China's Prices and Policies Under Global Inflation
Daofu CHEN
There are various indicators to measure the overall price level, each reflecting
price fluctuations from different dimensions and aspects, including CPI, PPI
and GDP deflator. From the perspective of monetary policy, to maintaincurrency stability, the focus is on changes in the overall price level after
excluding the influences of technological advancements, improvements in thequality and quantity of goods and services. In other words, the focus is therelative changes in monetary prices. Since the 1980s, the world entered aperiod of low inflation and even experienced low-interest rates with low
inflation for some time. However, in recent years, major global economies,
except for China, have experienced inflation again. The causes of this roundof inflation are complex, involving both cost-side and demand-side factors,
accompanied by structural ones. China used to be a significant contributor to
global low inflation and is currently experiencing quasi-deflationary
conditions in the global inflationary environment.
I. Price Trends Since China's Reform and Opening-Up
1. Four Rounds of Inflation (Pressure) and Their Governance Practices
Since the Reform and Opening-Up in 1978, China has experienced four
significant rounds of inflation, which were effectively managed throughreforms and macroeconomic policies, particularly through successful
monetary and financial policies.
a. Inflation and Its Management In 1984
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In 1984, building on the successful reforms in rural economy, China
accelerated the reform of its urban economic system and promoted theestablishment of specialized banks in the financial sector. Against thisbackdrop, China experienced its first inflation since the initiation of reformand opening-up. The year-on-year growth rate of retail prices surged from 3.1%
in December 1984 to a peak of 10.9% in September of the same year andremained above 10% for the remaining four months. This was linked toexcessive expansion in investment, consumption, and bank credit in 1984.
Industrial production increased by 16.3% that year, fixed asset investment inunits of comprehensive ownership grew by 24.5%, wage-related cash
expenditures rose by 26.2%, significantly surpassing the 13.6% growth innational income for the year. Bank loans increased by 32.8% year-on-year,
rising by more than 20 percentage points, and cash injection amounted to 26.2
billion yuan, 2.9 times that of the previous year. This substantial increase inbank loans and cash injection was related to the new credit fund management
method introduced that year. According to the new credit fund management
method, financial institutions were allowed to issue a large amount of loans
and inject cash at the end of 1984 in a bid to secure a higher base.
In response, the Chinese government (State Council) issued the 'Urgent
Notice on Strictly Controlling Fiscal Expenditure and Vigorously Organizing
Monetary Tightening' in November 1984, implementing economic andmonetary contraction policies. The main measures included strict control of
fixed asset investment, stringent control of fiscal budget expenditures, and theuse of the newly established central banking system and credit management
system to implement monetary and credit policies to tighten the money supply.
The policy effects were extremely significant. After more than a year ofefforts, by 1986, the growth rate of fixed asset investment had declined to
18.7%, dropping by more than 20 percentage points. Wage-related cash
2 / 29expenditures grew by 20.8%, falling by 5.4 percentage points. The year-onyear growth rate of retail prices decreased to around 6%, and the money
supply growth dropped to 12.3%.

b. Inflation and Its Management in 1988
1988 marked the most severe inflation in China's history after the initiation ofreform and opening-up. The year-on-year growth rate of retail commodity
prices reached its peak in February 1989 at 27.9%, and the overall retailcommodity price increase for the entire year of 1988 was 18.5%. The
Consumer Price Index (CPI) rose by 18.8% that year. In August of the same
year, there was a frenzy of commodity purchases from south to north, leading
to a run on deposits in banks, causing negative growth in urban and rural
residents' savings deposits for that month.
This inflation was related to the government's push for demand expansion andbreaking through price barriers during the economic transition process.
China's coastal regions began participating in the international economic
cycle of 'import more, export more,' while the central and western regions had
to catch up. The nation as a whole pushed for comprehensive price increases.
In 1988, industrial production increased by 20.8%, and fixed asset investment
3 / 29grew by 23.5% year-on-year, leading to extreme shortages in energy, rawmaterials, and transportation capacity. In terms of monetary credit, bank loans
increased by 16.8% year-on-year, and cash injection reached nearly 68 billion
yuan. The year-end money supply growth rate increased by 46.7%, second
only to the 49.5% growth rate in 1984.
To manage this inflation, the People's Bank of China, under the leadershipand support of the State Council, implemented a contractionary monetary
policy. The State Council issued the 'Decision on Further Controlling
Currency and Stabilizing Finance,' supporting the People's Bank of China's
monetary tightening measures. The People's Bank of China adopted a
combination of direct and indirect controls to achieve monetary credit
contraction. Specifically, they intensified control over the total amount ofmonetary credit, reinstated mandatory planning management for loan sizes,
and utilized indirect control tools such as statutory deposit reserve ratios,
deposit and lending interest rates, and special deposit accounts.

The primary approach was to use monetary credit tools to manage inflation,
which was more direct and effective but had significant side effects. The
People's Bank of China only took measures to control inflation from August
1988. By September, savings deposits started to rise, and industrial production
4 / 29and fixed asset investment began to decline from November. In 1989, theyear-on-year growth rate of bank loans decreased to 17.5%, and cash issuance
dropped to 9.1%. Meanwhile, industrial output decreased by 6.8%, and fixed
asset investment declined by 11%. The GDP growth rate plummeted from
11.3% in 1988 to 4.1%, but CPI remained high at 18.0%. By 1990, GDP
growth continued to decrease to 3.8%, and CPI dropped to 3.1%. The
economy entered a recession, with insufficient industrial activity, increased
employment pressure, and severe accumulation of unsold goods.
c. Inflation and Its Management in 1993-1994
In 1992, Deng Xiaoping's Southern Tour Speech inspired the market vitality,
leading to a real estate and development boom in the latter half of the year.
Fixed asset investment surged by 61.8% year-on-year in 1993, causingwidespread tension in infrastructure and basic industries. Retail prices
increased by 13.2% in 1993 and rose by 21.7% in 1994. Consumer prices roseby 14.7% in 1993 and 24.1% in 1994. Retail price growth reached its peak in
November 1994 at 25%, and consumer price index growth hit its highest point
in September 1994 at 27.3%. Cash injection and credit growth rates were alsohigh during these years, with a year-end money supply growth of 36.4% in
1992, 35.3% in 1993, and 24.3% in 1994. Financial irregularities such as
chaotic fundraising, lending, and interest rate hikes emerged, with a large
amount of credit flowing into real estate and stock markets. This round of
inflation was accompanied by a significant and rapid devaluation of theChinese yuan against the US dollar, depreciating by 45% from November
1992 to May 1993, further exacerbating domestic inflationary pressures.
The inflation in 1993-1994 was caused by economic overheating. To address
this, the central government and the State Council implemented 16
comprehensive measures to eliminate inflation caused by economic
overheating. In the financial sector, efforts focused on rectifying the financial
5 / 29order and employing financial tools to enhance macroeconomic regulation.
Measures included cracking down on illegal activities such as chaotic lending,fundraising, and interest rate hikes. The 'Three Guarantees' policy was
implemented to protect state-owned enterprises, key construction projects,
and agriculture. Interest rates on deposits and loans were raised twice, andefforts were made to encourage savings and accelerate cash circulation.
The inflation in 1993-1994 lasted for a relatively long period and was
effectively controlled only in 1996. In that year, the year-on-year retail priceincrease dropped to 6.1%, the consumer price index growth rate decreased to
8.3%, and the economic growth rate fell to 9.7%. However, in 1997, China
faced the Asian financial crisis, leading the country into a practice ofmanaging deflation.

d. Inflation Pressure and Its Management in 2004 and 2007
In 2002, China joined the WTO, initiating deep integration with the global
economy. In 2003, China started the market-oriented process for real estate,
6 / 29and local governments began urban development, accelerating infrastructure
construction. With China's sustained high-speed growth, labor and input
factors such as industrial raw materials and energy became relatively scarce,
leading to a rapid rise in global commodity prices. This, in turn, affected
China's Producer Price Index (PPI) and Consumer Price Index (CPI) throughimports, resulting in significant inflation pressures at the end of 2004 and the
beginning of 2008. The year-on-year growth rates of all industrial prices
reached their respective peaks in October 2004 (8.4%) and July 2008
(10.03%). Similarly, the year-on-year growth rates of the consumer priceindex reached their peaks in July 2004 (5.3%) and February 2008 (8.7%).
Persistent inflationary pressures existed from 2003 to the first half of 2008,
which were related to China's excessive trade surplus, overly rapid growth in
fixed asset investment, and excessive monetary and credit expansion during
this period. This round of inflation pressure was also accompanied by thecontinuous rise in real estate market prices and the appreciation of the RMB
exchange rate.
To address this inflationary pressure, the People's Bank of China implemented
a prudent monetary policy, using a combination of open market operations,reserve requirement ratios, benchmark interest rates for deposits and loans,and reforms in the interest rate and exchange rate systems to maintain relative
market stability.

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2. Uniqueness of China's Inflation Mechanism and Governance
Methods
a. China's inflation is always related to some form and degree of supply
constraints, often accompanied by economic and social structuraladjustments and the development of industries (factors).
The three major inflations in China all occurred during periods of economic
scarcity. The inflation pressures in 2004 and 2007 were related to China's realestate, infrastructure, and export growth, causing relative shortages in global
commodities. Before the reform and opening-up, China established arelatively complete heavy industrial system. After the success of rural reforms,
shortages emerged in light industry, followed by shortages in durable goods,
all accompanied by shortages in infrastructure and basic industries such astransportation and energy. During inflation and its governance, China not only
utilized idle land, labor, and environmental resources but also established a
8 / 29relatively complete and competitive industrial system. Consequently,
industrial and social structures changed accordingly. After prolonged highgrowth in fixed asset investments, China faced overcapacity and deflation.
China initiated the process of real estate marketization, which, in turn,improved infrastructure. China also joined the WTO, integrating into global
development. Prolonged high growth depleted China's previously abundant
low-cost labor force and created a substantial demand gap for global energy
and raw materials. This led to rising prices in the service industry, energy, andraw materials. As China gradually integrated with the world, the RMB
exchange rate appreciated, accompanied by rising domestic prices of nontraded goods such as real estate.
China's experience with inflation provides an insight: sometimes, economic
and social structural adjustments need to be achieved through inflation (asset
bubbles). Inflation can be seen as a dynamic improvement for market
insufficiencies, one of the mechanisms for economic structural adjustments.
Overlooked and unseen values, once widely recognized and restored in supply(with limited supply elasticity, typical products being real estate,
infrastructure, and public services such as hospitals and education), canimpact relative price systems within specific time frames. By supporting priceincreases in deficient areas through monetary expansion, inflation triggers
adjustments in the relative price system, achieving significant adjustments inthe benefit structure and, consequently, in social structure, all in anenvironment with relatively minor pains.
b. Price Barrier Breaking and Release of Suppressed Price Pressureduring Transition
China's inflation is related to its transition from a planned economy to amarket economy. Under the planned economy, there was no price system, andall material circulation was closed and operated under administrative
9 / 29commands. With the shift to a market economy, there was a gradual allowance
for supply-demand relationships outside the system, leading to the emergenceof a price system outside the planned economy framework. In times of scarcity,
besides price adjustments, supply-demand relationships were balanced
through non-market methods such as rationing and queuing.
As market prices were liberalized, especially during the significant pricebarrier-breaking in 1985, many supply-demand gaps that were previously
balanced through non-market methods were now balanced through priceincreases. This led to a substantial rise in prices, making implicit inflation
explicit. However, China's experience also showed that during significant
periods of supply-demand relationship adjustments, especially when pricecontrols and other balancing mechanisms were in place, there were motives
such as market manipulation that prolonged the adjustment period tomaximize the interests of certain entities. Examples include rent-seeking andspeculative behavior during the period of China's dual-price system, andcontrol over land prices and the real estate market during periods ofsignificant real estate price increases.
Prices reflect the process of discovering and acknowledging value, as well as
imbalancesin

supplyanddemand.

Therefore,

major

economictransformations, technological changes, and other processes lead to priceadjustments, which are necessary for upgrading and transforming the
economy. During significant adjustments in the domains and mechanisms ofsupply and demand, prolonged or short-term inflation often occurs. Comparedto implicit mechanisms for supply-demand balance, the price mechanism isthe least dissipative mechanism for value. However, up to now, China still
experiences some implicit inflation, indicating the need for attention to theways in which pressure is released.
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c. Non-Market Goals and Soft Budget Constraints Exacerbating
Inflation
Entities with non-market goals and budget soft constraints are outsiders in amarket-oriented economy. They can inject additional demand into theeconomy beyond economic cycles, but they can also lack constraints, leading
to greater economic fluctuations. The theory of financial cycles, to someextent, regards the central bank-dominated financial system as an outsider inthe market economy, exacerbating economic cycles. In the process of China's
economic development, different types of entities with non-market goals andbudget soft constraints existed at different times. Typically, local governments
and state-owned enterprises (SOEs) are considered entities with non-market
goals and soft budget constraints. However, during periods when bankruptcy
mechanisms were not well-established, there were specific historical periods
where regular enterprises and individuals also transformed into entities with
non-market goals and budget soft constraints. This transformation occurredespecially when there were rigid redemption requirements for individuals andimplicit government unlimited liability.
Impulses for investment and habitual investment, as well as the expansion of
consumer funds (related to benefits for state-owned enterprise employees,
among other factors), have consistently been important driving factors for
inflation during periods of scarcity. China's market entities have not reachedthe legal sense of an independent legal person according to corporate law.
Decision-making and risk-bearing are not entirely independent, and to someextent, market entities also possess non-market goals and budget soft
constraints. Therefore, not only during scarcity periods and not only in China
but also in more developed areas of market economies, factors related tosocial welfare and the protection of vulnerable groups still exist. These factors
lead to non-market behaviors, such as the rise in wages due to labor unions
and rigid expenditures on social welfare. These factors, when combined with
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supply shocks, can contribute to demand-driven inflation, forming a selfrealizing loop of inflation.
d. Monetary Credit Always Supports Inflation to Some Extent
Every inflationary episode in China has been accompanied by a significant
increase in monetary credit. During the inflations in 1984 and 1988, when thecommercial banking system had not yet been established, credit was strictly
controlled through planned directives. The expansion of monetary credit
mainly manifested as a substantial increase in supportive cash injections
driven by market demand. In the inflations of 1993-1994 and 2004-2007,
there were instances of 'financial chaos' and a substantial increase in credit
volume.
China's experience with inflation demonstrates that whether under planned
directives or in relatively market-oriented environments, China's monetarycredit system has adopted decision-making mechanisms with selective
characteristics. Consequently, there have always been sufficient reasons andinherent drivers supporting later-stage inflation. However, given that China's
economy and finance are continually evolving, especially within a multilayered and multidimensional management system employed by thegovernment in economic and financial domains, it is not suitable to introduce
a rule-based monetary policy framework. The specificity of China's monetary
policy transmission is discussed in the following section.
e. Inflation is Both a Result and a Means; Governance is Needed for the
Self-reinforcing Loop of Inflation
Analyzing various factors and their impact on inflation comprehensively,
inflation only becomes a possible candidate for "getting out of control," or inother words, requiring governance when it forms a self-sustaining inflation
cycle. Countries generally experience self-sustaining inflation triggered by
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the 'wage-price' cycle. China has also seen 'wage-price' cycles at different
times. However, apart from this, China has witnessed a unique 'consumptioninvestment' cycle that leads to sustainable price increases. Developing
countries often have low income levels, but to enhance long-term economic
growth, they need to increase savings to expand investment and raise percapita capital stock. Some specialized equipment also needs to be imported.
Therefore, it is necessary to delegate authority and offer incentives tostimulate the enthusiasm of microeconomic entities, expanding the consumer
fund while simultaneously increasing investments for future higher economic
growth.
China has adopted two specific approaches, in addition to balancing macro
policies. One approach is to slow down the demand for foreign exchange andsavings funds required for capital imports through the 'three reductions andone supplement.' The other approach involves implementing market-oriented
transitions sector by sector, known as the 'scissors strategy.' Historically,
China has used the 'scissors strategy' to redistribute the benefits of ruralmarket reforms to urban and industrial sectors, mitigating potential
inflationary pressures. Later, it used the 'scissors strategy' in areas such as thenortheast and coal-rich provinces, differentiating costs to alleviate priceshocks. During the period of massive real estate development, cross-subsidies
were achieved through the price differentiation of industrial land, effectively
managing the inflationary impact.
3. Financialization has Impacted the Price Transmission Mechanism
Observing the inflation in 2004 and 2007, as well as the price recovery after
the economic recovery in 2008, phenomena like "flour being more expensive
than bread" have appeared. The financialization of commodities has
significantly influenced the traditional price adjustment mechanism.
Commodities are no longer just 'goods' but have prominent 'asset'
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characteristics, and their prices are mainly based on anticipated fluctuations.
With ample market liquidity and expectations of increased demand forcommodities during economic recovery, commodity prices adjust rapidly in ashort period. This leads to two consequences. First, it reduces the enthusiasmof commodity producers to quickly resume production. In the current
environment, increasing production cannot further enhance profits and mighteven reduce them. This hampers the proactive expansion of production bycommodity producers, affecting the rate at which supply-demand gaps arefilled. Second, the price adjustment mechanism along the industrial chain
shifts from demand-driven profit to cost-sharing, decreasing price adjustment
efficiency. In normal adjustment logic, when demand slightly recovers, lower
upstream prices can provide a price difference (profit) for the recovery of enddemand. However, commodity prices preemptively reflect the economic
recovery effect, causing an inverted price difference. This not only inhibits
demand recovery but also squeezes profits in the midstream industry, turning
economic adjustments into inefficient cost sharing.

When observing prices within a broader framework, at least three parallelworlds of prices can be identified. One is the prices denominated in currency
formed by the supply and demand of goods and services in the physical world.
The prices in upstream factor markets and their conversion and absorption by
manufacturers in the middle and downstream become the supply in the market
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for goods and services. Market demand is influenced by purchasing power
derived from income and wealth conversion and also by purchasing power
created by the financial system's credit creation. The former is related tostructural issues like income distribution and aging, while the latter is related
to the expectations and capabilities of the financial system. Another world isthe financial world, where the supply side consists of asset providers,
including securitization of existing wealth and capitalization of future projects,
and the demand side consists of asset seekers. Supply and demand form asset
prices, which represent the pricing and competition for future economic
models. The physical world and the financial market merge and influenceeach other. The third world appears in the digital space and representscompetition based on rule-formed ecosystems.
4. The Uniqueness of China's Monetary Policy Transmission
Examining the history since the People's Bank of China specifically exercised
central banking functions in 1983, China's financial system and monetary
regulation methods have undergone several adjustments. There is still nouniversally recognized indicator to measure the efficiency of monetary policy
transmission, but from empirical observations, the transmission of monetary
policy has been relatively smooth during two periods.
First is the period of strict scale control. During this time, China's monetary
policy and financial regulation were unified within the central bank. China
did not allow inter-corporate financing, except for exemptions for personal
financing. The capital market was underdeveloped, and financial activities
were concentrated within the banking system. Under strict industrial policy,
controlling credit expansion and credit scale, in reality, controlled money
supply and market behavior. However, this approach also brought rigidity andfaced the dilemma of "over-effective transmission," as it was influenced by
the saying, "once loosened, chaos follows; once tightened, stagnation occurs."
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Second is the period when foreign exchange deposits dominated money
supply. During this time, the transmission of monetary policy was essentiallya bottom-up reverse induction. Enterprises obtained foreign currency due totrade surpluses, and under strict and proportionally enforced foreign exchange
conversion and settlement regulations, they had to sell it to banks (foreignexchange settlement). At this point, deposit money was created. After banksreceived US dollars, they were required to settle with the central bank, forcing
the central bank to inject base money. Excessive base money promoted
domestic credit expansion. The central bank had to freeze a portion of thisexpansion by establishing a "reserve pool" through statutory deposit reserve
ratios and issuing central bank bills, ultimately achieving controlled credit
expansion and monetary supply. During this stage, the overall monetaryenvironment was loose, and the central bank mainly implemented relatively
effective "tightening" policies. Monetary policy transmission was smooth.
During other periods, China's monetary policy transmission efficiency was
not satisfactory. Of course, the reasons are multifaceted. Many periods fell
under policies that aimed for a loose monetary policy, resulting in weakened
efficiency. The breadth and depth of financial markets expanded significantly,
reducing the controllability of credit expansion influenced by money supply.
Additionally, Chinese financial institutions were more concerned about noneconomic factors and financial stability than financial efficiency. They wereless sensitive to policy adjustments aiming at interests. China has
implemented numerous reform measures to enhance efficiency, such as
expanding the monetary statistical scope, adjusting monetary regulation
frameworks and methods, shifting from scale management to proportional
restrictions, then to price corridors, and partially returning to scale control.
Efforts have also been made to establish government bond yield curves andstrengthen the linkage between the credit and bond markets. While the
16 / 29efficiency of monetary policy transmission has marginally improved, it is stillplagued by inefficiencies.
If we step outside the Western black-box approach (which essentially assumes
that microeconomic entities are independent and interest-driven actors) instudying the monetary policy transmission mechanism, penetrate theorganizational black box of financial institutions and enterprises, and return
to behavioral analysis, we will find that China's monetary policy transmission,
to some extent, is not policy transmission but rather coordination andcooperation among government departments. It is not market analysis but acomplex and uncertain game analysis (China's current focus of the game is
not between market entities but between market entities and government
regulatory agencies).
We can use the following diagram to illustrate the government management
behind the operation of China's financial system.

Therefore, each of our controls and policy adjustments is not only an
adjustment of market behavior but also a significant adjustment of the entire
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management system. Policy coordination and integration have always been
the focal point and challenge of government work.
From the perspective of monetary policy transmission, we can attribute thisphenomenon to the insufficient implementation of micro-subject marketoriented reforms; it has not yet "grown up." In recent years, reforms in microsubjects and financial markets, as well as macro-control and regulatory
system reforms, have been optimizing and changing the interaction between
the market and the government. The aim is to transform it into an interaction
among market entities, allowing the government to relatively transcend.
However, up to the present, China's monetary policy transmission still reflects
the result of the complex evolution of a system that combines adjustments inmarket behavior, optimization of government management, financial stability,
and leadership promotion. Especially in an environment where administrative
management predominates and paternalism is prevalent, it is premature to rely
too much on the independent maturity of micro-subjects. It is still necessary
to continue adhering to the primary analysis of monetary policy transmission
based on game theory.
II. Prices and Policies within the China-U.S. Framework
Analyzing China's inflation also requires an analysis within the China-U.S.
framework. When the economies of China and the United States operate in a
China-Americanmanner, the price trends in both countries are highly

correlated. The price indices of production materials are closely related,primarily influenced by commodity prices determined by the international
market. The fluctuation range of the U.S. Producer Price Index (PPI) isslightly higher than that of China's PPI.

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However, the correlation in price trends measured by the year-on-year growthrate of Consumer Price Index (CPI) between the two countries is not as strongas the correlation in price trends measured by production material prices.
Clearly, the CPI fluctuations in the United States have been relatively stablesince 2000, whereas China's CPI has experienced significant fluctuations.
Specifically, from China's full accession to the WTO in 2002 to the outbreakof the pandemic before 2020, there was a strong correlation in the year-onyear growth rates of CPI between the two countries. However, after theoutbreak of the pandemic, there was a notable deviation between the CPI
trends of China and the United States. Since 2022, the United States has evenentered a high inflation zone, while China has been hovering on the edge ofdeflation.

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Further observation of the relationship between the year-on-year growth rates
of consumer spending in the United States and the year-on-year growth rates
of imports from China reveals a strong correlation between the two. However,this correlation weakened after 2021.

III. China’s Prices and Policies in the Current Stage
1. Main Features of China's Economic Operations
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a. Differentiated Recovery in August, Yet Fragile Foundation
In August, there was a differentiated recovery in social retail sales (up by 4.6%
YoY, accelerating by 2.1 percentage points), industrial value added byenterprises of a certain scale (up by 4.5% YoY, accelerating by 0.8 percentage
points), the service industry production index (up by 6.8% YoY, acceleratingby 1.1 percentage points), and improvements in the year-on-year and monthon-month comparison of goods import and export. The Consumer Price Index(CPI) and Producer Price Index (PPI) also showed slight improvements,
partly due to robust summer tourism spending after strict control ofextracurricular tutoring in August and some companies replenishing theirstocks due to extremely low raw material inventories.
However, the economic recovery's foundation remains fragile, with thepossibility of relapses. Recent indicators reflect signs of insufficient intrinsic
economic vitality:
M1 growth rate continues to decline. In August, the M1 growth rate wasonly 2.2% YoY, 0.1 and 3.9 percentage points lower than the end of theprevious month and the same period last year, respectively. M1 is morereflective of economic activity; its low and declining rate indicates subdued
economic activity.
Bulk commodity futures prices have diverged. While earlier increases inbulk commodity futures reflected restocking behavior in the raw materials
sector, recent prices have shown significant divergence. Prices of domestic
demand-supply-related commodities like rebar and hot-rolled coil havedecreased significantly, while commodities related to overseas markets suchas steel, coking coal, petroleum, etc., have remained strong. This indicatesweak domestic supply and demand.
21 / 29Fixed asset investment continues to decline, especially in the real estate
sector, where most indicators related to development and sales are stilldecreasing.
b. High M2 and Social Financing Growth, Low Inflation and GDP
Growth, Widespread Micro-Entity Debt Swaps
In August, M2 grew by a high 10.6% YoY, social financing increased by 9%
YoY, but CPI and PPI were only 0.1% and -3%, respectively. Corporate
weighted average lending rates have reached their lowest point in available
data history, yet monetary easing has not significantly stimulated economic
growth. Correspondingly, various micro-entities have engaged in widespreaddebt swaps. Residents continue to increase savings and reduce various loans,the government is conducting comprehensive debt swaps, and businesses areobserved swapping high-interest-rate debt for lower-interest-rate debt.
China's low interest rates and monetary expansion primarily support thesemicro-entity debt swaps.
c. Macroeconomic Liquidity is Reasonably Abundant, but Micro-Entity
Liquidity is Scarce
In August, the interbank RMB lending and repurchase rates were 1.71% and1.76%, respectively, indicating relatively abundant liquidity in the money
market. However, corporate receivables and bills remain high, and in someregions, private enterprises are reluctant to undertake government projects
due to their inability to handle project debts. The situation is worsened by thepartial collapse of China's private lending market. Many private enterprises
are struggling to repay debts, and regions where private lending was once
active now witness borrowers openly refusing to repay, disrupting themarket's credit mechanism. Foreclosed property numbers have rapidly
increased this year; enterprises facing liquidity shortages are selling
properties, exacerbating liquidity scarcity, especially for micro and private
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enterprises.
d. Market Confidence is Still Insufficient and Fragile
Market confidence remains low recently, reacting sharply to negative news
while showing

sluggish responses

to positive news

and recent

macroeconomic growth. Several concerning trends include:
Continuous outflow of foreign capital: The People's Bank of China's
disclosed Foreign Direct Investment (FDI) hit historical lows, dropping by asignificant 87.1% compared to the same period in 2022. Securities markets
have witnessed continuous net outflows of northbound funds in the third
quarter (accumulating a net outflow of 123.951 billion RMB from August 1
to September 26). Long-term funds that invested in China have largely exited,with a noticeable decrease in attention to the Chinese market, primarily fromshort-term investment hedge funds. Several international investment
institutions have recently withdrawn their operations from Shanghai,
reflecting not just concerns about short-term economic fluctuations but alsoquestioning China's medium to long-term issues, such as population, debt,
real estate, etc., with growing pessimism about China potentially experiencing"Japanization."
Lack of confidence in domestic asset markets: "Sell on the peak" behavior
is widespread. The stock market continues to fluctuate, often unexpectedly.
There have been multiple market fluctuations inconsistent with policy
intentions, showing brief upward trends in response to policies but quickly
dropping afterward. After the introduction of the "recognize the house, not theloan" policy in the real estate market, the number of second-hand listings
increased rapidly, but the duration of increased transaction volumes in thesecondary market is limited. This is related to the need for the sale of existing
properties before purchasing new ones and reflects low market confidence.
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Continuous pressure on RMB/USD exchange rates: Due to a strong US
dollar index, significant interest rate differentials between China and the US,
and the window for international students' tuition payments, the RMB/USD
exchange rate has been continuously depreciating recently. The central bankhas taken several measures, including issuing central bank bills in Hong Kongand reducing the reserve requirement ratio for domestic US dollar deposits.
However, the effects have been limited. The market is concerned that outflows
of northbound funds, withdrawal of institutions, and increased relative RMB
supply through currency swaps with some countries are adding pressure on
the RMB/USD exchange rate. China's domestic gold prices are significantly
higher than international gold prices, reflecting the not fully reflected pressureof RMB depreciation against the US dollar (international board gold price453.8 RMB/g, implied RMB/USD exchange rate 7.43; international board
gold price 473.1 RMB/g, implied exchange rate 7.74).
2. Fundamental Factors in the Current Economic Trends:
a. Pains and Differentiation Under Structural Transformation:
China is currently undergoing unprecedented structural changes. Various
sectors are undergoing significant transformations, such as the rapid
development of the digital economy, environmental protection industries,
especially new energy vehicles, and some high-tech sectors. However, thecurrent GDP measurement method might not fully reflect these newcontributions. Additionally, the transformation in the real estate industry,changes in export patterns, and the impact after the relaxation of pandemic
control measures create significant challenges. In an environment where
market differentiation is severe and predicting pains and possible nonlinearchanges is difficult, forming consensus on the situation and policy responses
is challenging.
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b. Rapid Decline in Real Estate and Exports:
China is transitioning from an economic model supported by "real estate+ exports" and debt to a model supported by "investment + consumption" andequity. However, real estate and exports remain vital components of China's
economic growth. The simultaneous significant decline in both areas creates
substantial demand shocks for the Chinese economy in the short term. The
new economy and post-pandemic consumption rebound are not sufficient tooffset these shocks. Additionally, existing debts built upon previous demandlevels face real pressure. Hence, there is a sudden emergence of significant"demand gaps" and "risk exposure."
Special attention needs to be given to the secondary impact of the realestate market adjustment on China's financial system. Considering China's
relatively high down payment ratio and strict control over developers'
development loans, the direct impact risk of real estate market adjustments on
the financial system is generally controllable. However, real estate is an
essential channel for credit expansion in China. Rapid contraction may leadto a shrinkage in credit creation. The value-added of the real estate industry
and its upstream and downstream industries accounts for a high proportion ofChina's GDP. Its adjustment, especially coupled with a decrease in exports,
reduces demand and has a multiplier effect on the national economy.
Additionally, China's real estate market is closely related to the land market,
and fluctuations in land finance have a significant impact on local
governments' fiscal revenues and debts. Therefore, considering various
indirect impacts, the rapid adjustment of the real estate industry will
inevitably bring a secondary shock to the financial system, a risk that needs
high attention. This is also a matter of concern domestically andinternationally.
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The secondary impact involves multiple aspects and lasts for a long time.
Therefore, measures should be taken comprehensively in various areas,
including the real estate industry, the financial industry, and macro demand,to alleviate risks and offset the shrinkage in demand effectively.
Land finance is related to China's significant increase in infrastructure andurban operation demands. However, considering that the latter has become
quite mature, the so-called "land finance gap" mainly reflects historical stock
deficiencies rather than future additional demands. China's land revenue has
been somewhat pre-empted by capitalization in a historical sense, and there
is already a "boundary." Many local governments are actively establishingvarious government-sponsored industrial investment funds, promoting theestablishment of local modern industrial systems, reflecting deep-seatedchanges in government behavior logic. Therefore, as long as there is abreakthrough in the previous understanding of demand stimulus means anddebt, China has the conditions to creatively mitigate the adjustment shockrisks in real estate, land finance, and debt.
c. Micro Entities Adopting Risk-Averse and Low-Desire Behavior
Patterns:
China's micro-entity behavior patterns have undergone significant
changes, profoundly affecting the assessment of economic trends and policy
effects. In an environment of high uncertainty due to a large number of
unpredictable and uncontrollable factors over a long period, Chinese
economic entities have exhibited characteristics of being risk-averse andhaving low desires. Enterprises, residents, and governments havesignificantly reduced their risk preferences and increased risk reserves. For
example, residents are increasing precautionary savings and downgrading
consumption, businesses are reducing risk investments, and governments arefocusing on immunity from responsibility, among other behaviors. China has
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also witnessed certain low-desire social characteristics, such as the emergenceof the "Three-Not Youth" (those who do not get married, do not buy houses,and do not have children) and various "lying flat" phenomena. Currently,
China is promoting structural adjustments in the economy under the
expectations and reality of "living tight," leading to profound changes in
micro-entity behavior patterns.
3. Debate on Three Economic Policy Approaches:
In the face of the complex current economic situation, there are three debatedpolicy approaches in China:
a. Intensifying Short-term Demand Stimulus:
This approach argues that insufficient demand is the primary contradictionin the current economic operation. Short-term changes in economic structureor the short-term stimulating effects of structural policies are not significant.
To avoid economic "shock," it is necessary to adopt demand-stimulating
policies, even if they might have significant side effects or limited
effectiveness.
b. Structural Reforms to Break the Stalemate:This approach believes that short-term policies need to be consideredwithin the framework of long-term growth. The effectiveness of demand
stimulus policies has become increasingly limited in recent years and cannot
sustain economic growth. Since some types of structural reforms havesignificant demand-stimulating effects, it is suggested to focus on
fundamental structural reforms to achieve stable and high-quality economic
growth.
c. Seeking Solutions Outside the Economic Sphere:
This approach, predominantly advocated by overseas experts, suggests
exploring solutions beyond the economic domain since there seems to be no
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clear short-term or long-term solution in the economic field.
The debate on policy approaches reflects significant differences in thecomprehensive assessment of China's economic mechanism and state. In
reality, China's current economic operation lies between the short-term andlong-term. China's potential growth rate is gradually declining, and somestructural changes in recent years have exacerbated the rate of potential
growth decline. It is generally believed that this year's economic growth,
especially measured by the two-year average growth rate, is below thepotential economic growth rate. There are still idle resources, such as
unemployment and excess production capacity, which are reflected in low
inflation. This implies that China still has room to increase economic growththrough demand stimulus policies. However, it is challenging to determine
whether China's current "unemployment" and "excess production capacity"
can still be absorbed into economic growth or if they are ineffective and need
to be eliminated. The concept of potential growth is not easily visible and ishighly comprehensive, making it difficult to assess the situation and form a
consensus.
In reality, the current difficulties and challenges in China's economic
operation result from a combination of systemic, structural, and cyclicalproblems. The catch-up economic growth driven by factor inputs, especiallythe economic cycle supported by "real estate and exports" and debt, isunsustainable. China needs to shift toward innovation-driven high-quality
development. This requires China to build institutional mechanisms andmodern industrial systems compatible with high-quality growth. However,the past economic growth model and economic cycle have left behind an
economic structure and debt burden that are no longer sustainable. This
manifests as structural contradictions and risks in real estate, debt, andfinancial institutions. Additionally, the past three years of pandemic and the
28 / 29technological blockade from the United States, along with the industry chain
differentiation strategy of "China+1" have placed additional demand shocks
on China.

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