What Ails China? A Long-Run Perspective on Growth and Inflation (or Deflation) in China

Since 1994, China has experienced a prolonged period of sluggish growth and declining inflation. Prices have actually declined over much of the last three and a half years. These problems are often attributed to conditions of weak aggregate demand. Not unexpectedly, the Chinese government has cut interest rates and pursued expansionary Keynesian policies, but these measures have largely failed. We argue that the key to the sluggish growth resides in the financial sector, specifically, its inability to efficiently intermediate funds to China’s non-state sector. This has adversely affected investment in the non-state sector, which has been the source of much of the dynamism in the Chinese economy since reform. Our analysis suggests that the current reform strategy for China’s financial sector, while important, will not solve this fundamental problem. Rather, the solution lies in the introduction of new, privately owned, locally based financial intermediaries that can provide efficient financial intermediation for the small and medium sized enterprises in the non-state sector. Published in East Asia in Transition: Economic and Security Challenges edited by A.E. Safarian and Wendy Dobson, University of Toronto Press, 2002.