In daily life, consumers tend to substitute inexpensive goods for those that are rising in price.

 

This year, major indicators for the Chinese economy declined, and the recent plunge of A-shares drew comparisons to the American stock market crash that preceded the Great Depression in the 1930s. In such a context, dire forecasts of China’s precipitous decline have proliferated around the world once again, and anxiety over the economy is widespread among the Chinese public. Despite signs of recession, the Chinese government is still capable of thwarting a sharp downturn through various macroeconomic regulations.

One worrisome indicator is the output gap, which refers to the difference between potential and actual GDP. It was negative from 2012 to 2014. Since the reform and opening up in 1978, a negative output gap has appeared on three occasions, and each time it was accompanied by a recession. The three instances were the period following the failure of price reform in the late 1980s, the Asian financial crisis from 1996 to 2001, and the global financial crisis from 2008 to 2010.
 

Another sign is the GDP deflator which has consistently decreased since 2012 and was below zero entering 2015. Previously, a negative GDP deflator only appeared during the Asian financial crisis and the 2008 financial crisis.

In addition, the Consumer Price Index (CPI) and the Producer Price Index (PPI) show low demand from consumers and a cautious attitude toward production from enterprises. The year-on-year growth of CPI was about 1 percent from January to May this year, but it picked up after May. However, it should be noted that CPI has overestimated the price level considering that its calculation is based on a fixed market basket of consumer goods and services, but consumers tend to substitute inexpensive goods for those that are rising in price.
 

As of July, the PPI had fallen for 41 consecutive months, which is a more prolonged period relative to declines seen during the Asian financial crisis and the 2008 crisis. Moreover, it continued to drop at a higher rate and in July, fell 5.4 percent year-on-year to the lowest point in the last six years.This means that the PPI is unlikely to turn around in the near future.
 

At present, Chinese fiscal policy is hamstrung by diminishing government revenue coupled with soaring debt, and monetary policy is less effective. Thus, some people believe the Chinese government does not have enough policy space to avoid depression. However, this is not completely true.
 

First, there are sufficient assets that can ensure fiscal policy has the capacity to play its crucial role in important periods. According to the latest national balance sheet published by the Chinese Academy of Social Sciences, by the end of 2014, China’s sovereign assets totaled 227.3 trillion yuan, while sovereign debts reached 124 trillion yuan. Moreover, local governments owned about three times more assets than debt. Even considering factors like the liquidity of assets, the Chinese government can still remain solvent for a long time.
 

Second, there is still large space for reduction in interest rates and reserve requirements. Unlike the zero lower boundary in America and Europe, the benchmark loan rate in China is 4.6 percent, and its reserve ratio is 17.5 percent, which gives bigger flexibility to the central bank. Though China’s monetary policy has become less efficient due to financial innovation driven by interest rate liberalization, the market interest rate decreased 0.87 percent following four interest rate cuts that were implemented from November 2014 to June 2015, and the real reserve ratio decreased 1.7 percent after three cuts in the reserve ratio during this period.
 

In addition, in special circumstances, steady growth can be achieved through unconventional monetary policy, such as funding policy banks and increasing the quota for local governments to replace their existing debts with new bonds. 
 

Third, coordination between fiscal and monetary policies could be improved. Illustrating the relationship between real output and interest rates, the IS-LM Model shows that the proactive fiscal policies and prudent monetary policies implemented since 2011 have raised the interest rate and aggravated the debt burden, greatly nullifying their effect. However, calculations show that a proactive fiscal policy and a moderately loose monetary policy can increase financial expenditures by 4.7 to 5.7 percent.
 

Moreover, China has the highest rate of household savings, the largest foreign exchange reserves and adequate preparation for bad debts and RMB depreciation, which could also help the government prevent economic depression.

 

Chen Yanbin and Liu Zhexi are from the School of Economics at Renmin University of China.