The Secrets of China’s Growth

This paper was submitted during the Macroeconomics course of my MBA, so please excuse the rather ‘academic’ dry tone, but at least in the end it did receive a Distinction grade (dry tone and all!).  It analyses China’s recent period of slowing growth and provides several economic policy recommendations in light of China’s current economic conditions.  It was fascinating to spend a month diving deep into China’s economy, and I wanted share it for those interested.

The paper concludes that China’s slowing growth is a predictable result of a structural decline in the rate of productivity growth as the economy experiences diminishing returns to capital as it travels closer to the theoretical production possibility frontier.

As a result, policies designed to foster stability in the short term and innovation and technological advancement in the longer term are suggested in order to create the most fertile environment for growth.  Long term growth in potential GDP can only be achieved primarily as a result of continued improvements in productivity through innovation and adherence to market based principles that drive the efficient allocation of resources.

1      Introduction

For the first time in the memory of many of its citizens, China is experiencing a sustained economic slowdown in its historically strong growth that by all accounts will continue into the foreseeable future (OECD, see figure 3 below).

As the world’s second largest economy, and by far Australia’s largest trading partner (more than Japan the U.S.A. combined), it is critical that both the nature of the growth, and the cause of the current slowdown are correctly diagnosed, and the correct measures be put in place in both China and Australia to support sustainable growth into the future.  Incorrectly identifying the cause, and applying the wrong policy as a result could have disastrous effects.  As will be explained later, for example, measures designed to stimulate demand could lead to high inflation if the slowing was more structural in nature than cyclical, and the economy was already close to full employment.

The aim of this paper is to investigate the forces at work behind China’s high and now slowing growth, and the subsequent presentation of several policy measures designed to maximise the long term growth prospects for China.

2      Brief Background

Following the market based reforms to the Chinese economy introduced by Deng Xiaoping in 1978, growth in real GDP has averaged over 10% for the last 36 years, leaping the economy from tenth to second in the world in US$ GDP nominal terms, and currently first in purchasing power parity terms (according to the IMF).  The accompanying large increases in productivity allowed real GDP per capita to grow strongly as a result :

Figure 1 : China’s historical growth :   Source World Bank.

At is most basic level, this rapid growth in real GDP can be illustrated on the production possibility frontier (PPF) diagram.  What is a PPF?  Its really just a very simple yet powerful way of illustrating that most basic decision at the core of all economic action.. whether to consume your production in the present, or not consume and instead produce ‘capital’ goods that are then used to produce more goods in the future.

All production in an economy requires capital goods, but to have the ‘money’ to invest in capital goods you have to choose to consume less right now.  There is only so much ‘product’ an economy can produce, and its up to you to decide to produce capital goods and grow your manufacturing base, or live for the moment and consume all your production now.  If you ‘invest’ more then you are setting the stage to grow your production in future periods.. you have a larger base of capital goods with which to produce.

The PPF diagram then really simply shows that trade off between capital and consumption as a line called the ‘production possibility frontier’.  By definition you simply can’t produce out side the line, as that line represents the basic productive and technological limits of your economy.  You simply make trade offs to move along the line.. spend a bit more on capital and a bit less on consumption, and you move up and to the left along the PPF.

Looking now the diagram below, in the case of China, starting from an inefficient position “A”, well inside the PPF, by allowing the economy to more efficiently coordinate through market mechanisms and opening up to foreign investment, and taking advantage of China’s historical high savings rates to facilitate both large capital investment and increases in production efficiency, China rapidly both expanded its productive potential (i.e. the PPF), and also moved closer to its PPF at point “B”, much closer to the PPF and far from “A”.

As the economy becomes more efficient in the allocation of resources, it moves closer to the theoretical maximum efficiency that is represented by the PPF line.   The aim is to use every trick in the book to get your economy humming along efficiently and producing as much as you can from your limited resources.

Figure 2 : Chinese Growth : moving closer to the efficient frontier.

In a sense, because China started from such low levels of productivity, China experienced a ‘reverse’ paradox of thrift :  where low consumption combined with high savings (nearly 50% of income)  to provide copious amounts of funds available for investment.  This generous supply of internally generated savings (which are in turn deposited, then re-lent by banks for investment), actually helped accelerate investment and growth, and as a result, aggregate demand and the overall size of the economy (see Appendix Two for more discussion of the paradox of thrift) .

The normal concept of a ‘paradox of thrift’ is simply when consumers in an economy save more (say they fear a recession), they by definition spend less, which reduces overall consumption and contracts the entire economy.  The net result of the increased savings to prepare for a recession can therefore be to induce a recession and everyone becomes worse saving more is not actually good for the economy as a whole… a paradox.

In the case of China, the high savings rate existed prior to the acceleration of economic growth, primarily because if you are a poor farmer, and no state safety net of unemployment or health insurance exists, your very basis for survival necessitates having more set aside for a rainy day than those in well off economies with a large welfare safety net.  Of course there are layers of complexity to this paradox, and only the most simple aspect of it is explained here for want of space.

Overall, taking this paradox into consideration, we can see now that a pre-condition for continued Chinese economic growth is the continued promotion of consumption growth, which can also mean assisting the population to save less through providing them with a supportive welfare safety net.

3     Detailed China Economic Overview

3.1    Goods Markets : GDP and Potential GDP

Economic growth is carefully defined by economists as growth in ‘Potential’ GDP, i.e. that level of GDP produced by the economy at the ‘Full’ or ‘Natural’ rate of employment, where the labour markets are in equilibrium (i.e. wages are stable and not under pressure), and the economy is producing at maximum allocative and productive efficiency right on the production possibility frontier.

Think of ‘potential GDP’ as the theoretical ‘capacity’ of the economy to produce without pressure, and actual GDP the actual level of production.  If actual production is below potential, then headroom exists for non-inflationary expansion.. i.e. there is spare capacity.  If actual production is above the neutral capacity of ‘potential GDP’, then there is no spare capacity, and expansion can only happen if more workers are lured into the workforce through higher wages for example.  The higher wages of course feed directly into companies costs, which are then passed on to consumers as higher prices.. and bam.. off goes inflation!

The inflation then reduces living standards, and ‘real’ GDP can then contract.  You can now see why economists are preoccupied with promoting growth in ‘potential’ GDP, for example through improvements in technology and productivity.  Simply promoting spending to expand actual GDP is actually self defeating in an inflationary environment as we discussed.

Returning now to discussing China’s economic growth, as a result primarily of slowing growth in potential GDP, OECD forecasts show real GDP growth rates continuing to decline as China gets closer to the ‘global’ productivity frontier through continued capital accumulation, innovation and foreign investment :

Figure 3 : Actual and Forecast Real GDP annual growth rates : Source : OECD Long Term Baseline Projections 2014

3.2     Cause of the Slowdown : Long Term Structural or Short Term Cyclical?

Economists from the Reserve Bank of Australia have performed detailed projections that show long term declining growth to 2050 and beyond (Fang & Lu 2014).  After performing detailed analysis of labour, total factor productivity (TPF), inflation, population and many other growth indicators, they concluded that since 2012 China has been experiencing simultaneous slowing of both actual GDP and potential GDP, with generally low inflation figures and moderate growth indicating actual current output is approximately at or around potential.  In other words, the slowdown appears primarily structural (slowing potential GDP growth) and not cyclical.

3.3     Goods Markets : Prices and Deflation concerns

Currently consumer price inflation (CPI) has been hovering in the low 1 – 2% range (1.3% for October 2015).  Most worrying however are the sustained falls in producer prices (PPI) :  – 5.8% most recently, with these falls expected to filter through to the CPI with the potential for a disastrous deflationary spiral (Sweeny 2015) (please see Appendix Three for further discussion of deflation).

Figure 4: Chinese Consumer Price Index and Producer Price Index.  Source : IMF.

3.4     Money Markets : Interest Rates

The Peoples Bank of China (PBoC) benchmark lending rate has been reduced 6 times in the last 12 months, and currently sits at 4.35%, a record low :

Figure 5: Peoples Bank of China Benchmark Lending Rate (%) : Source : IMF

Currently, deposit rates on private savings are in the region of 0.35%, so with inflation running around 1.5%, negative real interest rates are currently driving large official and ‘shadow’ capital outflows in search of higher returns, one example being the Sydney property market, putting significant depreciation pressure on the Chinese Renminbi (CNY).   In recognition of this pressure, China recently allowed a 2% currency depreciation (Maley 2015). See Appendix Five for a discussion of these outflows.

China has historically taken advantage of their very high savings rate (currently 49% of GDP), by keeping deposit rates low, and thereby funnelling vast sums of cheap credit to the State Owned Enterprises.  By comparison, the savings rate in the USA is approximately 8%, and 8% in Australia (Burg 2015).

3.5    Balance of Payments

The opening of the economy to foreign investment, combined with the rapid growth achieved as the economy was moving towards the PPF meant that for most of the last 30 years China had the unique situation of twin Current Account and Capital Account surpluses and large foreign exchange reserves.

China’s high current account surplus can be explained through the circular flow of income and national accounting identities below, their high national saving rates and the printing of vast sums of Yuan to exchange for the huge capital inflows resulting in massive foreign exchange reserves (US$ 3.5 Tr) :

Please see Appendix Four for further discussion of this important accounting identity.

3.6     Foreign Exchange Markets

Although the PBoC has been allowing the exchange rate to appreciate moderately in recent years, this has now had the effect of generating the perfect conditions for the ‘carry trade’ and ‘hot money’ that take advantage of the relatively high interest rates in China versus the relatively low interest rates in the rest of the world (particularly in “QE3” USA) (Alloway 2015; Li 2015) :

Figure 6 : Carry Trade and Hot Money capital flows

Please see Appendix five for a discussion of these flows.

3.7     Government Income and Expenditure

By virtue of consistent high levels of domestic saving and foreign investment, China’s high growth has by and large allowed the government to not build up large levels of debt brought about by any need to stimulate the economy (and thereby crowd out investment).  Currently, China runs a moderate budget deficit of 2.1% of GDP, and has a net debt position of 41%.  This compares favourably with the USA which currently has deficits and net debt of approx. 2.2% and 103% respectively.

Figure 7 : China vs USA Government Budgets : showing moderate Chinese deficits reducing crowding out effect ; Source IMF.

3.8    Labour Markets

The aging population, and the forecast peak working age population imply that China will experience declining labour force participation rates in the future, harming its prospects for GDP per capita growth.  Please see Appendix Six for details.

4      Theoretical Analysis

4.1     Growth and Diminishing Returns

Economic growth is carefully defined by economists as growth in ‘Potential’ GDP, i.e. that level of GDP produced by the economy at the ‘Full’ or ‘Natural’ rate of employment, where the labour markets are in equilibrium, and the economy is producing at maximum allocative and productive efficiency right on the production possibility frontier.  Growth in Potential GDP is illustrated by shifts of the PPF upwards, illustrating an increase in output at each level of input.  From a theoretical perspective, assuming all other factors of production are fixed (land, capital, entrepreneurship), we illustrate the aggregate production function for labour as follows :

The decreasing slope of the production function PF shows the law of diminishing returns : DGDPb is less than DGDPa.  L1 represents labour market equilibrium and full employment at the natural rate of unemployment.  An increase in population would increase the supply of labour, but without change in productivity, diminishing returns mean whilst Potential GDP would rise, it would not rise as much as the increase in workforce, and GDP per capita would fall.

4.2    Growth of GDP per capita

The main aim of the government is to not just grow GDP, but grow GDP per capita.  There are other measures of welfare (e.g. the U.N. Human Development Index) but we focus here on GDP per capita.  The following formula provides powerful insights into GDP per capita growth.  Simply by multiplying GDP per capita by N/N (N = labour force, P = population), we arrive at the formula :

Very simply, to increase GDP per capita one can focus on either improvements to productivity per worker, or increases in the participation rate, or both.

4.3     Productivity

The law of diminishing returns to capital provides a hint as to why high growth emerging economies eventually experience declining growth.  Looking at the simple production function

we see this function states that total production Y (in this case GDP) is a function of total factor productivity (TFP), and the amount of physical capital, human capital and the labour supply.  The model highlights the core role of productivity in determining GDP, and its growth.

4.4     What does NOT drive growth

What is most interesting about these formulas is what they don’t contain.  GDP growth is NOT associated with either aggregate demand or prices (of goods or money).  Policies designed to simply stimulate growth in aggregate demand do not in themselves have any effect on the growth of potential GDP, but merely lead to changes in prices.

4.5     Growth Theories

Space prevents a detailed exposition here of the differences between Classical, Neo-Classical and New-Growth theories.  It is suffice to say however that New Growth Theory seems to describe the continuing nature of modern growth.  New-Growth theory emphasises the role of population growth in providing the incentive for the continued R&D and innovation necessary to provide for increasing productivity and GDP growth.   Innovation does not occur randomly by chance, but is in fact propelled by the demand for ever higher standards of living, and it is this innovation that allows continued growth in productivity to offset declines caused by any diminishing returns on capital.  See Appendix Seven for further discussion.

4.6     Aggregate Demand / Supply and Keynesian Growth Illustration

Growth in potential GDP (PGDP) is represented on the AD/AS and Keynesian 450 models as a shift of the vertical ‘long term aggregate supply’ or ‘full employment’ line to the right to a new long term equilibrium position :

Figure 8 : AD/AD model of growth

One of the most impressive aspects of these models is they demonstrate how the level of Aggregate Demand (or planned expenditure in the 45deg Keynesian model) does NOT determine the level of Potential Real GDP.  In the long run, the level of AD only affects the price level, a critical awareness for governments involved in managing long term growth (of potential GDP) when it comes to short term desires to boost AD.

4.7     Economic Stability

It is worth noting that critical to efficient long run economic growth is a stable economy, otherwise large amounts of physical and human capital are wasted during times of recession.  See Appendix Eight for further discussion.

5      Policy Recommendations

In summary, the following fundamental facts about the Chinese economy are evident :

  • The slowdown is structural in nature, and not a result of short term deficiencies in aggregate demand below full employment
  • The economy in fact appears to be currently operating at or just below full employment
  • Inflation is very low, and falling producer prices risk a deflationary spiral
  • The Yuan is under depreciation pressure as the economy cools and capital seeks an exit
  • Interest rates are at record lows
  • The aging population implies a future reductions in participation rate.
  • Growth is reliant primarily upon continued improvements in productivity

Taken together these fundamental facts imply the following policy recommendations :

  • Even though the economy is close to full employment, inflation is in fact very low, indicating that further stimulatory measures such as a measured reduction in interest rates may be considered to reduce the risk of deflation.
  • Depreciation of the Yuan to boost export competitiveness should be avoided where possible as it has also has the negative effect of propelling ‘hot money’ capital outflows, placing local pressure on liquidity and investment. Where necessary due to depreciation pressures from falling local interest rates and profits, and an associated desire for capital to flow out of the country, local measures to boost liquidity, such as further reducing bank capital reserve requirements should be considered.
  • A measured ‘enhanced’ enforcement of capital controls (without causing concern to international investors) may be necessary to reduce the volatility of capital outflows as a result of slowing growth, falling interest rates and expected depreciation.
  • Removal of the ‘one child’ policy to promote growth in working age population and participation rate declining (note post script – China has just announced this measure!).
  • Above all else, the government must place emphasis on measures designed to improve productivity such as :
    1. Education and training to increase human capital
    2. An emphasis on innovation as the key to growth (as opposed to the old notion of large scale investment by State Owned Enterprises (SOE’s)
    3. Reduction in ‘favoured status’ of SOE’s to provide a true incentive for the more efficient private sector to grow and propel productivity
    4. Further dismantling of government interference in the market to enhance efficient allocation of resources

5.1     Policy Timeline

The short term requirement to stabilise an economy often works against the long term need to provide for growth in potential GDP.  It is with this in mind, the following table outlines how the policies outlined above interact, and the lag before any effect becomes apparent in the economy.

Policy Implementation Timeline Lag effect Timeline
1. Measured Reduction in interest rates 3 – 12 months if necessary 12 – 18 months for changes in investment behaviour
2. Yuan Depreciation Use only when necessary to inhibit hot money volatility Immediate effect
3. Enhanced Capital Controls Immediate Immediate
4. Removal of ‘one child’ policy Immediate Long Term
5. Innovation & Productivity Emphasis Immediate Medium to Long Term

6      Conclusion

China’s growth over the last 30 years has been a remarkable but yet, predictable result of allowing an emerging economy starting from a low base to adopt efficient market driven coordination mechanisms, and also accept foreign investment to help fund the massive infrastructure required to modernise the economy.  After the initial rapid phase of growth, the long term ‘natural’ cooling now being experienced due to the effects of the law of diminishing returns on capital and operating closer to the PPF should not cause alarm.  Adherence to the principles of the efficiencies of a market driven economy, together with a strict recognition that long term future growth can only be achieve through innovation and associated improvements to the growing stores of human and physical capital, should provide a fundamental basis for prosperity into the future.


Alloway, T, One of China’s Most Popular Trades May Be Coming to an End, 11 Aug 15. Available from: <>. [1 Nov 15].

Burg, G, China’s Economy at a Glance : National Australia Bank Monthly Update 20 Oct 15, National Australia Bank. Available from: <>. [1 Nov 15].

Fang, C & Lu, Y 2014, ‘Chian’s shift from the Demographic Dividend to the Reform Dividend’, in Deepening Reform for China’s Long Term Growth and Development, vol. Canberra, ANU Press, pp. 27 – 50.

Li, F, China Reserves Fall in July as PBOC Steadies Yuan Amid Outflows, 7 Aug 15. Available from: <>. [5 Nov 15].

Maley, K, Chinese interest rate cut will spur more capital outlfow, Australian Financial Review 27 Oct 15. Available from: <>. [27 Oct 15].

Sweeny, P, China deflation fears grow as producer prices sink most in six years, Available from: <>. [5 Nov 15].

The author would like to point out that a great deal of research was performed in preparation for this paper.  Over one hundred articles and reports were read to form a general picture of the Chinese economy as its currently stands.  Due to the general nature of this research, a great deal of it is not directly referenced here, however should it be required, the author is happy to provide the document files should the reader be interested in further analysis and investigation.


8.1      Appendix One: Primary Article :

The Economist 29th August 2015 “The Great Fall of China”

Financial markets

The Great Fall of China

Fear about China’s economy can be overdone. But investors are right to be nervous

Aug 29th 2015 |  From the print edition

ONCE the soundtrack to a financial meltdown was the yelling of traders on the floor of a financial exchange. Now it is more likely to be the wordless hum of servers in data centers, as algorithms try to match buyers with sellers. But every big sell-off is gripped by the same rampant, visceral fear. The urge to sell overwhelms the advice to stand firm.

Stomachs are churning again after China’s stock market endured its biggest one-day fall since 2007; even Chinese state media called August 24th “Black Monday”. From the rand to the ringgit, emerging-market currencies slumped. Commodity prices fell into territory not seen since 1999. The contagion infected Western markets, too. Germany’s DAX index fell to more than 20% below its peak. American stocks whipsawed: General Electric was at one point down by more than 20%.

Rich-world markets have regained some of their poise. But three fears remain: that China’s economy is in deep trouble; that emerging markets are vulnerable to a full-blown crisis; and that the long rally in rich-world markets is over. Some aspects of these worries are overplayed and others are misplaced. Even so, this week’s panic contains the unnerving message that the malaise in the world economy is real.

China, where share prices continued to plunge, is the source of the contagion (see article). Around $5 trillion has been wiped off global equity markets since the yuan devalued earlier this month. That shift, allied to a string of bad economic numbers and a botched official attempt to halt the slide in Chinese bourses, has fueled fears that the world’s second-largest economy is heading for a hard landing. Exports have been falling. The stock market has lost more than 40% since peaking in June, a bigger drop than the dotcom bust.

Yet the doomsters go too far. The property market is far more important to China’s economy than the equity market is. Property fuels up to a quarter of GDP and its value underpins the banking system; in the past few months prices and transactions have both been healthier. China’s future lies with its shoppers, not its exporters, and services, incomes and consumption are resilient. If the worst happens, the central bank has plenty of room to loosen policy. After a cut in interest rates this week, the one-year rate still stands at 4.6%. The economy is slowing, but even 5% growth this year, the low end of reasonable estimates, would add more to world output than the 14% expansion China posted in 2007.

China is not in crisis. However, its ability to evolve smoothly from a command to a market economy is in question as never before. China’s policymakers used to bask in a reputation for competence that put clay-footed Western bureaucrats to shame. This has suffered in the wake of their botched—and sporadic—efforts to stop shares from sagging. Worse, plans for reform may fall victim to the government’s fear of giving markets free rein. The party wants to make state-owned firms more efficient, but not to expose them to the full blast of competition. It would like to give the yuan more freedom, but frets that     a weakening currency will spur capital flight. It thinks local governments should be more disciplined but, motivated by the need for growth, funnels credit their way.

Fears over China are feeding the second worry—that emerging markets could be about to suffer a rerun of the Asian financial crisis of 1997-98. Similarities exist: notably an exodus of capital out of emerging markets because of the prospect of tighter monetary policy in

America. But the lessons of the Asian crisis were well learned. Many currencies are no longer tethered but float freely. Most countries in Asia sit on large foreign-exchange reserves and current-account surpluses. Their banking systems rely less on foreign creditors than they did.

If that concern is exaggerated, others are not. A slowing China has dragged down emerging markets, like Brazil, Indonesia and Zambia, that came to depend on shoveling iron ore, coal and copper its way (agricultural exporters are in better shape). From now on, more of the demand that China creates will come from services—and be satisfied at home. The supply glut will weigh on commodity prices for other reasons, too. Oil’s descent, for instance, also reflects the extra output of Saudi Arabia and the resilience of American shale producers. Sliding currencies are adding to the burden on emerging- market firms with local-currency revenues and dollar-denominated debt. More fundamentally, emerging-market growth has been slowing since 2010. Countries like Brazil and Russia have squandered the chance to enact productivity-enhancing reforms and are suffering. So has India, which could yet pay a high price.

The rich world has the least to fear from a Chinese slowdown. American exports to China accounted for less than 1% of GDP last year. But it is hardly immune. Germany, the European Union’s economic engine, exports more to China than any other member state does. Share prices are vulnerable because the biggest firms are global: of the S&P 500’s sales in 2014, 48% were abroad, and the dollar is rising against trading-partner currencies. In addition, the bull market has lasted since 2009 and price-earnings ratios exceed long-run averages. A savage fall in shares would spill into the real economy.

Were that to happen, this week has underlined how little room Western policymakers have to stimulate their economies. The Federal Reserve would be wrong to raise rates in September, as it has unwisely led markets to expect. Other central banks have responsibilities, too. Money sloshing out of emerging markets may try to find its way to American consumers, leading to rising household borrowing and dangerous—and familiar—distortions in the economy. So Europe and Japan should loosen further to stimulate demand.

Monetary policy is just the start. The harder task, in the West and beyond, is to raise productivity. Plentiful credit and relentless Chinese expansion kept the world ticking over for years. Now growth depends on governments taking hard decisions on everything from financial reforms to infrastructure spending. That is the harsh lesson from China’s panic.


8.2     Appendix Two : Paradox of Thrift

The classic paradox of thrift in more developed consumption based economies occurs when increases in savings traditionally mean decreases in consumption, and decreases in aggregate demand as a result.

One could say China’s rapid growth was the quite predictable result of allowing a large and inefficient economy starting from a low base to operate openly and efficiently.

As a result, the high savings rates actually enhanced China’s ability to invest and grow from such a low base, in this circumstance a kind of ‘reverse’ paradox of thrift.


8.3     Appendix Three : Deflation

The falling producer prices currently being experience in China are a result of a combination of falling input prices, over capacity and over supply set against weakening national and global demand (Sweeny 2015).  The risk for China at present is deflation not inflation.   This producer price deflation puts pressure on company profits (income) and debt servicing ability, and creates an expectation of further falling prices and profits, which at worst could lead to a disastrous ‘demand pull’ deflationary spiral dragging investment, income and demand further down with it. Lower expected future prices decrease aggregate demand by pushing consumption into the future where prices are expected to be lower :

Figure 9 : Deflationary Spiral

The danger of deflationary expectations leading to a disastrous deflationary spiral shows the government must focus on both the real economy as well as intangible ‘expectations’ of the economy (which it is in fact doing, for example, through recent liquidity measures designed to support massive losses in the Chinese stock market, creating the impression the government is in control etc).

It is seductive to only consider real monetary indicators as the only way to monitor an economy, however as Keynes points out, ‘animal spirits’ are a large factor driving aggregate demand, and must be taken into consideration and managed by the government as closely as ‘hard’ indictors such as actual interest rates and money supply.


8.4     Appendix Four : Balance of Payments

This situation of China’s twin surpluses and high foreign exchange reserves evolved as the PBoC decided to essentially ‘print’ Yuan to exchange for the vast inflows of foreign currency required to purchase their exports and provide for foreign direct investment (FDI) inflows.

This had two effects :

  1. The vast sums of Yuan released into the market kept the Yuan exchange rate very low, most would say ‘artificially low’ much to the consternation of its major trading partners, and
  2. The build-up of huge reserves of foreign exchange, currently in the region of US$ 3.5 trillion, by virtue of the national accounting identity :

8.5     Appendix Five : Forex Rates and the Hot Money / Carry Trade issue

Although the PBoC has been allowing the exchange rate to appreciate moderately in recent years, this has now had the effect of generating the perfect conditions for the ‘carry trade’ and ‘hot money’ that take advantage of the relatively high interest rates in China versus the relatively low interest rates in the rest of the world (particularly in “QE3” USA) :

Figure 10 : Carry Trade and Hot Money capital flows

These flows are premised on an appreciating CNY, and in fact reinforce CNY demand, so as the Chinese economy is cooling and the interest rate and exchange rate is falling, vast sums of capital are flowing out of the country, putting huge pressure for further CNY depreciation.  On the 11th August 2015, the PBoC bowed to the pressure (and a cooling economy) and reduced its ‘peg’ rate a full 2% resulting in the largest one day loss for the CNY in two decades.

Such a depreciation also self-reinforced a ‘depreciation expectation’ in the markets, necessitating China to further tighten capital outflow restrictions.  The depreciation’s positive medium term effects on exports hoped for by the government was counterbalanced by the immediate capital outflows, restricting local liquidity to the extend the PBoC reduced bank reserve requirement ratios in an effort to boost local liquidity in response.

The ‘vicious cycle’ nature of speculative money flows is one case for capital movement controls which is apparently against the concept of a totally free market.  However there is some evidence that the number of financial crises in the last 20 years has increased in tune with decreased capital controls worldwide, leading to the recommendation for measured capital controls to limit the volatility caused by these speculative flows.


8.6     Appendix Six : China’s aging population and Peak WAP

As shown above, China’s working age population (15-64 years) is forecast to have either peaked, or be shortly peaking.  This combined with a large and growing aging population (65+) will lead unavoidable to declines in the participation rate.


8.7     Appendix Seven : Growth Theories Summary


Classical (Malthusian) Neo-Classical New Growth
Population Growth of Real GDP temporary : GDP growth leads to explosive Population growth, which reduce standard of living back to subsistence..i.e. population rise is the problem as resources are used up.  Population the source of falling GDP per person GDP and income growth drive lower birth rates (higher women’s incomes lead to higher opportunity cost of children) and death rates (better health care) leading to low and stable population growth Population & unlimited wants + incentives drive pace of discovery.  Higher population = more wants which drives innovation → higher labour productivity →↑GDP/person.
Technology Without advances don’t grow. Random technological change drives saving and investment that rises capital per labour hour…growth stops if Tech change stops (dim marg rtns on capital). Prosperity lasts (stable pop) but growth stops unless technology keeps advancing Incentives drive tech innovation. More people – more drive – physical capital accumulates and real interest rate falls.  Insatiable desire for higher standard of living.  No ‘brake’ : more
Pace of technology drives growth, but growth does not drive pace of tech – tech is random Discoveries a public good (zero opp costs).  Knowledge is Capital that does NOT have diminishing marginal returns (no opportunity cost)
Can’t keep growing just by capital accumulation – it levels off. “the growth rate depends only on people’s incentives and ability to innovate”


8.8     Appendix Eight : Economic Stability


It must be understood that idle capital will still deteriorate and become obsolescent even though it may not be currently engaged in production (during a recession), and unemployed workers quickly forget ‘knowhow’ related to a specific job.  Therefore it is critical that for maximum economic efficiency to be maintained, economic growth be as stable as possible, without fluctuations in output above and below the natural rate of unemployment unnecessarily wasting precious human and physical capital.  This is where the role of monetary and fiscal policy comes in, and the Government’s need to use these tools to promote stable growth with predictable levels of inflation and expected inflation.  Unpredictable inflation draws resources away from productive use and towards speculation.


8.9     Appendix Nine  : A discussion concerning Re-Balancing of China’s economy


With the growth of China’s economy seemingly a result of large scale investment in infrastructure and productive industrial capacity, there has been much comment about the need for the Chinese economy to ‘rebalance’ away from export lead growth, towards growth driven by higher levels of domestic consumer demand.

The argument is that with higher domestic consumption, the slowing in exports brought about by the slowing world economy would be offset and Chinese growth would be less volatile.

The problem with this argument is however that the slowdown in the Chinese economy is primarily a structural slowdown of growth in potential GDP, not a lack of domestic demand.  China’s historic high rate of savings, and associated low levels of domestic consumption have in fact helped provide cheap finance to the State Owned Enterprises that drove much of the growth in GDP.

Rather than put policies in place to specifically grow domestic consumption (for example putting an even lower cap in deposit interest rates ), rising incomes will naturally lead to an increased proportion of income being consumed rather than saved – i.e. an increasing income elasticity of demand.  Higher incomes and a better social safety net would reduce the necessity to save for retirement or a rainy day in the minds of Chinese consumers.


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