Zero interest rates seen as not a problem for China, thanks to Abenomics and Bernanke

China’s top economists debate fiscal vs. monetary policy

Despite marquee differences in political ideologies, China and the West have much in common when it comes to the social contract that they’ve established with citizens on core matters of economic management.

Like any Western nation, the Chinese government is entrusted with the twin yet conflicting missions of maintaining enough economic growth to provide employment, while at the same time keeping a lid on unchecked price inflation.

The tools that China uses to fulfil these missions are also the same as in other major world economies.

Beijing employs macroeconomic policy - in the form of fiscal policy (government spending and taxation) and monetary policy (interest rates and the money supply) - to regulate levels of growth in both output and prices.

As with other nations, China is similarly host to heated debate between policymakers and pundits on how to best use these tools to achieve the twin macroeconomic mandates of steady growth and stable inflation.

At present, China’s economic opinion-makers have reached significant consensus on the need for expansionary macroeconomic policy and higher deficit levels - given Beijing has made both an explicit part of its development agenda since the end of 2024.

The key area of contention currently concerns whether fiscal policy or monetary policy is the best tool for effectively priming China’s economy.

Sheng Songcheng (盛松成), formerly the head of the Chinese central bank’s statistical office, argues that monetary policy has lost much of its power to move the economy, due to low official interest rates and the ailing profitability of the state-owned banks.

The ex-central bank official believes that fiscal policy - not monetary policy - is the best means for boosting growth at present, as China continues to confront the dilemmas of insufficient domestic demand and unresolved tensions with the West.

In sharp contrast Zhang Bin (张斌), a senior researcher with the China Finance 40 (CF40) Forum and the deputy-head of the World Economy and Political Research Institute at the Chinese Academy of Social Sciences (CASS), argues that fiscal policy is fast losing its effectiveness as the economy matures.

Zhang believes that what the Chinese economy needs most right now is more vigorous rate cuts from the central bank.

He goes as far as to argue that China can cut interest rates to zero without fear of adverse consequences, pointing to what he considers to be the positive experiences of the US Federal Reserve and the Japanese central bank with such extreme monetary policy expedients.

This policy issue has recently become one of acute urgency for the Chinese central government’s senior-most decision-makers.

Beijing signalled the launch of more expansive macroeconomic measures at the end of 2024, in anticipation of the headwinds created by Trump’s second term in office.

The official stance of Communist Party is that Beijing will maintain expansionary macroeconomic policy settings in 2026 - a period of heightened symbolic importance as the inaugural year of China’s 15th Five Year Plan.

In this briefing:

• Why China shelved its unleashing of monetary policy.

• Fiscal policy seen as only short-term fix for China’s economy.

• How China’s monetary policy supports fiscal policy.

• Could zero interest rates save China’s housing market?

• Fiscal policy in China destined to lose its effectiveness.

• Advances in monetary policy make it the inevitable choice.

• China to follow the historic precedent of advanced economies.

• Bernanke and Abenomics as models for China.

Why China’s shelved its unleashing of monetary policy

Despite Beijing signalling at the end of 2024 that it would loosen monetary policy to levels last witnessed in the wake of the Global Financial Crisis (GFC), the central bank’s actions have thus far fallen short of expectations.

The loosening of monetary policy typically assumes the form of cuts by the central bank to short-term interest rates. Standard macroeconomic theory holds that cuts to interest rates benefit the economy, by making it cheaper for enterprises to borrow and thus fund their investment spending,

The Chinese central bank waited until May of last year to implement cuts to the policy rate (its official interest rate) and the required reserve ratio - it’s only such adjustments in 2025. It reduced the policy rate by a modest 10 basis points, and the required reserve ratio by just 50 basis points.

This stands in sharp contrast to two cuts to the policy rate in 2024 - which reduced it by 30 basis points, and two cuts to the reserve ratio that same year, bringing it down by a cumulative 100 basis points.

Since May 2025, the Chinese central bank’s only other adjustment has been its decision in January to make 25 basis point cuts to the interest rates for its structured monetary policy tools - instruments that channel credit to priority sectors of the economy via re-loans to the commercial banks.

Many pundits in China argue that the central bank has held back on the loosening of monetary policy because interest rate cuts are poorly positioned at present to boost economic activity.

The reason for this is that Chinese households and businesses are still reeling from the adverse impacts of the housing slump which commenced in 2021, as well as the lingering economic effects of Covid.

This means that even if the cost of borrowing declines, households and businesses will be hard pressed to take on more debt to spend and invest, given damage to their balance sheets and their dour expectations of future opportunities.

Domestic economists have raised the possibility that China is currently in the type of liquidity trap described by Keynes, where declines in borrowing costs are of no avail in boosting economic activity.

Another key factor is the low level of the Chinese central bank’s seven day reverse repo rate - its main policy rate, which stands at just 1.4% following the 10 basis point cut made in May last year.

The low level of the policy rate compounds the problem of Chinese banks struggling with profitability issues, due to the narrowing of their net interest margins in the wake of prior cuts.

The net interest margin is a key measure of the profitability of commercial banks in their role as financial intermediaries.

It’s the difference between the costs that lenders incur by borrowing funds from depositors and other sources, and what they earn by lending money onwards to borrowers such as businesses.

“In the current low interest rate environment, the net interest margin pressure of commercial banks does not support large-scale cuts to interest rates,’ Sheng Songcheng said in an interview with Shanghai Securities Journal (“盛松成：宏观调控精准施策 护航经济高质量发展”).

“This viewpoint already has a considerable amount of common consensus on the market.”

Fiscal policy seen as only short-term fix for China’s economy

Sheng Songcheng’s contention is that Beijing should make greater use of fiscal policy to enable the Chinese economy to maintain growth at a rate of roughly 5%.

He argues that China’s current macroeconomic system is intrinsically tilted towards the use of fiscal policy, with monetary policy designed to play a supporting role.

“In China’s macroeconomic adjustment system, fiscal policy plays the leading role and monetary policy is responsible for ‘the game of coordination,’” Sheng said.

Sheng further believes that fiscal policy is intrinsically better suited to the task of short-term economic stabilisation, given the immediacy of its impacts compared to monetary policy adjustments.

“Monetary policy - from implementation to transmission to impacts on the real economy, is often subject to a definite time delay,” Sheng said.

“Fiscal policy can directly intervene in economic activity, while monetary policy plays its role mainly through indirect measures.”

Sheng’s views are consistent with Beijing’s commitment to more expansionary fiscal policy made at the end of 2024, as well as its decision to raise the official deficit ratio to a China’s high of 4% in 2025 - a full percentage point above the 3% threshold long established as the deficit ceiling.

They’re also consistent with China’s current fixation on boosting domestic demand, with an especial focus on drumming up consumption.

One of Beijing’s chief proposals for raising domestic consumption is to step up fiscal transfer payments. This measure could kill two birds with one stone, by increasing economic growth in the short-term, while also adjusting the demand structure to give greater long-term play to consumption.

“At the current phase, fiscal transfer payments should be the leader and guide, rapidly stabilising the market for consumption,” Sheng said.

“In the short-term, targeted transfer payments can directly increase the cash flows of households - especially low and medium-income demographics - thus rapidly raising their propensity to consume.

“This has an immediate impact when it comes to boosting consumption. It’s also especially applicable to dealing with the pressure of short-term external shocks and inadequate domestic demand.”

Sheng believes that China will have ample room to make use of transfer payments as a means of boosting consumption moving ahead, given long-standing inequities in wealth distribution and shortfalls in welfare expenditures.

“Data indicates that in developed nations social welfare expenditures account for a share of between 10 to 20% of GDP,” he said.

“By comparison, China’s government expenditures on living standards are under 10%. There is still considerable room for increase.”

How China’s monetary policy supports fiscal policy

The question then arises of what the Chinese central bank should do, if interest rate cuts won’t shift the economy, and China’s macroeconomic system is characterised by the dominance of fiscal policy.

Sheng believes that instead of focusing on cuts to short-term interest rates like the US, the best thing is for the Chinese central bank to preoccupy itself with cuts to the required reserve ratio.

The reserve ratio determines the volume of money that commercial lenders are required to stow with the central bank, acting as a restraint upon their lending activities.

The higher the reserve ratio, the less lending the banks can undertake, as more of their funds are tied up in their central bank accounts.

Conversely, reductions to the reserve ratio serve to free up liquidity for the banks, giving them greater latitude to create credit and supply loans to the rest of economy.

“I have long held the view that reserve cuts are better than interest rate cuts,” Sheng said.

“This does not at all deny the necessity of interest rate cuts, but is a case of reserve ratio cuts better suiting our current national conditions.”

Reserve ratio cuts are seen as especially complementary to fiscal policy in China, because the commercial banks are the chief purchasers of the government bonds that fund spending by the state.

The Chinese central bank is forbidden by law from purchasing government bonds directly, putting the kibosh on the direct monetisation of public debt.

The main buyers of government bonds in the Chinese financial system, however, are still state-owned commercial banks.

Sheng cites data indicating that Chinese commercial banks currently hold around 68% of central government bonds, as well as 75% of local government bonds.

This means that the government wing of China’s financial sector remains responsible for the direct monetisation of government debt, via the state-owned banks placing them on their own balance sheets.

Cutting the reserve ratio would give them more room to take on these issues of public debt. by freeing up liquidity.

Unlike interest rate cuts, cuts to the reserve ratio still retain their potency as an instrument of Chinese monetary policy. Sheng estimates that every reduction of 0.5 percentage points injects the banking system with around one trillion yuan in long-term liquidity.

China also still has ample room for reductions to the required reserve ratio, unlike many advanced economies where the ratio has long sat at zero and adjustments have fallen into disuse as a policy tool.

While the reserve ratio for active deposits in the US stood at 0% by the start of the Covid pandemic, in China the average reserve ratio for depository financial institutions currently sits at 6.3%.

Could zero interest rates save China’s housing market?

Sheng and his like-minded peers believe interest rates and bank profitability are currently too low for further cuts to be a viable path for Chinese monetary policy at present.

Zhang Bin argues, however, that more aggressive rate cuts from the central bank are the best solution for China’s economic challenges at present.

He goes as far as to argue that the Chinese central bank should consider slashing its policy rate to zero, given the positive experiences of advanced economies with the use of such radical measures.

In the CF40 research report entitled “Using Macroeconomic Policy to Spur Endogenous Drivers to Expand Domestic Demand (“以货币政策激发扩大内需的内生动力”), Zhang and co-authors Zhu He (朱鹤) and Zhao Manyi (招曼仪) contend that monetary policy is still “the most important matter of all” when it comes to supporting China’s economy in 2026.

“We should not believe that there is no further room for operation - even if the policy rate is approaching zero,” he writes. “There are still other tools we can use.

“The experiences of Japan, Europe and the US all clearly indicate that the space for policy action is ample.”

Zhang wants the Chinese central bank to make “even larger scale reductions” to the policy rate (the seven-day reverse repo rate which currently sits at 1.4%), as well as drive reductions to bank deposit rates and the benchmark loan prime rate (LPR).

In Zhang’s view, if the Chinese central bank had the gumption to reduce the policy rate close to zero, this would shift the profit metrics enough for both corporations and homebuyers to resume investment and purchasing activity.

He highlights the profound shift since 2021 - when China’s housing slump first commenced - in the cost of financing vis-a-vis corporate profits and home price gains.

From 2010 to 2021, the average net return on assets was 6.7% for China’s listed companies, while the yield on 10-year government bonds during this period (representing the risk-free cost of funds) was around 3.3%.

This meant there was a 3.4 percentage point positive spread between the two, making investment profitable for the vast majority of Chinese corporations.

The situation has shifted sharply since the start of China’s housing slump, however.

The 10-year government bond yield has fallen to around 2%, while the ROA for listed companies has simultaneously fallen to about 2%. This means that the ROA and financing costs are fundamentally the same, or under certain circumstances even negative.

“In this kind of environment, enterprises lack the impetus to expand investment,” Zhang observes in an opinion piece on the CF40 research report (“张斌：重建经济增长内生机制，还需依靠货币政策”).

Zhang says the central bank is in a position to use active monetary policy to remedy the issue, by firstly promising to raise inflation from to 1% at present to 2% within one to two years, as well make large-scale cuts to the policy rate to put downwards pressure on the cost of borrowing.

This could expand the spread between corporate ROA and ten-year bond yields to three percentage points, which would “markedly enliven the willingness of the private sector to invest.”

“At present, out of over 5000 listed companies, only around 20 - 25% of enterprises have the conditions to achieve an ROA that is three or more percentage points higher than financing costs, and thus have the willingness to invest,” Zhang writes.

“However, if the spread can expand to three percentage points, this would bring 35 - 40% of enterprises into the ‘investible’ zone, where the financial returns of investment would be assured.”

A similar logic applies to China’s housing market, where investor demand has crumbled as a result of home price gains sinking beneath financing costs.

“Prior to 2021, purchasing homes made more sense than renting for Chinese households,” Zhang writes.

“The reason for this was at the time the residential mortgage rate was 3 - 4%. During the same period nationwide housing prices were rising at 5 - 6% (and even higher in major cities).

“This meant that homebuyers not only could live in homes for free, but they could profit from asset value increases.

“By comparison, the rental return rate was in general only 1.5 - 2% (slightly higher in smaller cities).

“For this reason, the rational choice was to ‘buy if you can buy - just buy even if you don’t know where you’ll borrow the money.’”

After the housing slump that began in 2021, however, Zhang says this logic was flipped on its head. Home prices were no longer rising, the rental yield stood at around 2%, yet home mortgage rates remained at a lofty 3%.

Zhang says further adjustments to interest rates could upend this situation completely, reviving the housing market and helping Beijing to achieve its much vaunted goal of boosting domestic demand via wealth effects.

“If the rental yield and the mortgage rate are the same - such as 3% - then the cost of renting and buying is equal,” he writes.

“If the central bank reduces interest rates by one percentage point - from 3% to 2%, then this means that up until the point that housing prices rise 50%, buying a house will be more economically sound than renting a house.

“This provides huge room for home price increases.”

Fiscal policy in China destined to lose its effectiveness

Sheng is convinced that the short-term fix for China’s macroeconomic challenges lies in leaning more on the nation’s traditional dependence on fiscal policy, with monetary policy playing a supporting role,

Zhang Bin considers this policy arrangement to be largely unsustainable, however, as a result of the fundamentals of the Chinese economy continuing to shift.

“In the past, when China was confronted with inadequate demand, it would customarily lean on fiscal policy, and use public investment projects to drive aggregate demand,” he writes.

“While the results were pronounced, this model will need to undergo adjustment in future.

“Looking at things from a longer-term perspective, in future China’s counter-cyclical policy will need to lean more on monetary policy, and not fiscal policy.”

According to Zhang, the effectiveness of fiscal policy is fast declining, with most of the low-hanging fruit of infrastructure projects that promise longer term benefits now gone.

This has left fiscal policymakers with projects that only offer lower returns, and are also less likely to translate into rapid-fire spending.

“In the past, fiscal investment was made in bridges, roads and underground pipe systems, which would immediately drive demand and was also of benefit to long-term development” Zhang writes.

“Today, however, the conditions for large-scale short-term fiscal investment are far from what they were in the past.

“On the one hand, urban boundaries are expanding, and space for new construction on empty land is already very limited.

“Fiscal expenditures have already shifted towards urban upgrades and other adjustments to existing buildings and infrastructure stock.

“These projects are usually far more time-consuming, and it is difficult for them to rapidly create large-scale expenditures.

“Under such conditions, it’s very hard for fiscal policy to form large-scale support in the short-term the way it did in the past, to thoroughly turnaround insufficient demand.”

Zhang finally highlights concerns over the government debt incurred by fiscal spending, and the impacts that this can have on market sentiment.

“In the past, China’s debt levels were low and its deficits weren’t high,” he writes.

“Even if I personally believe that public debt problems are not a source of excess concern, there is definitely a considerable mood of anxiety on the market [about them].

Advances in monetary policy make it the inevitable choice

Zhang believes that monetary policy is destined to play a greater role in Chinese macroeconomic management, taking over the dominant position long enjoyed by fiscal policy.

As the potency of fiscal policy dwindles, Zhang sees the effectiveness of monetary policy rising in tandem with the expansion of the financial sector and the refinement of the central bank’s methods.

“Compared with Keynes’s time, the tools and understanding of monetary policy have undergone fundamental changes, benefiting from advances in the financial environment and the diversification of policy methods,” he writes.

“Following massive shifts in the financial environment, the scope and impact of monetary policy has markedly expanded.

“Households participate more widely in credit and capital markets, which means monetary policy not only affects the balance sheets of enterprises, but also deeply impacts the financial condition of households.

“It is precisely because of these changes that monetary policy can play an increasingly strong and prominent role.

“At present and in future, we will need to depend more on monetary policy to expand domestic demand.”

Zhang sees the key to effective monetary policy as lying in the ability of a central bank to shift expectations of future rates of inflation, via the credibility of its signalling as the economy’s supreme monetary authority.

“The central logic is the use of the central bank’s authoritative promise to influence the public in its future inflationary expectations, and enable everyone to expect future prices to rise, thus removing their deflationary mindset.

“This in turn spurs economic activity, by making “enterprises willing to invest and households willing to consume.”

In China’s specific case, Zhang advocates a simplification of the central bank’s monetary policy targets, in order to avoid causing the market undue confusion.

“We should concentrate on a single target, such as vigorously driving a recovery in inflation this year and sparing no measures to achieve this.

“Targets must be as clear and few as possible.”

China to follow the historic precedent of developed economies

In switching its focus from fiscal policy to monetary policy, Zhang argues China will simply be embarking upon a journey already undertaken by the world’s advanced economies.

Those nations needed to adjust their macroeconomic policy tools in the second half of the 20th century in response to shifting conditions, such as the maturation of their infrastructure assets and the rising sophistication of their financial systems.

“I believe that China is in a similar phase of transition,” he writes, pointing out that the macroeconomic conditions of mid-20th century developed economies closely resembled those in China until just recently.

“From the 1950s to the 1970s, the main tool for countercyclical adjustments in developed economies was fiscal policy, with monetary policy playing an ancillary role.

“This was because the economy was at the peak period of industrialisation, undergoing rapid growth and urbanisation.

“Counter-cyclical public investment undertaken by fiscal policy could stabilise current demand, while its construction projects (bridges and roads) could also prove useful over the long term.”

Zhang points out that because these projects resulted in high growth and thus stronger tax returns, governments did not suffer from major deficit or debt problems as a result of fiscal spending.

For the past four decades since the start of the 1980s, however, the main force for counter-cyclical policy in developed nations has become monetary policy. Fiscal policy has only risen to the fore on rare occasions, during major contingencies such as the Global Financial Crisis (GFC) and the Covid pandemic.

Bernanke and Abenomics as models for China

Zhang points specifically to the actions of the central banks of the US and Japan as exemplifying the power of monetary policy as a wing of macroeconomic management, as well as worthy models of emulation for China.

According to Zhang, the central banks of these two nations made exceptional use of monetary policy during two key periods of recent economic history - Benjamin Bernanke’s time as head of the Federal Reserve during the GFC, and Shinzo Abe’s implementation of “Abenomics” during his second term as Japanese prime minister.

“The 2008 sub-prime crisis was a once-in-a-century financial crisis,” Zhang writes.

“The US household sector suffered severe damage to its balance sheet, consumption and investment sharply contracted, and demand hit extreme levels of insufficiency.

“Under Bernanke’s leadership, the US Fed implemented large scale interest rate reductions and implemented multiple rounds of QE, as well as coordinated with fiscal policy, successfully turning around market expectations.

“The path to recovery was an extremely typical textbook case. First was the mood of financial markets improving and share prices recovering.

“Enterprise profit expectations subsequently recovered, driving investment recovery, before household consumption, employment and housing markets all gradually warmed up.

“The economy steadily emerged from the crisis. This is a classic episode of dealing with an urgent case of deep-seated demand insufficiency.”

Zhang further argues that Shinzo Abe’s adept use of monetary policy enabled Japan to finally bring an end to decades of lost growth, by depreciating the yen and stimulating the domestic economy.

“Prior to 2013, Japan was in a state of long-term deflation,” he writes. “Deflationary expectations had taken deep root and structural problems were complex.

“The rest of the world believed that it would be difficult to reverse this. However, once Abe was elected and promoted Abenomics, the situation rapidly changed.

“That same year Japanese stocks rose 50% and housing prices ended their multi-year decline, with Tokyo home prices rising 3 - 5%.

“The unemployment rate rapidly fell from 4% prior to Abe taking office to 3%, then soon stabilised at around 2.5%.”

While Abenomics consisted of the “three arrows” of monetary policy, fiscal policy and structural reform, Zhang points out that Koichi Hamada - the economist who designed Abenomics, gave pride of place to the effectiveness of monetary policy in rescuing Japan from its doldrums.

Hamada gave second place to fiscal policy in terms of impact, while declaring that structural reforms were wholly ineffective.

Zhang points to these episodes as providing empirical support for China’s own expanded use of monetary policy in future.

“These two historical episodes I believe explain the effectiveness of monetary policy,” he writes.