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1 Research Division Federal Reserve Bank of S. Louis Working Paper Series Wihsanding Grea Recession like China Yi Wen and Jing Wu Working Paper A hp://research.slouisfed.org/wp/204/ pdf March 204 FEDERAL RESERVE BANK OF ST. LOUIS Research Division P.O. Box 442 S. Louis, MO 6366 The views expressed are hose of he individual auhors and do no necessarily reflec official posiions of he Federal Reserve Bank of S. Louis, he Federal Reserve Sysem, or he Board of Governors. Federal Reserve Bank of S. Louis Working Papers are preliminary maerials circulaed o simulae discussion and criical commen. References in publicaions o Federal Reserve Bank of S. Louis Working Papers (oher han an acknowledgmen ha he wrier has had access o unpublished maerial) should be cleared wih he auhor or auhors.

2 Wihsanding Grea Recession like China Yi Wen a;b and Jing Wu b (This version: March 9, 204) Absrac The Grea Recession was characerized by wo relaed phenomena: (i) a jobless recovery and (ii) a permanen drop in aggregae oupu. Daa show ha he Unied Saes, Europe, and even counries wih lesser ies o he inernaional nancial sysem have su ered large permanen losses in aggregae oupu and employmen since he nancial crisis, despie unprecedened moneary injecions. However, he sympoms of he Grea Recession were no observed in China, despie a 45% permanen drop in is expors one of he larges rade collapses in world hisory since he Grea Depression. Our empirical analysis shows ha China s success in escaping he Grea Recession is aribuable o is bold and powerful 4 rillion renminbi simulus package launched in lae We sudy he precise channels hrough which he simulus programs work in China. We also consruc a simple model o raionalize he dramaically di eren impacs of simulus programs across counries. Keywords: Coordinaion Failure, De aion, Fiscal Muliplier, Grea Recession, Jobless Recovery, Liquidiy Trap, Sae Capialism, Quaniaive Easing, Chinese Economy. JEL Codes: E32, E58, E62, H2, H50. a. Federal Reserve Bank of S. Louis; b. Tsinghua Universiy. Jing Wu, Insiue of Real Esae Sudies and Deparmen of Consrucion Managemen, Tsinghua Universiy; Room 4, Building 0, Tsinghua Universiy, Beijing, P.R.China; Tel: (86) ; Fax: (86) ; Yi Wen, Deparmen of Economics, School of Economics and Managemen, Tsinghua Universiy, Beijing, P.R.China; Federal Reserve Bank of S. Louis, S. Louis, MO Tel: (34) ; We hank Mahias Traband, Pengfei Wang, and seminar paricipans a Beijing Universiy and he S. Louis Fed-Tsinghua Moneary Policy Conference 203 for commens and suggesions, and Judy Ahlers and Maria Arias for ediorial and research assisance.

3 Inroducion Cenral banks and governmens around he world reaced wih unprecedened simulus programs o comba he 2008 global nancial crisis. I was a ime when bold acions and exraordinary measures were needed o preven anoher Grea Depression. According o he Inernaional Moneary Fund (IMF, 2009a, 2009b), he iniial simulus packages in 2008 hrough 200 were as large as 5% of gross domesic produc (GDP) in he Unied Saes and China, while similar-sized packages were also announced and implemened by oher indusrial counries. However, he performances and e ecs of simulus programs vary grealy across counries. In paricular, China was he rs major economy o recover from he nancial sunami. GDP growh in China rebounded o is double-digi pre-crisis rae in lae 2009 (a.4% per year), less han one year afer unveiling is simulus package, and i rose signi canly above is longrun average in he rs quarer of 200 (a 2.2% per year). In conras, GDP growh in he Unied saes and Europe had no recovered o pre-crisis raes as of lae 20 even hough hey reaced o he crisis earlier han China. Mos srikingly, GDP levels in hese developed counries have declined permanenly since 2008 by as much as 0% below heir respecive long-run rends, despie more han 5 years of coninuing quaniaive easing afer he crisis. China s GDP level, however, had fully rebounded o is long-run rend in early 200 wihou appealing o unconvenional moneary policies. Toal indusrial producion in China nearly doubled beween 2007 and 203 despie he crisis and an exremely weak inernaional demand for Chinese goods, whereas he Unied Saes has experienced zero growh in indusrial producion and ha in he European Union and Japan has declined by 9.3% and 7.%, respecively. No wonder China s economic growh conribued 50% of global GDP growh during he crisis (IMF, 200), even hough is income level accouned for less han 0% of world GDP and is oal expor demand has remained 45% below rend since he crisis. I hus appears ha in he wake of he crisis and is afermah, China has proved srucurally and macroeconomically much sronger han developed counries in wihsanding he Grea Recession. Therefore, one canno help bu wonder: Wha is special abou China and is simulus programs? Obviously, China was growing much faser han Wesern counries before he crisis. Bu simply growing faser before he crisis does no make China special in wihsanding he crisis 2

4 (see he deailed analysis in Secion 2). Many Souheas Asian counries, such as Malaysia and Thailand, were growing rapidly before he Asian nancial crisis in 997, bu all plunged ino deep recessions (wih negaive growh raes) immediaely afer he Asian crisis. I is also obvious ha China s nancial secor is no ye fully inegraed ino he global nancial sysem, which may explain China s rapid recovery. However, several major developing counries, such as Russia and Souh Africa, were equally disengaged from he global nancial sysem in erms of oxic nancial asses and banking scandals, ye hese economies su ered large permanen losses in GDP jus like in he Unied Saes (see Secion 2). A key reason for his loss is he collapse of expors: Like China, hese developing economies all su ered a heavy blow o heir expor secors. As did many counries, he Chinese governmen injeced massive amouns of money ino is banking sysem in lae 2008 and Thanks o sharp increases in aggregae invesmen immediaely following he money injecion, he Chinese economy rebounded quickly o is pre-crisis level. How could Chinese banks nd borrowers o lend a massive amoun of credi so quickly o jump-sar a fading economy while he U.S. and European banks were incapable of doing so? Why were Chinese rms willing o borrow o inves when demand collapsed and he fuure appeared so gloomy and uncerain? In his paper, we argue ha he key o China s success is no so much ha China had a double-digi growh rae before he crisis, or because Chinese banks are more solven or more deached from he global nancial sysem han ohers, bu raher because China implemened bold, decisive scal simulus programs ha no oher major naions dared o adop. In paricular, he Chinese governmen cleverly used is sae-owned enerprises (SOEs) as a scal insrumen o implemen is aggressive simulus programs in 2009, consisen wih he very Keynesian noion of aggregae demand managemen hrough increased governmen spending and he scal muliplier principle. The empirical facs provided in Secion 2 show ha during he 2009 simulus period when Chinese oal expors collapsed, SOEs subsanially expanded heir credi borrowing and xed invesmen. A rapid revival of privae invesmen and GDP growh soon followed. Alhough he relaive size of he SOE secor has declined sharply since he marke-oriened reform in 978, i sill accouned for 20% of oal indusrial employmen in 2008 when he world nancial crisis sared. The SOEs acions were hus able o generae a signi can counercyclical force agains he meldown of oal expors and aggregae demand. Therefore, SOEs in China aced very much like an auomaic scal sabilizer (or marke coordinaor) for he Chinese economy: When he economy is in recession, he SOEs consen 3

5 o boosing producion and invesmen spending; bu in normal imes, hey are supposed o be pro maximizers jus like privaely owned enerprises (POEs), albei less e cien and pro able. This abiliy of he public secor o move counercyclically helped insulae he Chinese economy from he nancial sunami during he crisis period. Ex pos, mos of he public secor losses resuling from invenory buildups and ine cien invesmen in 2009 have been repaid by he consequen coninued booming economy. Alernaively, had he SOEs no aced swifly, he enire economy migh have been crushed by he rade collapse and he consequen coss migh have been very dear. 2 By comparing China s economic performance during he crisis wih ha in he Wes, he e ec of he simulus package in China looks like a dream oucome of any Keynesian scal policy ha he indusrial counries large-scale asse purchase programs had hoped o achieve. Unforunaely, he same sor of boosing e ec did no happen in Wesern counries despie more maure and beer-funcioning markes and insiuions. We argue ha he key di erence is ha China s simulus programs are scal in naure, whereas hose in Wesern counries are almos purely moneary. 3 This paper also provides a heoreical model o raionalize he di erenial impacs of scal and moneary simulus programs in China and oher counries during he nancial crisis. Our model explains no only he wo sympoms of he Grea Recession, bu also he key feaures of he Grea Depression in he 930s. Our model suggess ha he Roosevel New Deal policies implemened in and large miliary spending boh before and during World War II may have played a pivoal role in he U.S. economy s full recovery in he 940s, in erms of boh growh rae and GDP level. Our model is in spiri closely relaed o he model of Eggersson and Krugman (EK, Alhough China s projeced long-erm GDP growh rae has fallen from 0% o around 7.5% since 202, his is largely accouned for by he counry s deliberae macro policy for a srucural change of is growh model. Is cenral governmen aced swifly o curail public invesmen spending and luxury goods consumpion in he wake of rapidly rising labor coss, corrupion, and environmenal problems. The srucural adjusmen aims o make China s economic growh more susainable in he longer run. 2 Our argumens in his paper do no imply ha SOEs are preferable. Raher, he crucial lesson learned from China is ha scal policies maer while purely moneary policies do no in eliminaing a coordinaionfailure crisis. 3 The scal simulus packages in he Unied Saes included he Economic Simulus Ac (ESA) of 2008 and he American Recovery and Reinvesmen Ac (ARRA) of The ESA was $52 billion (abou percen of GDP) and was used mainly o provide emporary ax relief for individuals and businesses. The ARRA oaled abou $862 billion and was spread over 0 years (abou 0.5 percen of GDP per year). The acual increase in governmen purchases of goods and services was even smaller. Using daa from he Bureau of Economic Analysis, Cogan and Taylor (200) found ha he governmen purchases hrough he 2nd quarer of 200 has been only 2 percen of he ARRA (abou $7 billion). They blame governmens a he sae and local levels for he failure o increase heir purchases of goods and services (insead hey reduced borrowing and increased ransfer paymens). Thus, he U.S. scal simulus packages were e ecively very small, in sharp conras o is moneary simulus packages: Toal asse purchases were 8.7 percen of GDP beween 2008 and 200 and his value increased o abou 22 percen in 203 (see, e.g., Fawley and Neely, 203). 4

6 202). EK provide a prooype dynamic sochasic general equilibrium (DSGE) model wih incomplee nancial markes and deb consrains o show ha a sudden reducion in deb limis riggered by a credi crunch can explain he Grea Depression and some long-sanding puzzles, such as deb de aion and he liquidiy rap, ha ofen render moneary policies ine ecive. In he EK model, because consumpion demand depends on deb limis, a deb crisis can depress aggregae demand. Since debs are se in nominal erms, when he aggregae price falls, he real burden of he deb increases, furher depressing consumpion demand. Moving he economy away from he recessionary spiral requires a sharp reducion in he real ineres rae o simulae aggregae demand. However, if he nominal rae is already a is zero lower bound, furher reducion in he real rae by expansionary moneary policies becomes impossible because of de aion, hus making scal policies he bes alernaive o reviving aggregae demand. 4 Our model complemens he EK model in several imporan aspecs: (i) Their model focuses on debs, whereas we focus on xed producion coss as an alernaive mechanism for generaing he liquidiy rap and marke-coordinaion failures. The need for an alernaive mechanism is obvious because no all recessions are relaed o deb crises (such as he one experienced in China and Russia in ). (ii) In he EK model, recessions and underemploymen are highly ransiory phenomena; hey occur only afer a su cienly large exogenous shock o he deb limi and do no persis longer han he duraion of he shocks. In conras, recessions and underemploymen in our model can be highly persisen because marke-coordinaion failure is a Nash equilibrium in he model. Thus, our model can shed ligh on jobless recoveries and he persisence of recessions wihou relying on large exogenous and permanen shocks o deb limis, echnologies, or preferences. (iii) EK do no model asse prices and capial accumulaion; herefore, heir model is silen on he high correlaion puzzle beween asse price crashes and high unemploymen (as well as weak invesmen demand), which we argue are key for Keynes s (936) analysis of recessions and economic recoveries based on rms animal spiris. 5 (iv) Finally, we provide an empirical case sudy for he e eciveness of scal simulus programs in China during he worldwide Grea Recession. Mos economic aciviies involve xed coss. Indeed, xed coss are perhaps one of he mos imporan sources of non-convexiies and increasing reurns o scale, as well as he mos imporan raionale for he exisence of markups and rms moives for expanding marke 4 Chrisiano, Eichenbaum and Rebelo (20) also argue ha he governmen spending muliplier can be subsanially larger han one a he zero lower bound. 5 See, e.g., Farmer (202, 203). 5

7 shares in a compeiive world. Using a simple dynamic general equilibrium model, we show ha requiring a leas some rms a some sages o pay for xed coss of producion is a surprisingly powerful assumpion. Equilibrium wih marke-coordinaion failures, price and wage de aions, sock marke crashes, he liquidiy rap, and a raionale for he posiive role of scal policies in economic crisis all emerge naurally from he model. The inuiion behind our model is simple. Wih xed producion coss, privae rms may op o shu down producion when anicipaed prices (revenues) are oo low o cover he xed operaion coss, hus riggering a reducion in invesmen and labor demand. In paricular, pessimisic expecaions of fuure demand will induce rms o pospone invesmen, hus depressing demand for capial goods and forcing capial-goods producers o cu employmen. A reducion in employmen will in urn depress wages and weaken aggregae consumpion demand, which leads o a fall in aggregae prices, hus recifying he rms iniial pessimisic belief. A he same ime, wih anicipaed low pro s and dividends, rms equiy value in he sock marke will crash. Once asse reurns sar o crumble, savers (consumers) op o hoard cash insead of spending i. Moneary policies hen become ine ecive in boosing aggregae prices (demand). However, if here exis counercyclical scal insrumens, such as SOEs ha can lean agains he wind by commiing o produce in recessions even wih negaive pro s, dramaic falls in aggregae demand and prices can be sopped. Consequenly, expansionary moneary policy can sar working o push up commodiy and asse prices o resore he full-employmen equilibrium. Thus, viewed hrough he lens of our model, he subborn persisence of un(der)employmen (or he jobless recoveries) in he Unied Saes and Europe are aribuable o markecoordinaion failures and he inabiliy of heir governmens o implemen aggressive expansionary scal policies. In paricular, our model suggess ha moneary policies alone are insu cien o end he Grea Recession regardless of he zero lower bound on he nominal ineres rae. This explains why some European counries su ered he same jobless recovery problem and permanen GDP losses even hough heir nominal ineres raes had been su cienly above he zero lower bound. The res of he paper is organized as follows. Secion 2 provides an empirical case sudy of he e ecs of China s simulus package in combaing he crisis. These empirical facs sugges ha SOEs in China were he governmen s scal insrumen o implemen is unprecedened simulus packages and he key for China s recovery. Secions 3 and 4 build simple dynamic general equilibrium models wih coordinaion failures o explain why purely moneary policies (such as he large-scale asse purchase programs implemened by 6

8 he Japanese governmen in he 990s and he U.S. Federal Reserve since 2008) can fail o address a large crisis. Secion 5 inroduces SOEs (as an example of scal insrumens) ino he benchmark model and uses hem o explain he Chinese experience. Secion 6 concludes wih remarks for furher research. 2 Empirical Analyses 2. Growh Rae Recovery vs. Level Recovery Even a emporary drop in he rae of oupu growh can imply a permanen loss in he oupu level. Thus, a full recovery in he growh rae of oupu is no he same hing as a full recovery in is level. Therefore, when a recession has ended as de ned by he Naional Bureau of Economic Research (NBER), i by no means implies ha he oupu level has fully recovered. 6 In oher words, o avoid a jobless recovery or a permanen below-rend oupu level afer a recession, an economy needs a emporary "growh-overshooing" recovery period in which he growh rae of oupu exceeds is average long-run rae. Consider wo hypoheical oupu levels of wo counries, say China (red solid line in Figure A) and he Unied Saes (blue solid line in Figure A), wih he former growing faser han he laer. The slopes of he wo solid lines in Figure A represen he growh rae of oupu in he wo counries; hese are recapured in Figure B (i.e., he wo lines in Figure B are simply he respecive slopes of he wo solid lines in Figure A). Boh counries experienced an unexpeced recession in period, a which poin heir respecive growh rae fall below heir pre-crisis (long-run) growh raes say China s growh rae falls from 0% o 6% and he U.S. growh rae falls from 2% o -2%, so boh counries su ered a 4-percenage-poin drop in growh rae. Also, boh counries are able o resume (recover) heir respecive pre-crisis growh afer he recession ends in period +. However, a criical di erence is ha he growh rae of he Unied Saes recovers hrough a V-shaped growh pah (blue line in Figure B), whereas ha in China recovers hrough an invered Z-shaped growh pah (red line in Figure B). Tha is, China s growh rae overshoos is pre-crisis growh rae emporarily during he recovery period and reaches a rae of 4% per year in period + before resuming is 0% per year long-run rae afer +. This suble di erence in he paern of growh rae implies ha he GDP level in China is able o fully rever o is 6 Recession is de ned by he NBER as a leas wo consecuive quarers of negaive growh in aggregae oupu. Hence, he news media consider a recession o be ended as soon as he growh rae urns posiive and remains posiive hereafer. 7

9 long-run pah (red solid line A in Figure A), whereas he GDP level in he Unied Saes becomes permanenly lower han is original long-run pah (blue solid line B in Figure A). Since oupu is produced by labor, a permanen loss in GDP level implies a permanenly lower employmen rae or equivalenly, a "jobless recovery." Thus, he wo panels in Figure illusrae wo di erences, one imporan and one rivial, beween he U.S. experience and he Chinese experience: (i) The rivial di erence is ha he Unied Saes has a negaive growh rae of -2% during he recession period, while China has a posiive growh rae of 6% during he same period. Bu his di erence is meaningless wih regard o wheher a counry will experience a jobless recovery. (ii) The imporan di erence is ha he Unied Saes has aken pah B (blue line) in Figure A wihou undergoing he Z-shaped growhcorrecion period. The Unied Saes could have followed a di eren pah afer he recession (as indicaed by he blue dashed line A in Figure A), and China could have followed a jobless recovery pah (as indicaed by he red dashed line B in Figure A). Figure A. Hypoheical GDP Levels. Figure B. Hypoheical Growh Raes. Therefore, wha is imporan for a full recovery in he GDP level is ha he economy s emporary drop in growh rae in a recession needs o be fully correced by a emporary above-average growh rae during he recovery period, so as o fully o se he permanen loss of oupu caused by he slower growh. In he gures, we assumed ha China managed o emporarily overshoo is long-run growh rae during he recovery period, whereas he Unied Saes only managed o resume is long-run growh rae wihou such growh overshooing. Consequenly, even hough boh counries evenually recovered heir respecive 8

10 long-run growh rae afer he crisis (as Figure B shows), only China was able o reurn o is long-run oupu level (he red solid line A in Figure A), while he Unied Saes resumed only is long-run growh rae bu no is GDP level (as indicaed by he blue solid line B in Figure A). The following subsecions documen ha his scenario is exacly wha happened in he wo counries during he recen nancial crisis. 2.2 E eciveness of Simulus Packages As noed in he lieraure (e.g., IMF, 200; Inernaional Insiue for Labour Sudies, 20; Aiginger, 20), wih similar magniude and iming he simulus packages were much more e ecive in China in boosing economic performances han in he Unied Saes and Europe. The mos apparen evidence comes from he direc comparison of real GDP in China wih is U.S. and European Union (EU) counerpars before and afer he crisis. China Unied Saes Europe Figure 2. Log GDP Level (op row) and Growh Rae (boom row). 9

11 Figure 2 shows he real log GDP levels for he hree economies (solid verical bars in op panels) and he projeced GDP long-run rends (dashed lines in op panels), which are esimaed based on each economy s average growh rae in he pre-crisis period (i.e., beween 998 and 2007). 7 The lower panels in Figure 2 depic he year-over-year growh rae in quarerly daa (solid lines) and he average growh rae for he pre-crisis period (dashed horizonal lines). The gure shows ha China did no su er a permanen loss of GDP from he nancial crisis (op-lef window) even hough China s growh rae was subsanially a eced by he nancial crisis (lower-lef window). China s pre-crisis long-run growh rae was abou 0% per year. The growh rae was subsanially above he average growh rae for several quarers before he nancial crisis, bu i sared o fall dramaically below his long-run rae in 2008:Q3 and did no sop falling unil i hi he rae of 6.6% per year in 2009:Q. Consequenly, China s growh rae dropped by 7.4 percenage poins in oal during he crisis period, from abou 4% per year in 2008:Q o he 6.6% rough in 2009:Q. However, China experienced a growh-correcion period in lae 2009 and early 200 wih an invered Z-shaped growh pah: I sared o recover rapidly wih a growh rae of 8.2% in 2009:Q2, 9.4% in 2009:Q3, and hen oversho is 0% per year long-run rae in consecuive quarers (2009:Q4, 200:Q, and 200:Q2) wih a peak growh of 2.2% per year in 200:Q. Afer he growh-correcion period, China reurned o is long-run growh rae of abou 0% per year in 200:Q4. As a consequence of he emporary growh correcion during he recovery period, China s real GDP ucuaed only emporarily around is long-run pah during he crisis and did no su er any permanen losses afer he crisis. 8 In sharp conras, real GDP levels in he Unied Saes (op-middle window in Figure 2) and Europe (op-righ window) appeared o su er permanen losses afer he nancial crisis, as indicaed by he large and seemingly permanen gap beween he acual GDP level (he solid bars) and he poenial rend (he dashed line) in he op-row windows in Figure 2. The oupu gap is more han 0% of he poenial GDP level for boh economies. The lower- 7 The picure is very similar regardless of how he pre-crisis average growh is esimaed and he sample sizes. For example, see Wen (203) for an esimae of he permanen GDP losses in he Unied Saes based on much longer pos-war daa samples. 8 The invered Z-shaped growh-correcion paern is even more eviden and sriking if we sudy annualized quarer-o-quarer growh raes: The Chinese economy slowed signi canly in 2008:Q4 wih a growh rae of only 4.4% per year, compared wih 4.5% in 2008:Q2 and 9.% in 2008:Q3. The growh rae dropped even furher in 2009:Q o a rae of -3.2% per year. However, wih he e ecs of he simulus package aking place, he quarer-o-quarer growh rae jumped up o 8.7% in 2009:Q2 and 6.9% in 2009:Q3, overshooing he long-run rae by 8.7 and 6.9 percenage poins respecively. I also remained abou o 3 percenage poins above he long-run average rae for 4 more consecuive quarers beween 2009:Q3 and 200:Q3 before reurning o is long-run rae in 200:Q4. 0

12 row windows in Figure 2 show he reason: Neiher economy underwen growh correcion during he recovery period afer heir respecive growh raes dropped ino negaive erriory in Even hough he growh raes for boh economies evenually rebounded o heir respecive pre-crisis raes by 200:Q3 hrough a V-shaped growh pah, hey never oversho or emporarily rose above heir pre-crisis raes in he recovery period. This means ha he oupu losses caused by he slower growh rae during he nancial crisis have no been fully compensaed by a higher-han-normal growh rae since he crisis, leading o he permanenly lower level of GDP shown in he op-middle and op-righ windows in Figure 2. China Russia Souh Africa Figure 3. Real (log) Expors One may argue ha China was no hi as hard by he nancial crisis as Wesern counries because China s nancial sysem was no well enangled wih he inernaional nancial sysem. However, China s economy was much less sable han hose of indusrial counries and depended primarily on expors for growh (in addiion o domesic invesmen). China s oal expors su ered signi canly wih negaive growh for several quarers beween 2008 and 200: The growh rae shrank by 9 percenage poins in 2008 (from 26% per year in 2007 o 7% per year in 2008) and by an addiional 33 percenage poins in 2009 (reaching a negaive growh rae of -6% per year in ha year). Even hough he growh rae of oal expors evenually recovered o is pre-crisis rae in 200, China s rade secor never experienced a growh-correcion recovery period. As a resul, oal expors in China have remained abou 45% below heir pre-crisis rend since 2009 (lef panel in Figure 3, where he dashed line is projecion based on he pre-crisis growh rend as in Figure 2). Since oal expors accouned for 38% of China s GDP in early 2007, everyhing else equal, a permanen 45% drop in oal expors would have reduced China s GDP level permanenly by 7% below

13 is poenial rend. 9 Russia Souh Africa Figure 4. Log GDP Level (op row) and Growh Rae (lower row). An imporan feaure of he nancial crisis is ha i a eced no only counries wih close nancial links o he Unied Saes bu also counries wihou, such as counries ha depend heavily on world rade. For example, member counries of he BRICS, such as Russia and Souh Africa, hough no as closely linked o he U.S. nancial sysem as Europe bu have a relaively large expor secor (like China), su ered large permanen losses in GDP. Speci cally, in 2007, he share of expors in GDP was 30% for Russia and 3% for Souh Africa (compared wih 38% in China). The nancial crisis caused a 49% permanen drop in oal expors in Russia and a 9% permanen drop in Souh Africa (middle and righ panels 9 This value would be even higher if here was a muliplier e ec (see below). 2

14 in Figure 3). Consequenly, hese wo counries also su ered large permanen GDP losses he real GDP level has dropped 23% below poenial rend for Russia and 8% for Souh Africa (op panels in Figure 4). The boom panels in Figure 4 show he reason: Similar o he developed counries, neiher Russia or Souh Africa underwen a growh-correcion recovery period in GDP afer he crisis. The economic performances in BRICS counries during he nancial crisis are consisen wih he predicion of he exbook Keynesian muliplier heory. In 2007, he share of oal expors in GDP was 3% for Brazil, 30% for Russia, 20% for India, 38% for China, and 3% for Souh Africa. All of hese counries have su ered sharp declines in real expors since he crisis by 20, real expors in hese counries sill sood a 7%, 49%, 6.5%, 44% and 9%, respecively, below heir respecive long-run rends. Suppose he demand muliplier is.5 for each counry, hen wihou governmen inervenions such sharp and permanen declines in expors would have caused a permanen drop in he GDP level of 3.4% for Brazil, 22.3% for Russia, 2% for India, 25.3% for China, and 9% for Souh Africa. In fac, he acual GDP gap by he end of 20 was 2.9% in Brazil, 23.% in Russia, 0.8% in India, 2.7% in China, and 8.3% in Souh Africa. Therefore, excep for China, he prediced GDP gaps based on he muliplier principle are consisen wih he acual esimaed GDP gaps (Table ). Table. Expor and GDP Gaps in BRICS Counries Expor GDP Counry Raio Expor Gap GDP Gap Prediced GDP Gap (2007) (20) (20) (20) Brazil 3.36% 7.2% 2.9% 3.4% Russia 30.6% 49.2% 23.% 22.3% India 20.45% 6.5% 0.8% 2.0% China 38.3% 44% 2.7% 25.3% Souch Africa 3.48% 9% 8.3% 9.0% Noe: Prediced GDP gap is calculaed as.5( Expor GDP raio)(expor gap). Figure 5 visualizes he informaion in Table. I shows ha he prediced GDP gaps based on he muliplier principle mach he daa quie well for Brazil, Russia, India, and Souh Africa. The prediced gap (horizonal axes) and he acual gap (verical axes) form almos a 45-degree line for hese counries, suggesing ha even wihou igh nancial links o he Unied Saes, a developing counry s decline in GDP afer he crisis is closely linked o is decline in expors muliplied by he iniial share of expors in GDP before he crisis. The muliplier of.5 simply suggess ha he demand-side e ec of rade collapse is ampli ed universally across hese developing counries wih a similar muliplier. 3

15 China is a surprising oulier in Figure 5. The muliplier principle predics ha China s GDP level would be 25% below poenial rend, given is large (nearly 40%) expor share in GDP and nearly 45% permanen decline in oal expors (i.e., 0:38 0:44 :5 = 0:25). However, he acual GDP level in China was only slighly (-2.7%) below rend in 20, suggesing ha China had essenially compleely recovered from he crisis and was back on is long-run rend despie he caasrophic 44% permanen drop in expor demand. Some may argue ha because China was growing so much faser han he Unied Saes and he oher BRICS counries before he crisis, a emporarily slower growh maers much less for China han for he oher naions. This view is incorrec, as already shown in Figures A and B. Regardless of how fas China was growing before he crisis, i sill could have su ered large permanen losses in GDP level had he growh-correcion recovery period in no occurred. Figure 5. Expor-Driven GDP Gap Therefore, he only imporan and relevan quesion is "why did a growh-correcion (or growh-overshooing) recovery period occur in China bu no in he Unied Saes, Europe, Russia, and Souh Africa?" Table 2 sheds some ligh on his quesion by looking a he decomposed conribuions of he four major componens of aggregae demand (privae consumpion, governmen spending, aggregae xed invesmen of privae and public secors, and ne expors) o GDP growh in China, he Unied Saes, and Europe. 4

16 Table 2 reveals ha a large surge in oal xed invesmen in 2009 was he pillar for susaining China s phenomenal GDP growh and he growh correcion during is recovery period. The Chinese governmen announced a 4 rillion RMB (US $586 billion) simulus package in November 2008 and implemened i immediaely in December 2008 and hroughou Direcly afer he unveiling of he simulus package, he year-over-year growh rae of xed asse invesmen in China jumped 9 percenage poins from 2008:Q4 o 2009:Q and acceleraed furher o 38% per year in 2009:Q2. So for he enire year of 2009 he yearly growh rae of xed invesmen reached 30.9% almos wice as high as is average pre-crisis growh rae. As a resul, gross xed capial formaion conribued a phenomenal 8.06 percenage poins o China s 9.% per year real GDP growh in In oher words, invesmen alone was responsible for nearly 90% of he robus GDP growh in 2009 when Chinese expors collapsed and shrank by nearly 45%. Table 2. Percenage-Poin Conribuion o Real GDP Growh in 2009 Componen China Unied Saes Europe Privae consumpion 3.44 (37:8%) -.06 ( 37:9%) ( 20%) Governmen consumpion.4 (2:5%) 0.64 (22:9%) 0.46 (0:6%) Toal xed invesmen 8.06 (88:6%) ( 25:7%) ( 87:%) Ne expors ( 38:9%).4 (40:7%) -0.5 ( 3:5%) Toal GDP growh 9.0 (00%) (00%) (00%) In conras, oal privae invesmen in he Unied Saes collapsed in 2009 wih a negaive growh rae of -2.62%, furher down from -9.38% per year in 2008, making i he larges drop since he end of WWII. The sharp drop in invesmen lowered U.S. GDP growh by 3.52 percenage poins in 2009, conribuing more han 25% of he negaive GDP growh in ha year, far larger han he negaive conribuion from privae consumpion. In fac, weak invesmen demand was no only he culpri in he Grea Recession bu also key in he U.S. jobless recovery in he pos-crisis period. The siuaion in Europe was quie similar: The sharp decline in xed invesmen was he single mos imporan conribuor o Europe s negaive GDP growh during he crisis period, represening more han 87% of he negaive income growh in 2009, which was more han 4 imes he negaive conribuion from privae consumpion (see Table 2). Therefore, he e eciveness of moneary policy was dramaically di eren beween China and he indusrial economies. As he rs cenral bank reacing o he nancial crisis, he Fed sared massive moneary injecion as early as 2008:Q3. The oal moneary base has more han doubled wihin wo years, making i he single mos aggressive moneary injecion in 5

17 U.S. hisory. In addiion, he Fed conduced unconvenional moneary policies hrough largescale asse purchases o lower he longer-erm ineres rae. By 203, oal long-erm asse purchases reached $3.5 rillion, equivalen o 2% of U.S. GDP. However, banks responded by increasing excess reserves raher han increasing bank loans, and he public responded wih a subsanial igh o liquidiy in he form of currency and demand deposis. So he dramaic moneary easing did no ranslae ino increases in credi expansion in he Unied Saes; insead, he real growh rae of ousanding loan balances was negaive in 2009 and 200. As a resul, he growh rae of credi lending was 5 percenage poins below is pre-crisis average level despie he unprecedened moneary injecions (lef panel in Figure 6). Europe faced a similar dilemma (middle panel in Figure 6), alhough he magniudes of boh moneary injecion and loan balance shrinkage were relaively smaller han hose in he Unied Saes. Unied Saes Europe China Figure 6. Ousanding Loan Growh Before and During he Financial Crisis However, he siuaion in China was quie di eren. Following he lead of he Federal Reserve, he People s Bank of China (PBOC) sared o expand money supply by he end of The moneary injecion immediaely led o sharp increases in credi lending a nearly he same speed and magniude. Despie posiive in aion, he real growh rae of ousanding loan balances increased from 5% per year in mid-2008 o 2.49% per year in December 2008, and furher up o 32.5% per year in June 2009 a hisorical peak during he enire reform era since 978 (righ panel in Figure 6). As a resul of he credi boom in China, oal indusrial producion nearly doubled beween 2007 and 203, whereas ha in indusrial counries (such as he Unied Saes, Europe, and Japan) remained below he 2007 level unil 203. More speci cally, before he 6

18 crisis (in 2007), China s indusrial producion was only abou 60% of he U.S. level, bu by 202 i was already 26% of he U.S. level, making China he world s larges manufacuring gian and ending he U.S. dominance i enjoyed for a cenury. The comparisons above provide wo exbook examples of he poenial oucomes of expansionary moneary policies in recessions. In China, everyhing worked jus ne: A sharp increase in money supply expanded credi lending, which hereby boosed aggregae invesmen and nally resuled in full recovery and new economic growh. The Unied Saes and European experiences, however, were jus he opposie: Despie unprecedened, asronomical moneary injecions hrough boh convenional and unconvenional quaniaive easing, hese economies sill remain weak. The reasons for his persisen weakness are simple: (i) Firms are unwilling o borrow and inves when aggregae consumpion demand remains low, and (ii) consumers are no willing o spend when rms are no hiring a classic marke-coordinaion failure problem ideni ed by Keynes. Why did moneary policies fail in boosing aggregae demand in he Unied Saes and Europe while hey succeeded in China? The nex secion reveals he answers. 2.3 Conribuion of SOEs o China s Economic Recovery Furher invesigaion shows ha he e eciveness of China s simulus packages is derived from he conribuion of he public secor (SOEs). We sar wih rms borrowing behaviors, which is essenial in undersanding he e eciveness of China s scal/moneary policies. Since informaion on he breakdown of ousanding loan balances according o borrowers ownership is currenly unavailable, we choose o explore he issue indirecly by focusing on he manufacuring rms average leverage raio published by he Naional Bureau of Saisics of China (NBSC). Alhough he leverage raio in he pre-crisis period was similar beween SOEs (58.5%) and POEs (59.%), he dynamic pahs during he simulus period were quie di eren for hese wo groups (Figure 7A, where he dashed lines represens he pre-crisis average levels in each panel). On he one hand, he average leverage raio of saeowned manufacuring rms increased seadily: from 57.5% in 2008:Q o 59.9% in 2008:Q3, reached 60.6% in 2009:Q2, and nally peaking a 6.4% in 2009:Q4. On he oher hand, during he same period beween mid-2008 and 200, he average leverage raio of privaely owned manufacuring rms dropped coninuously from he pre-crisis level of 59% o 57%, which is quie similar o wha we observe in he indusrial counries. The sharp di erence in he leverage raio demonsraes ha only SOEs were willing o expand heir debs during 7

19 he crisis, which provides one major clue as o why he money injeced by he cenral bank could be e ecively ranslaed ino new loans in China. A. Leverage Raio SOEs POEs B. Fixed Invesmen Growh SOEs POEs Figure 7. Behaviors of Chinese Manufacuring Firms Bolsered by new loans, Chinese SOEs promply expanded heir xed asses invesmen. Figure 7B (where he dashed line in each panel represens pre-crisis average) shows ha before he crisis POEs were clearly he major force behind aggregae invesmen spending in China. Beween 2004:Q (when he disaggregaed saisics of xed asse invesmen became available) and 2007:Q4, he real year-over-year growh rae of POEs oal invesmen in xed asses was remarkably high, a 35.5% per year (dashed line), almos hree imes as fas as ha of SOEs (2.88% per year). Bu his paern changed dramaically during he 8

20 crisis period. From a normal growh rae of.59% per year in 2008:Q2, he real growh rae of SOEs xed invesmen spending increased rapidly o 2.09% per year in 2008:Q4 and reached an asonishing 45.3% per year in 2009:Q2. This was no only more han 33 percenage poins higher han is pre-crisis level in 2008:Q2, bu also abou 0 percenage poins higher han he pre-crisis average growh rae of POEs invesmen. Thus, he acual invesmen growh rae of SOEs sayed a 20 percenage poins above is pre-crisis average rae for several quarers beween 2008:Q4 and 200:Q. Meanwhile, he invesmen growh of POEs decreased sharply from 30% per year in 2007:Q3 o 20% per year in 2008:Q4. However, following he lead of SOEs, a rapid revival of privae invesmen also followed: The real growh rae of POEs xed invesmen recovered from a rough of 20% per year in 2008:Q4 o abou 33% per year in 2009:Q2 and 2009:Q3, even hough hese raes ucuaed beween 24% o 30% per year afer he simulus program ended in 200:Q Evidence from Panel Sudies These sylized facs poin o a criical role of SOEs in China s dramaic recovery in GDP and employmen levels during he crisis. We can furher suppor his conclusion by using panel daa a he province level. We use a simple di erence-in-di erences economeric model based on daa from 3 provinces in China beween 200 and 200. The underlying logic of our analysis is fairly sraighforward: If he e eciveness of China s simulus package did indeed rely mainly on he public secor, we should expec regions wih more SOEs or higher SOE shares in oal regional oupu (or employmen) o su er less and recover faser from he crisis. To con rm his conjecure, we run he following regression: GDP j; = X + (X Z j; ) + j + e j; ; () where denoes he rs-di erence operaor; GDP j; is he provincial oupu level (in logarihm) in province j and period ; X is he STIMULUS dummy variable for he simulus period (i.e., 2009 and 200); Z j; is a proxy of he share of SOEs in province j in period ; and e j; is an error erm. The province xed e ecs ( j; ) are inroduced o capure any unobserved aribues such as naural resource endowmens across provinces, wih he assumpion ha hese facors would no subsanially change wihin a shor ime period (such as he simulus period). If SOEs have made major conribuions o he e eciveness of he simulus package, he coe cien should be posiive and saisically signi can. 9

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