Return on assets

China: Mao Strikes Back

China is now a top-rank, market-moving source of daily news. It is not only the world’s second largest economy, but over the past decade, it accounted for nearly thirty percent of global economic growth. No wonder stories about a slowdown in China and trade conflict with the United States send shudders through financial markets. As conditions are worsening, uncertainty has jumped to record levels in China and elsewhere.

In the near term, if China and U.S. trade negotiators can come to an agreement avoiding a further hike of U.S. tariffs, some of this heightened uncertainty may fade. But a more persistent source of risk arises from China’s medium- and long-term growth prospects. While the country has sustained 6%-plus growth since 1991, in recent years it has done so by increasing investment per unit of growth. The prominence of these diminishing returns from incremental capital outlays lead many informed observers to conclude that a further medium-term deceleration is inevitable. Worries about the sharp increase in nonfinancial corporate debt over the past decade, and the lack of transparency regarding the risks in China’s financial system, only serve to compound this pessimism.

Given these circumstances, Nicholas Lardy’s excellent new book, The State Strikes Back, could hardly arrive at a better moment. Using careful analysis to challenge common hypotheses, Dr. Lardy takes a close look at the principal factors affecting China’s longer-run growth prospects. Ultimately, he is hopeful, but realistic: China could sustain its recent pace of growth for an extended period—or grow even faster—but only if the government is willing to return to its earlier commitment to serious reforms that favor market, rather than state, allocation of resources. So far, despite the prominent market advocacy in its 2013 “policy blueprint”—the first under President Xi Jinping’s leadership (see the opening citation)—the Xi government has shifted in precisely the opposite direction.

In the remainder of this post, we explore Lardy’s conclusion that China’s growth potential remains high. On the key issues of substance, his logic is compelling. A combination of the opportunities generated by convergence to advanced-economy productivity levels, continued improvements in competition and trade, and a renewed shift toward the private allocation of resources—especially through changes in the structure of both state-owned enterprises and the financial system—points to the possibility of a return to higher growth. Nevertheless, we find ourselves somewhat less hopeful. Even if China’s government were to make fundamental economic reform its top priority, in our view the odds favor a further slowdown over the next decade….

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Negative Nominal Interest Rates and Banking

The financial crisis of 2007-2009 taught us many lessons about monetary policy. Most importantly, we learned that when financial systems are impaired, central banks can backstop both illiquid institutions and illiquid markets. Actively lending to solvent intermediaries against a broad range of collateral, purchasing assets other than those issued by sovereigns, and expanding their balance sheets can limit disruptions to the real economy while preserving price stability.

We also learned that nominal interest rates can be negative, at least somewhat. But in reducing interest rates below zero―as has happened in Denmark, Hungary, Japan, Sweden, Switzerland and the Euro Area―policymakers face concerns about whether their actions will have the desired expansionary effect (see here). At positive interest rates, when central bankers ease, they influence the real economy in part by expanding banks’ willingness and ability to lend. Does this bank lending channel work as well when interest rates are negative?

Why should there be any sort of asymmetry at zero? Banks run a spread business: they care about the difference between the interest rate they charge on their loans and the one they pay on their deposits, not the level of rates per se. In practice, however, zero matters because banks are loathe to lower their deposit rates below zero….

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