China’s Remarkable Recovery From the Great Recession, and Implications For Its Future

Although China was hit hard by the Great Recession, its economy rebounded very quickly. Why? (2) 

The Great Recession was a period marked by a sharp decline in economic activity, beginning in December 2007 and lasting officially until June 2009. It started in the United States when the housing market crashed, but contagion effects spread to the United States’ trading partners, one of the biggest of which was China. China’s economy relies hugely on exporting their goods overseas, and when American households lost about $16 trillion of net worth in the recession, they couldn’t afford to buy as many imported goods from China. Despite China’s permanent level of exports falling by 45%–a staggering amount–its economy rebounded incredibly fast, faring much better than that of any developed country. The crisis even affected countries without close financial links to the United States, such as Russia and South Africa, with these nations also decreasing their demand for Chinese products. Why did China recover so fast, given its export-driven growth model, while the rest of the world didn’t? The answer lies in the response of the Chinese government and a party system with the control necessary to push through stringent domestic policies, even if they caused short-term pain for its already struggling firms.

To start with, China introduced a RMB¥ 4 trillion (equal to $584 billion) stimulus package in 2008, to be put into infrastructure and social welfare programs by 2010. This stimulus was comparable in size to the United States’ own stimulus packages, but it came from an economy about one-third the size at the time, so the effect was more drastic and the initiative much bolder than any other country dared to enact. With its packages, China hoped to spur economic activity and increase its citizens’ total demand for goods and services, or aggregate demand, through the creation of jobs and welfare initiatives. If consumers use the money from these support policies to purchase more goods and services, their spent money circulates and get re-spent on new goods and services, bolstering the economy otherwise weakened from the recession. All of this went superbly for China: “total industrial production in China nearly doubled between 2007 and 2013 despite the crisis and an extremely weak international demand for Chinese goods, whereas the United States has experienced zero growth in industrial production and that in the European Union and Japan has declined by 9.3% and 17.1%, respectively.”

The United States enacted programs with similar goals, so why did China’s work while the United States’ didn’t? The difference was largely influenced by the Chinese government’s control of the economy. China has a market authoritarian system, where the government can keep a much closer handle on any economic activity in their country. In the United States, there is a much less restrictive free market system, and firms are under less pressure to do anything for the good of the country, instead focusing on minimizing profit loss. Once the Great Recession hit, American firms were hesitant to borrow and invest in expanding operations when aggregate demand was still low, and consumers weren’t willing to spend when firms weren’t hiring. In China, this wasn’t the case; they had things like state-owned enterprises (SOEs) run by the government, and the government took rapid steps to help the country even though they incurred debt and loss in the short run.  

China’s state-owned enterprises also acted as a sort of automatic stabilizer for their economy. Automatic stabilizers are policies and programs designed to balance fluctuations in a nation’s economic activity without needing intervention by policymakers. This stands in contrast to the pro-cyclicality of typical, privately-operated firms, which tend to restrict their operations in times of recession. While this minimizes the risks they take during a downturn, it also means firms are less eager to do business, dragging out the length of economic recovery. Normally SOEs are supposed to maximize profit just like privately owned enterprises, but beginning in 2008, they consented to increased production and investment spending, which provided major benefits to the economy and helped the economy start to grow again. Favorably for China, almost 20% of industrial employment following the 2008 crisis came from SOEs; with so many jobs remaining active during and after the recession, their economy was able to recover much more quickly and effectively in a manner not possible in countries without SOEs or similar programs.

While China’s policy actions involving SOEs worked out in the short run, risks posed by its Keynesian approach should be addressed. The timeline for the recovery of demand can vary greatly, so Chinese firms that stepped up production post-recession would be in an even worse position if their increased output went unpurchased. Past efforts by the Chinese government to influence demand have been notoriously unsuccessful, especially thanks to its people’s strong propensity to save. Data also show that from 2008 to 2015, China’s M2 measure of money (total cash and checking deposits plus savings deposits, money market securities, mutual funds, etc) increased by 16 percent annually, but during the same period, China’s economy expanded at a rate less than half that. Domestic inflation, as well as expectations of inflation, has been high since 2008. Taken as a whole, China’s success should be taken with a grain of salt and under different circumstances may have even damaged the economy more.

Beyond these unrealized risks, China also created several other hazards for itself set to materialize in the coming years, including increases in its already dangerous levels pollution and higher inequality among Chinese citizens. It has overproduced steel thanks to government subsidies and tax breaks, drawing the ire of competing steel-producing nations. Its debt has risen to approximately 50% of its GDP in part because of its post-recession policy actions, and it’s uncertain how easily they can repay it. Furthermore, with demand for Chinese exports unlikely to return to pre-recession levels, and because investment already accounts for almost half of its economic activity, China should look to do things like boost household incomes through higher wages and lower social security contributions, put in place fairer resource prices, interest rates, and distribute dividends from state-owned enterprises, or increase spending on pensions and healthcare if it wants to continue its economic growth and achieve its promise for the future.

Index Funds Help Curb Corporate Short-Termism

Stock Stock Market Photo

Active money management has lost its luster. Since the Great Recession, investors have given up on expensive hedge funds and their mediocre returns, preferring far less flashy options like index funds. Even after years of loose monetary policies and low volatility, weary investors are hesitant to jump back into the fray of active investing. Passive investing in index funds is now the new normal for the stock market. If investors want to see companies return to innovation and long-term growth, they should hope it stays that way.

Passive investing holds promise as a key tool in the fight against an increasingly common issue: corporate short-termism. Measuring data for publicly traded companies from 2001 to 2015, a McKinsey report found a significant, upwards trend in short-term thinking by corporations. For public companies, short-termism typically takes the form of share buybacks. Rather than reinvesting profits in new projects, these companies use the money to buy shares from their investors to boost their stock prices. As a result, short-term companies invest less in innovation and, according to the same McKinsey report, experience lower earnings growth than companies with long-term strategies.

Company executives cite pressure from investors, arising from increased media coverage and lower trading costs, as one of the main reasons for their short-term thinking. Index funds offer insulation from these pressures, allowing corporate executives to worry less about volatile investor reactions and focus instead on long-term growth. Index fund investors focus on the performance of the fund as whole, and the diverse companies that make up these funds dilute the impact of any one company’s stock fluctuations. Because of this, missed quarterly earnings face less scrutiny when many investors are only looking at the performance of the index and not the individual stocks it is comprised of.

Furthermore, for the casual investor, index funds are typically part of a hands-off investing strategy, again offering more leeway for companies to pursue long-term growth. Individual investors increasingly recognize that neither day trading nor actively managed funds are likely to outperform stock indexes over the long term. In response, these investors rely more on diversified index funds, offering better returns and peace of mind. This means fewer stockholders scrutinizing the performance of individual companies, leaving fewer people to exacerbate price changes by jumping into the dangerous strategy of buying rising stocks and selling falling ones. Thus, index fund investors escape the dreaded “buy high, sell low” scenario that plagues traders of individual stocks, while corporations avoid the volatility that accompanies this positive feedback loop.

However, index funds do not erase volatility altogether, especially when one considers that not all index funds investors are so passive. In fact, trading data for a type of index fund known as an exchange-traded fund (ETF) indicates higher volatility for stocks making up ETFs due to the low trading costs of these funds. Importantly, though, this increased trading can largely be considered “noise,” not tied to market fundamentals of individual stocks. Because of this, individual companies’ actions have little effect on this volatility, still allowing executives to pursue long-term projects with less pressure from myopic investors.

By moderating investor pressure to meet short-term expectations, the popularity of index funds grants corporations more freedom to invest in innovation, even when these projects take time to turn a profit. Because most project expenses are immediate while resultant increases in revenue may take time to materialize, investments in innovation often fall prey to shortsighted expectations for a company’s bottom line. Other companies avoid investing in innovation due to the uncertainty of success, weighed against the investor backlash if they fail. If companies expect an outsized impact on their stock performance should a project prove unprofitable, otherwise-promising investment opportunities go unrealized. In either case, companies can invest more in innovation as more projects become worthwhile when given enough time to overcome the costs of the initial investment.  

Some critics of index funds charge that rather than promoting innovation, the popularity of index funds instead encourages monopolization and other anti-competitive practices. Supposedly, index fund managers use their large ownership stakes of companies within the same industries to discourage competition and raise prices. As a recent piece from The Atlantic highlighted, though, fund managers can only offer their low-cost index funds by avoiding costs of highly active management. Thus, the coordination required to design and enforce anticompetitive efforts on such a large scale would prove prohibitively expensive for these index fund managers.

Furthermore, in instances where index fund managers do exercise their voting power, they typically do so in ways that support long-term company performance. In August 2017, Vanguard voted against ExxonMobil’s management to require disclosure of climate change risks. In the long-term, this increased transparency will help the company, boosting its reputation for honesty and encouraging it to adapt to the climate risks it will face. For Blackrock, issues over executive compensation make up the largest proportion of its votes against management. Both of these asset managers are willing to exert their influence to encourage long-term thinking in the companies they hold, largely because it is long-term performance that index funds’ customers seek.

These criticisms do raise another valid concern over the rise of index funds. While freedom from excessive investor scrutiny can encourage companies to pursue innovative projects, it can also allow corporate executives to engage in dubious business practices with fewer repercussions. Investors play a key role in disciplining C-suite executives through company votes, but this threat is only credible if investors catch wrongdoing in the first place. As large shareholders, index fund managers should remain vigilant of wrongdoing, monitoring companies on their own or heeding the warnings of activist investors.

The popularity of index funds has eased some of the pressure restraining corporate investment in long-term growth, but it is still up to index fund managers to ensure company executives use this freedom to enrich their investors, not to line their own pockets.