'China needs to solve 3 economic puzzles'

26 Feb '16

5 min read

Weakening growth has prompted policy makers to cut interest rates to mitigate downside pressures. However, those rate cuts have made it more challenging to manage pressures of a trilemma - flexibility of exchange rate, openness of capital account, and control over domestic interest rates - as an environment of poor returns and narrowing real rate differentials with the US have intensified capital outflows and, consequently, depreciation pressures on the yuan.

To mitigate some of the pressures, policy makers had moved on Aug 11, 2015, to a new currency management regime, from managing the yuan to hold stable against the US dollar to anchoring relative stability in a trade-weighted index. However, in January, the intensification of capital outflows renewed the trilemma pressures. In this environment, if policy makers were to proceed with a relatively fast pace of monetary easing, it could quicken the pace of currency depreciation.

“Our base case outlook for China: Growth will continue to slow, deflationary pressures to persist, monetary easing will proceed at a gradual pace, as will currency depreciation. Under this environment, debt-to-GDP ratios also will likely keep rising,” the report said.

To address the deflation risks and transition to a slower but sustainable productive growth cycle, Chinese policy makers should adopt five steps, the report said.

It said policy makers should accept slower growth, in line with changing potential growth dynamics due to structural factors, such as a decline in the working age population, high levels of debt and slowing productivity growth.

Policy makers must address the moral hazard risks in the banking system and/or tightening prudential norms, and cut back on excess capacities to ensure efficient capital allocation. This will invoke a period of risk-aversion in the financial system and could entail significant job losses.

The report also advocates cutting real interest rates to incentivize private-sector borrowing for productive investment. But it warned that cutting real rates in an aggressive fashion could trigger intense capital outflows and currency depreciation pressures. In this context, policy makers will also have to allow exchange-rate adjustments.

Ahya’s report also said policy makers should initiate structural reforms to encourage productive private-sector investment and improve potential growth.

It also called for policy makers to provide temporary fiscal stimulus to boost consumption. (SH)

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