Free exchange | Stimulus v reform in China

Likonomics: what's not to like

Too many economists in China now think that stimulus is antonymous with reform, as if microeconomic evolution requires macroeconomic pain

By S.C. | HONG KONG

JAPAN is still enjoying the effects of Abenomics, a campaign to reflate the economy named after Shinzo Abe, the prime minister. (The campaign stopped consumer prices, excluding fresh food, falling in the year to May.) China, on the other hand, is now enduring the effects of something called "Likonomics".

Pronounced lee-conomics, the term has nothing to do with Facebook's economy of endorsements. It refers instead to the emerging doctrine of Li Keqiang, China's prime minister, who has overseen the country's economy since March. The term was coined on June 27th by three economists at Barclays Capital: Yiping Huang, Jian Chang and Joey Chew.

Like the three "arrows" of Abenomics, Mr Li's strategy comprises three parts, they argue. Unlike the arrows of Abenomics, however, all of them hurt.

Likonomics stands for:

1. No stimulus. Whereas Abenomics embraces both monetary and fiscal stimulus, Likonomics champions neither. In a bracing speech to officials on May 13th, Mr Li argued that China had little scope for stimulus or government-directed investment. In China, like the United States, stimulus is now a dirty word. But it fell into disrepute for opposite reasons. In America, stimulus failed to win favour because it was too small. In China the post-crisis stimulus was discredited because it was too big.

2. Deleveraging. In China, credit, broadly defined, has been growing much faster than GDP. The stock of "total-social financing", an eclectic measure of loans, corporate bonds and a bit of equity financing, is now about 190% of GDP. Mr Li is committed to lowering this ratio, according to the Barclays economists, who cite last month's alarming cash crunch in the interbank market as evidence.

3. Structural reform. Mr Li talks a lot about the need for structural reform. "Reform is 'the biggest dividend' for China," he has said. At a May meeting of the State Council, China's cabinet, he outlined many worthwhile initiatives, from liberalising interest rates to raising utility prices. The hope is that he will flesh out these proposals at a big communist-party meeting in the autumn (the third plenum of the central committee of the Chinese Communist Party).

There is a lot to like about Likonomics, especially its third arrow. But I have some qualms about it. In particular, I worry that it reflects the growing influence of China's "pain caucus".

The aversion to stimulus is an obvious example. China may have little room for stimulus spending in the form of further heavy public investment. But if the economy weakens further, it could still benefit from stimulus of a different kind. Tax cuts are one example. Higher social spending is another. To his credit, Mr Li has espoused both. But too many economists in China now think that stimulus is antonymous with reform, as if microeconomic evolution requires macroeconomic pain. It doesn't.

China can change the composition of spending, even while maintaining a healthy growth in spending. Its economy can change in shape, even as it continues to expand in size. Its own recent history proves this. China's critics use to lambast the economy for being overly dependent on exports. But in the past five years, it has managed to reduce the share of exports from over 38% of GDP to less than 26%, even as the economy grew by over 9% a year on average.

What about leverage? The Likonomists are right to worry that China's credit ratio is increasing too fast. When this ratio drifts too far above its historical trend, trouble often follows, as economists at the BIS have demonstrated. They define the credit "gap" as the difference between credit, as a percentage of GDP, and its long-term trend. By this definition, China's credit gap is about 14% of GDP, according to my calculations based on BIS data. Historically, a gap bigger than 10% has served as a reliable early-warning indicator of a crisis within the next three years, with only a 15% chance of a false alarm, according to a study of 39 countries by Mathias Drehmann of the BIS. Mr Li is right to heed this alarm.

But there are two sides to every ratio: top and bottom. If credit is rising so much faster than nominal GDP, the extra loans cannot be adding much to the economy. Thus it should, in theory, be possible to curtail them without subtracting too heavily from it. Richard Werner of Southampton University has pointed out that loans for consumption or capital expenditure would all add to nominal GDP, if only through higher product prices. But a third kind of credit--namely lending for the purchase of existing assets, such as land or real estate--does not add directly to GDP, because GDP measures only freshly produced output. If he's smart, Mr Li will try to curtail this third kind of credit without crushing the first two.

Amid all the recent talk about China's excesses, it can be easy to forget one simple fact: China is not a country living beyond its means. The country still runs a sizeable current-account surplus, which shows that it spends less than it earns--its domestic demand falls short of its supply. And consumer-price inflation remains low, which shows that domestic and foreign demand combined are not putting undue pressure on its productive resources. China does not need to spend less. It just needs to spend differently.

The three Barclays economists argue that Likonomics will be good for China over the long run, helping it to sustain a growth rate of 6-8% over the next decade. But Likonomics also poses some short-term risks, they argue. The combination of rebalancing and deleveraging could temporarily drag quarterly growth down to 3% or below at some point over the next three years. If so, Likonomics will feel more like Lakonomics.

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