Pressure on China’s Economic Growth

January 28, 2022
About the author:
Zhang Jiarui
Fellow, Taihe Institute
Assistant Professor, Nottingham University Business School
Researcher, China Europe International Business School (CEIBS)


There is no doubt that China is one of the most successful countries with regard to COVID-19 pandemic control. However, the pandemic has still brought significant challenges and costs to China’s economic development. Such impact seems to be persistent and long-lasting because global economic activities are integrated, yet other countries’ efforts on pandemic control are quite differentiated. Different policies on pandemic control around the world is just one source of pressure on China’s economic growth. It is an external pressure that threatens the world supply chain and China’s exports. The most significant pressure on China’s economic growth, however, actually emerges internally. The growth of China’s total factor productivity (TFP) has remained slow or even negative in recent years. Profitability and survival pressure of private firms, particularly small and medium-sized enterprises (SME), differ sharply from that of state-owned enterprises (SOE) during the pandemic years. Monetary policy has not been working efficiently enough to achieve its objectives, and fiscal policy has been constrained by government budget. China’s central government recognized the pressure of shrinking demand and supply side shock, and dampened expectations in its 2021 annual Central Economic Work Conference. Knowing how these pressures come from is the prerequisite to find a way out.
Pressure from the Shrinking Investment Demand
Perhaps the most significant pressure is the so-called shrinking demand, also known as shrinking investment demand. For the past two decades, China’s economic growth relied heavily on investment, with an average of over 40% of its GDP invested in fixed asset each year. Because of the diminishing return, the efficiency of this growth model falls, and the problems such as excessive capacity, high leverage ratio, and low utilization rate of inventory have emerged. The weakness of investment growth is a result of falling productivity. When many firms’ investment efficiency fell lower than the cost of external finance, they became more financially constrained, as, technically speaking, they were unable to repay their debt with their investment returns. These firms had to borrow the new to repay the old, and their leverage ratio climbed up passively. Resources were unfortunately lent to these inefficient firms to keep them alive, while other productive firms were more or less crowded out from financial markets. Moreover, the lending banks were not fully supporting these firms’ new investment but to roll over their old debt, and this is why we observe the situation that the growth of credit supply diverges from the growth of investment.
“With the development of the pandemic around the world,
the global supply chain became unstable.”
The pressure on investment demand increased in 2021. With the development of the pandemic around the world, the global supply chain became unstable. Sporadic outbreaks of COVID-19 within China also forced many local factories to shut down from time to time. The world’s leading economies were all increasing money supply to stimulate the economy. All these factors contributed to the sharp increase in energy prices that started in the beginning of 2021. The eruption of energy prices had two unpleasing effects. First, it increased the cost of production. This effect is more damaging to those SMEs, because typically they are downstream firms who purchase the output from upstream firms as input to make their own production. Upstream firms are typically large SOEs. The SMEs lack bargaining power when they make purchase from those upstream firms. As a result, they had to accept the rising prices asked by the upstream firms. On the other hand, when SMEs finished the production and were ready to sell the final goods to consumers, they realized that the demand for final goods from consumers was also weak. Worse, their products were not too significantly differentiated from competitors. This implies that these SMEs cannot mark up the price of their own products to transfer the rising costs of production to consumers. Higher costs of production without an increase in the products meant the profits of SMEs were significantly narrowed. In fact, the majority of SMEs in China made losses in 2021. These firms are now facing the problem of solvency and survival, and they lack the incentives or the ability to increase their investment demand to expand.
Second, rising energy prices and other commodity prices disturbed financial markets. As mentioned, many central banks were conducting excessive expansionary monetary policies to fight the negative shock of the pandemic. These policies first contributed to the inflation of commodity prices, as inflation is always and anywhere a monetary phenomenon. On the other hand, abundant liquidity in financial market continued to fuel the bubble. As the commodity prices increased, both financial companies and many non-financial firms found it profitable to arbitrage.1 They diverted significant amount of funds to financial markets. This further caused the investment in real sectors to fall. The expansionary monetary policy, which aimed to stimulate the real demand, failed to achieve this objective because liquidities were searching for yield. 
Pressure from the Shrinking Household Demand
Another very strong pressure of the shrinking demand comes from the household side. The weakness of household demand arose for three main reasons, all of which are long-term deep-rooted issues. The first reason is the slow growth of income. The growth rate of China’s GDP has constantly outperformed the growth rate of its per capita income. This is also a natural result of investment-driven growth, where a large share of GDP is used to pay for capital or to purchase new capital. The imbalance between labor and capital pushed up the labor cost as well, because in the situation where capital is abundant while labor is relatively scarce, the marginal product of capital falls while the marginal product of labor rises up. The pandemic has further pushed up labor costs, as factories were locked down from time to time and the labor mobility was restricted. Many factories from traditional industries in China’s coastal areas find it much more costly to hire labor nowadays. Noticeably, a labor market mismatch has emerged: laborers cannot find a job while firms cannot find workers. The result is a rising unemployment rate coupled with rising labor costs. Income does not increase at the same pace of GDP, not to mention the growth of money supply and price levels. 
The second reason for the shrinking household demand is the weakening of their financial balance. In other words, households have been in heavier debt and their leverage ratio has been increasing. Rising household leverage has been widely discussed among academics and policymakers. It is argued that rising property prices have attracted households to issue mortgages and purchase real estate. Indeed, the strong growth of long-term loans to households indicated that money was flowing towards the housing market. This phenomenon was more significant two or three years ago. The housing market calmed down in 2021, and house prices in many major cities even fell to some extent. Indeed, falling house prices discouraged additional demand for houses, which may help prevent the household sector from getting more into debt. However, we must also realize that the largest source of wealth of a typical household in China is their property. Falling property prices brought a negative impact on their wealth and this negative wealth effect also dampened their demand for other consumer goods. Because the household sector has already accumulated too much debt and mortgages, and the wealth of individual households depends heavily on property prices, falling house prices cannot help the households improve their financial condition, not to mention to stimulate their demand for other goods. 
“China’s government announced in its 2021
annual Central Economic Work Conference
the orientation of the country’s economic policy in 2022.
Stabilization comes back as the main objective.”


Besides mortgages, which mainly impact the older generation, the younger generation is also under the pressure of financial imbalance. Consumer loans and cash loans have been devouring this generation’s ability to consume in the future.
The third reason of the shrinking household demand is the aging population. Although the Chinese government has implemented the two-child or three-child policies, on the one hand, these policies came a bit late; on the other hand, the effect has not been satisfactory so far. This can also be attributed to the slow growth of income and the high leverage of the middle-aged group. 
Pressure on the Government Policies
In light of the two sources of pressure mentioned above, China’s government announced in its 2021 annual Central Economic Work Conference the orientation of the country’s economic policy in 2022. Stabilization comes back as the main objective. As expected, the government will adopt expansionary monetary policy and fiscal policy to stabilize the economy. The central bank lowered the reserve ratio in December 2021, followed by an interest rate cut in January 2022. More monetary expansions are expected to arrive soon as well. 
As for the fiscal policy, local governments were given the priority to stimulate the economy, supported by an expected increase of central government spending. The financial market was inspired by these policies and announcement, as is always the case, but actually, there are hidden pressures on both monetary policy and fiscal policy.
Regarding the monetary policy, the major problem is insufficient liquidity supply. Because the investment return rate was low, commercial banks were less willing to supply credit to firms, and firms were not motivated to borrow to invest more. The transmission mechanism of monetary policy was weakened due to the low productivity and profitability of firms. As mentioned, many firms are living on borrowing new to repay the old. Many SMEs are not profitable and are striving to simply survive. The solvency risk of these firms is very high. Although the central bank cut the benchmark interest rate and imposed on commercial banks the quota of lending to SMEs, these firms still found it extremely costly to borrow external finance. There is no doubt that the natural strategy of commercial banks, if they would be willing to lend to high-risk firms, is to charge a high risk premium on interest rate. This means that although the benchmark interest rate is low, the actual interest rate that these SMEs pay is still very high. What’s worse, to meet the quota of loans to SMEs, commercial banks will even make agreements with SME-type borrowers in private, which dictates that the SMEs must immediately deposit the loan back to the lending bank. The lending bank pays SMEs an interest rate spread as a compensation. Of course, this is a waste of resources. But this also shows how bad the situation is when SMEs want to raise external finance. In short, monetary expansion no longer has the same stimulating effect on aggregate demand as before. Instead, we should be alert to the bubbles in financial markets.
Regarding the fiscal policy, the pressure is even stronger. In the old times, government spending and investment in infrastructure were the key toolkits to stimulate aggregate demand. At the current stage, nevertheless, local governments have limited ability to perform such toolkits. While the investment in infrastructure contributed significantly to China’s economic development, its investment return is long-term, and the return rate is not very high. Local governments used to resort to the so-called local government financing vehicle (LGFV) to raise additional funds to finance the infrastructure investment and other spending. The interest rate on LGFV was much higher than the investment return rate. As a result, the long history of expansionary fiscal policy, particularly after the 2008 global financial crisis, contributed to the significant increase of local government debt. Around 2015, local government debt became unsustainable, and they had to resort to debt replacement. Still, trillions of government debt needs to be repaid each year. The pandemic further deteriorated the governments’ situation. On the one hand, local governments increased spending to hedge against the negative shock; on the other hand, falling economic growth dampened their income. Local governments are now under severe budget constraints, and 2022 happens to be the year when massive local government debt is due. Therefore, although the central government has urged local governments to stabilize the economic growth, we can hardly expect any strong moves of local governments in 2022.
The Way Out
Massive stimulus is costly, and it may not achieve the objective of stabilization. It is time to consider resource reallocation. The significance of this statement is three-fold. First, reallocate resources from less productive firms to more productive firms. This will increase the aggregate productivity of the economy. Of course, this is a long-term project. It depends on the efficiency of the market. The market will divert resources to more productive sectors and firms if there are no interventions or capital market imperfections. Saying this, the Chinese government needs to remove the distortions and imperfections in its financial markets. This will support the financing of productive firms, including productive SMEs rather than those unproductive ones, much more effectively. Imposing a quota on SME loan cannot divert resources to more productive firms, as there are also many unproductive SMEs. The market can help distinguish qualified borrowers from those who should be rationed from the credit market.
“Massive stimulus is costly,
and it may not achieve the objective of stabilization. 
It is time to consider resource reallocation.”


Second, reallocate resources from the financial sector to real economy. While many SMEs and private firms suffered profit loss in 2021, the profits of commercial banks maintained a positive and very decent growth. The health of commercial banks is surely very important for the macroeconomy, but if commercial banks are the only players who are making positive profits, the fundamentals of the economy are questionable. It is suggested that commercial banks need to moderately give away some of their profits to the production sector. This is not to say that the banks’ high profitability is problematic, or that the government should force commercial banks to cut interest rate on loans. Quite the opposite, it is very important for commercial banks to maintain positive profit growth, and they need to be compensated for diversifying risks. What people are worrying about is the super market power of commercial banks. It is well known that a monopoly supplies less output but charges a higher price. Commercial banks, if protected by administrative monopoly, will supply less credit but charge higher interest rates. China should further develop its banking industry and develop a multi-layered capital market, where firms can resort to more sources of external financing. 
In addition, with abundant liquidity supply, the development of financial markets has gradually diverged from the development of the real economy. Financial markets have a much higher return rate than the real economy, as the asset price has been climbing while the real economy is suffering diminishing return. This attracts more funds to financial markets, which pushes asset prices up further. The real economy finds it increasingly difficult to raise fund to finance its investment. We call this phenomenon financial crowding-out effect. The real economy needs to improve its productivity and return rate to compete for resources; the central bank needs to control liquidity supply that may fuel the financial asset bubble; and the financial regulation should pay attention to the fund that is circulating and arbitraging in the financial market.
Third, reallocate resources from governments to firms. Expansionary fiscal policy has various forms. Government spending is just one of them, and it is a substitute of private spending. To increase spending, the government also needs to finance itself, and, therefore, it competes for the resources with the private sector, usually leading to a crowding-out effect as well. Thus, it is frequently observed that while the growth rate of government investment increases significantly, the growth rate of the overall investment continues to fall. The stimulating effect is limited. But the government would accumulate more debt. Market observers acknowledge that expansionary fiscal policy is necessary under the current situation, particularly if the government wants to stabilize the economic growth in 2022. However, analysts suggest that alternative measures of expansionary fiscal policy, such as cutting tax rates would be better. Reducing costs is the most urgent need for many firms to survive. Cutting taxes also leaves firms with more disposable earnings. When the production sector booms, government tax revenue will not be significantly affected by the rate cut. 
To sum up, confidence comes from better profitability and higher productivity, not from additional money supply or government spending. The pandemic caused disorder to the world economy, but China should take this challenge as an opportunity to improve its fundamentals of the economy.


This article is from the January issue of TI Observer (TIO), which is a monthly publication devoted to bringing China and the rest of the world closer together by facilitating mutual understanding and promoting exchanges of views. If you are interested in knowing more about the January issue, please click here:
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