China needs debt-fuelled stimulus to avoid Japan's long-term fate

Economist Yu Yongding says Beijing has room to pile up debt for fiscal stimulus.

Yu Yongding (余永定), one of China’s most influential macroeconomic experts, believes Beijing needs to step up debt-driven fiscal stimulus to avoid a long-term Japan-style recession.

He says China still has ample space to achieve this feat, given tepid levels of inflation and record-low long-term Treasury yields.

Yu argues that Beijing has long been highly reluctant to engage expansive stimulus policy.

He says this is due to worries about excessive levels of government leverage, as well as fiscal instability.

“In China, a balanced budget has always been an important policy goal, even if this hasn’t been explicitly stated,” Yu writes (“余永定：中国的财政政策取向与地方债务化解策略”).

“Prior experience and current economic conditions demand that we re-assess this goal.

“Fiscal imbalance - in particular imbalance created by expansionary fiscal policy, is extremely important for spurring economic growth.”

China should heed the lessons of Japan’s lost years

Yu says the woes of the Japanese economy provide a critical lesson for China.

He knows from first-hand experience, having visited Japan multiple times since the late 1990s, to research its macroeconomic policies.

According to Yu, failure to launch fiscal stimulus led to a sharp drop off in Japan’s economic growth.

In 1997, Japanese officials said they needed to reduce the deficit and cut national debt as a share of GDP, or Japan would suffer from fiscal collapse.

Japan’s national debt to GDP ratio was 91% at the time, while its fiscal deficit was over 5% of GDP - both ahead of the Maastricht Treaty’s ceilings of 60% and 3% respectively.

Japan tightened up fiscal policy by increasing the consumption tax and slashing expenditures.

Yu says the result was an immediate suppression of economic growth in 1998, and a sharp worsening of fiscal conditions.

The simple reason was that fiscal tightening not only reduced the deficit, but economic growth as well, leading to an increase in the debt-GDP ratio of the Japanese government.

Japan eventually came round to highly expansionary fiscal policy, following a change in government in July 1998.

By that point, Japan’s government debt to GDP ratio had already hit 255%.

“In spite of this, Japan is still implementing expansionary fiscal policy, and all spheres of opinion believe that if this wasn’t the case, economic growth would further fall, and Japan’s fiscal condition would further worsen,” Yu writes.

Can China afford more debt?

Yu argues that China is currently in a far better position to pile up debt to drive highly active fiscal policy.

This is because inflation is tepid, while long-term interest rates have fallen to record lows, with 10-year Treasury yields at less than 2%.

“According to economic textbooks, if a nation’s economic growth rate exceeds its interest rates, then there is no need to be concerned about fiscal imbalances,” Yu writes.

“This is because the revenue created by economic growth means government can make its interest payments, and outstanding debt can be rolled over successively by ‘borrowing new to repay old’ (借新还旧).”

According to Yu, low long-term yields give China ample room to raise more debt.

“To kill two birds with one stone, China should increase treasury issuance,” he writes.

“In summary, the root method for solving fiscal problems is maintaining the highest possible nominal growth, and at the same time reducing interest rates as much as possible.

“What’s regrettable is that we have yet to reach common consensus on these issues.”

Yu says Beijing only recently shifted macroeconomic course

In 2008, Beijing launched a 4 trillion yuan stimulus package to weather the GFC.

Since 2011, however, Yu argues that macroeconomic policy has been “neutral to tight.” The distinct features of China’s macroeconomic policy have been:

• Not adopting short-term stimulus measures.

• Not increasing the deficit.

• No excessive issuance of money.

• Not engaging in monetary” irrigation.”

China’s macroeconomic policy stance only began to change after the pandemic, from the end of 2022 to 2023, as growth continued to slow and unemployment rates markedly increased.

In March 2023, the Government Work Report clearly stated that the main contradiction faced by China’s economy was insufficient aggregate demand. This signalled a major change to the direction of macroeconomic policy.

However, despite this pivotal signalling, it wasn’t until September 2024 that China unveiled a vigorous macroeconomic stimulus plan, further details of which will be revealed at the Two Sessions congressional event in March.