We have heard good news recently about Beijing reversing recent policies and beginning to curb the creation of more overcapacity in China. Although there are risks associated with this policy change, the risks of not changing have become significantly greater.
Probably the most difficult aspect of the crisis for policymakers has been that conflicting policy objectives require almost opposite policy choices. In other words, should China target the most rapid and efficient adjustment to a world of sharply reduced net consumption, or rising short-term unemployment caused by a collapse in the export markets?
With the US trade deficit shrinking fast in the past two years, Beijing has been forced to tackle the excess capacity its policies have created in the past decade. But what could it do?
On the one hand, the rapid fall in Chinese exports in the short term would lead to a sharp rise in unemployment that could only be combated by a significant rise in investment, much of which would end up increasing current and future Chinese capacity. At the same time, if a significant part of this increase in investment was misallocated, it would lead to rising non-performing loans, which ultimately would be paid for directly or indirectly by Chinese households and so would make it difficult for them to boost consumption.
On the other hand, if policymakers want to address the gap between domestic production and domestic consumption directly, the most effective way would be to reverse the historic policies that have constrained consumption and subsidised production. Reversing these policies - forcing wages to rise, raising interest rates, revaluing the yuan, removing energy subsidies, and so on - would make matters worse for the tradable goods sector in the short term, and exports would fall further and unemployment would rise.
