China's economy may have slipped into a “liquidity trap”

Data: FactSet, People’s Bank of China; Chart: Axios Visuals

The world’s second-largest economy may be in treacherous macroeconomic terrain known as a “liquidity trap.”

Why it matters: China’s massive economy has been the main source of global economic growth for most of the last three decades.

  • While it had long been expected to slow from the double-digit growth rates it regularly hit between 2000 and 2010, its current performance is far worse than many forecast just a few years ago.
  • For instance, prior to COVID in early 2020, the IMF expected China to grow at an annual rate of just under 6% in the coming years. (Over the last six quarters, growth has averaged less than 3.5%.)

The latest: China’s central bank cut interest rates again on Tuesday, in yet another attempt to kickstart an economic engine still sputtering in the aftermath of COVID.

Context: It was the most recent attempt to find some way to help the country recover from three years of economic shocks and political swerves that amount to the biggest economic change since the country shifted toward the market system in the early 1980s.

  • The country is also planning a fresh debt-financed infrastructure-building binge, in the hopes of boosting economic activity.
  • Plus, the government has allowed its tightly controlled currency to weaken sharply against the dollar, traditionally a boon to exports.

Yes, but: Some say these tools, which China has long used to manage growth, are increasingly ineffective after the recent shocks.

Flashback: Even before COVID hit, China’s export-focused growth model was facing pressure as a trade war broke out with its biggest trading partner, the U.S.

What is a liquidity trap?

The series of economic blows appears to have done serious damage to the confidence of both consumers and corporate leaders. Demand for loans — the fuel for economic growth — from both groups has dropped.

  • Big shocks — think back to the U.S. in the aftermath of the financial crisis — often mean consumers and companies are slower to respond to government efforts to juice growth by making it cheaper and easier to borrow.

Economists call this state of affairs a “liquidity trap,” and it can be particularly difficult to shake.

  • The concept emerged during the Great Depression in the U.S. and has also been applied to Japan in the aftermath of the early 1990s bust that led to its long battle with falling prices, or deflation.

The bottom line: The traditional way to escape a liquidity trap is through massive government borrowing and spending, something China’s state-led model is ostensibly well designed to do.

  • But President Xi — who has shifted the national narrative away from growth, toward confrontation with the West — may not be prioritizing economic growth the way the ruling Communist Party did under his predecessors.
  • In a recent series of articles aimed at Chinese youth — now facing record unemployment — his advice was to “eat bitterness,” an idiom meaning endure hardship.

What they’re saying: “We don’t expect the government to unleash large-scale stimulus, especially when compared with the 2008-09, 2015-16, and the 2020 experience,” Goldman Sachs analysts wrote this week.

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