflows and renminbi (RMB) depreciation, despite China’s large current account surplus.

China needs to keep a watchful eye on the RMB exchange rate and cross-border capital flows. But a flexible exchange rate and a certain amount of capital controls should be enough for the PBOC to maintain the independence of monetary policy and ensure financial stability.

Inflation could be a problem with China’s high PPI. But due to weak consumption and investment demand, PPI inflation has not yet translated to CPI inflation.

Due to the Ukraine war and tightening sanctions on Russian oil and gas, energy and food prices might increase further. As the largest trading nation in the world, China’s manufacturing products are highly dependent on imported parts and components.

Chinese inflation is spreading from producers to consumers. Photo: Facebook

Higher prices of intermediate products in the United States and other advanced countries will pass through into China’s price indexes.

China is likely to partially regain its growth momentum. But when downward pressure on inflation created by weak aggregate demand is reduced, inflation in China might worsen quickly. China may need to learn to live with a higher inflation rate because the top priority for the Chinese government is to bring an end to the gradual but steady decline of the GDP growth rate.

Despite facing many pandemic-related setbacks in early 2022, China should be able to do better in the second half of 2022. Importantly, China’s long-term growth perspective is still bright.

Yu Yongding is a Senior Fellow at the Chinese Academy of Social Sciences and former member of the Monetary Policy Committee of the People’s Bank of China.

This article was first published by East Asia Forum, which is based out of the Crawford School of Public Policy within the College of Asia and the Pacific at the Australian National University. It is republished under a Creative Commons license.