However, the Keynesian model of demand management does not work in China. The most serious shrinkage in China is not the shrinkage of demand, but that of supply; or a problem caused by the lessening of demographic dividends, the rise of the prices of productive factors and the sluggish growth of total factor productivity (TFP). With the decline of demographic dividends, the high return-on-capital rate China has so far enjoyed from the low cost of production is very much likely to end in the next five years. The low cost-based, extensive growth model is no longer sustainable.

China must change its approach to economic analysis from the “troika” model to a long-term-supply model, because only long-term supply is the decisive factor for a nation’s potential growth. The current theories on “restructuring” are mostly focused on striking a rebalance between exports and investment and consumption. The discussions are all within the concept of general demand, but it was only the substantial shrinkage of supply that restrained China’s economic growth.

In 2008, the Chinese government adopted a stimulus package to cope with the pressures from the global financial crisis. The measures paid off and the economy rebounded powerfully. But the recovery came at a price. The governmental, household, industrial and banking sectors all saw their debt ratios soaring. Statistics from the IMF indicate that the debt to GDP ratios of China’s non-banking sectors (households, non-banking industries and the government) kept rising from 2005 to 2012. The total volume of debts rose from 25.8 trillion yuan to 91.6 trillion yuan and the leverage ratio ascended from 139.3% to 176.3 % during the period, showing a strong momentum of balance sheet expansion.

Traditional expansionary fiscal and monetary policies are all targeted at a rightward shift of the aggregate demand curve by adjusting the commodity or monetary market’s equilibrium condition, so as to attain a higher equilibrium output. The price of which, however, is an ever-rising aggregate price level and even inflation. On the contrary, shifting the aggregate supply curve can also raise the equilibrium output, but the by-product is a fall of prices and improvement of production factors efficiency.

That’s why the Third Plenum suggested, for the first time, establishing a new framework for state governance. China needs to improve its medium and long-term supply capacity by “easing government control, optimizing institutional supply and raising the factors efficiency.”

The next round of reform will focus on an all-round marketization so as to establish an open, unified and orderly market system. More tax incentives, such as tax reduction and system reform, should be devised to enhance producers’ supply ability and encourage technological innovation. The government and market roles should be re-defined, and greater importance should be attached to productivity’s function in raising the aggregate supply. Only by doing so can we break the supply barrier and really liberate productive forces.

Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.

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