China's 2024 Stimulus Plan Won't Work

In this episode of 22 George Street, we evaluate China’s newly announced stimulus plan aimed at revitalizing its struggling economy. With the Chinese government optimistic about a rebound in the stock and real estate markets, many investors are eager to capitalize on potential economic growth. But what does the financial theory say about the effectiveness of such stimulus measures? Join us as we explore the implications of an oversized financial sector, the historical context of previous stimulus efforts, and the barriers to innovation and investment in China today. Tune in to discover whether this stimulus could truly pave the way for recovery or if it will lead to further challenges.

Transcript

Welcome back to 22 George Street! I’m your host, George. Today, we’re diving into an exciting topic: the substantial stimulus plan recently announced by China, aimed at revitalizing its economy. The Chinese government is optimistic, anticipating a rebound not only in the economy but also in the stock and real estate markets.

With this in mind, many investors are already rushing back into these markets, eager to capitalize on what they believe will be a surge in economic activity. But what does this really mean for the economy? How effective will this stimulus plan be in practice? Today, we’re going to break down the potential effectiveness of China’s stimulus through the lens of established financial theories.

Looking back between 2001 and 2012, China experienced remarkable economic growth, largely fueled by an expanding financial sector. However, the landscape in 2024 tells a different story. Financial theories suggest that while a certain level of finance can promote growth, once you surpass a threshold—around 100% of GDP—the impact can turn negative. According to the World Bank, domestic credit to the private sector reached a staggering 185% of GDP in 2022, and by March 2024, it had skyrocketed to 200.56%. This oversized financial sector may actually hinder economic progress rather than help it, increasing the risk of a crisis.

An important point to consider is the experience from the previous stimulus plan in 2008. At that time, state-controlled firms received more credit than they truly needed, distorting the pathway toward a more efficient allocation of capital. This situation aligns with what economist János Kornai refers to as the "soft budget constraint," a concept illustrating how state-owned enterprises often evade accountability for their financial performance, leading to what we call "zombie firms." These firms persist without effectively contributing to the economy, and this issue could worsen with the new stimulus measures in 2024.

Moreover, financial theories tell us that finance can indeed promote economic growth, but primarily for firms with genuine growth opportunities. Financial development plays a key role in reducing external financing costs, especially for businesses in industries that depend heavily on outside capital for growth and innovation. However, for China today, two significant barriers are stifling investment and innovation:

1. A growing culture of xenophobia and nationalism creates a non-inclusive environment, making it challenging for businesses to thrive.
2. Increased government intervention, coupled with weak protections for private property rights, limits viable investment opportunities.

Even before this latest stimulus, banks were already struggling to find borrowers. Startups in China saw a drastic decline in numbers, dropping from 51,302 in 2018 to just 1,202 in 2023.

Without demand from the private sector, funds are likely to be diverted to state-owned enterprises—much like in 2008—leading to further misallocation of resources and inefficiencies. The long-term outlook for the stock market ties directly to the discounted future cash flows, meaning that inflating current prices without solid value will ultimately lead to diminished future returns. In an efficient market, if investors anticipate a price drop following the next financial reports, that decline is likely to happen sooner rather than later.

In conclusion, while the new stimulus measures might seem like a proactive response to China’s economic challenges, they may not provide the solutions we hope for. China’s issues stem from a non-inclusive culture and institutional weaknesses that monetary policy alone cannot solve. It’s crucial to temper expectations regarding the potential impact of this stimulus plan on China’s economy.

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