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China is about to use again window guidance policy to battle deflation

The Chinese economy is in serious trouble. Its gross domestic product keeps declining further and further and the Chinese government becomes aggressive when questioned about the state of the economy.

China’s CPI has been declining since July 2023. Producer prices have been falling for 16 consecutive months, with a drop of 2.5% year on year. Consumer confidence is low due to factors like the housing slump and high debt levels. This is leading to less spending and lower demand for goods and services. The consistent decline has alarmed foreign investors who now see China as an unreliable market. Thus, in order to bring the Chinese economy back on track and make it more competitive, the Chinese government has decided to use the “window guidance” practice to boost its GDP.

China's Deflation

Source: China's National Statistics

Window guidance is an informal monetary policy tool used to influence the credit flow within an economy by directing banks toward specific sectors or industries. It's essentially "guidance" (sometimes called "benevolent compulsion") from central banks or other authorities suggesting, but not explicitly mandating, how banks should allocate their loans. Window guidance essentially focuses on regulating the supply of credit in specific sectors or industries.

The Chinese government has a history of using window guidance to influence the behavior of financial institutions and steer economic activity. However, the potential for its effectiveness in boosting GDP in 2024 is complex and depends on several factors.

The Chinese government seeks to increase the supply of credit in the manufacturing and exporting industries instead of real estate and infrastructure this time to boost growth. China's GDP growth has slowed down in recent years, and the government is aiming for a target of around 5.5% in 2024. Chinese President, Xi Jinping, argued that using window guidance practices could direct funding to specific sectors deemed crucial for growth, avoids rigid quotas, and allows banks some discretion in choosing borrowers.

There is a major problem in using window guidance, however. Window guidance steers credit towards specific sectors chosen by the government, often neglecting market signals. This can lead to misallocation of resources, where funds flow to favored sectors regardless of their actual profitability or efficiency. Indeed, The Chinese government is more concerned with boosting GDP rather than how the investment would be used. Thus, this could lead to malinvestment because the Chinese government wants to throw money at industries without knowing how the funds will be allocated and used to boost growth. This would consequently hinder the development of more promising sectors and stifle overall economic growth.

Beyond the misallocation of resources, window guidance policy creates moral hazards and dampens market dynamics. Indeed, when banks are pressured to lend to specific sectors regardless of creditworthiness, it encourages risky lending practices. This can create moral hazard, where banks believe the government will bail them out if they incur losses, leading to irresponsible financial behavior and potential financial instability. And by interfering with market forces, window guidance can suppress natural price discovery and discourage innovation. Instead of responding to market signals and consumer preferences, businesses might prioritize aligning their activities with government directives, potentially hindering long-term economic growth.

The use of window guidance will probably not stimulate the growth sought because the Chinese government disregards profitability and efficiency and is more concerned with only boosting its GDP numbers. This then gives an illusory growth while the actual economy continues to contract.


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