Editor’s Note: This article summarizes remarks by Professor Liu Yuhui, Chief Economist at TF Securities and Professor at the Institute of Economics, Chinese Academy of Social Sciences, from an internal meeting on February 20.
Professor Liu brings deep academic rigor and economic expertise to his work, and his research has long been valued for its professional insight and practical relevance to investment.
Summary:
The pandemic has caused a visible, severe contraction in aggregate demand. Less visible—but entirely possible—is a parallel collapse in potential growth. How should policy respond? Should the focus be on supply or demand?
If policy targets demand and triggers a sharp rebound, a positive output gap would almost certainly lead to rapid inflation. If it prioritizes the supply side—potential growth—it would effectively recalibrate China’s macroeconomic coordinates.
Simplified through the Balassa-Samuelson model, China’s core macroeconomic issue boils down to the gap between the RMB’s nominal and real exchange rates. This gap reflects economic rents spilling over from real estate and “perceived inflation.” Over time, it transforms into systemic risk.
Macro-policy should aim to narrow this gap, captured in a four-character framework: “devalue externally, appreciate internally.” External devaluation depends on circumstances and is difficult to achieve; internal appreciation means strengthening the RMB’s domestic purchasing power.
The pandemic has created a massive shortfall in livelihoods, putting pressure on the real estate sector. Real estate, in turn, squeezes local governments, which then pressure the central government. Logically, unless the central government can create space by “squeezing” the U.S.—i.e., allowing RMB depreciation—it cannot stimulate domestic demand without forcing the real estate sector to bear the full cost alone. But can we really squeeze the U.S.? Adversaries are currently exploiting the situation to compress China’s strategic space. Given Anglo-Saxon pragmatism and a “dark forest” view of international relations, how feasible is this path?
As the world’s industrial and supply chain hub—a $14 trillion economy—China has been largely paralyzed for nearly two months. Yet global financial markets have barely flinched; indices that should rise keep hitting new highs, seeming almost indifferent. The only coherent explanation is that the West may be conducting a long-desired stress test on the authenticity and resilience of China’s role in global supply chains: just how replaceable is it?
This is the reality we must confront. We must act urgently to rescue ourselves—and specifically, the “world’s factory.” The direction is clear: reduce economic rents and lower institutional costs.
The short-term stock market rebound is largely a liquidity story. The PBOC’s roughly ¥3 trillion in reverse repos provided temporary relief—not because the money flowed directly into stocks, but because it eased pressure across the debt network, lifting risk appetite and channeling deposits into equities. The PBOC must also know when to withdraw this liquidity to avoid severe side effects. What markets should really worry about are long-term issues: equity valuations ultimately reflect the quality of economic governance, not just economic performance.
Whether the market’s risk appetite can be sustained depends largely on whether subsequent policy shows enough will and capacity to curb—or even reverse—the rising trend of institutional costs embedded in China’s system.
The pandemic has delivered a catastrophic shock to China’s $14 trillion economy, bringing production and daily activity to a near-standstill for almost two months. Economically, we are witnessing a severe contraction in aggregate demand. Without recent data analysis at hand, I will share reflections on three areas for your consideration and discussion:
First, an abstract framework;
Second, a concrete perspective;
Third, capital markets and equities.
1. Abstract Framework
Recent years have seen heated debates on China’s macroeconomy—the “new cycle” debate in 2017, pre-pandemic arguments over defending 6% GDP growth, and post-pandemic discussions on stimulus. These debates stem from fundamentally different views on China’s potential growth. The key question is not the technical measurement of potential growth rates, but whether the economy is in a “steady state” or a “non-steady state.” This distinction is a primary determinant of policy orientation.
A steady state implies a Keynesian world where supply is assumed to be fixed or changing slowly and linearly.
A non-steady state means supply changes non-uniformly and non-linearly, accelerating sharply within certain periods.
I believe China’s potential growth has already entered a non-steady state, as we observe accelerating changes in both factor supply and factor quality. Limited by data frequency, existing measurement methods may struggle to capture these shifts in real time. For example, the declining number of newborns in recent years suggests the dependency ratio is undergoing structural change. Similarly, rising institutional costs reflect this shift. As the former Beijing Mayor Meng Xuenong reflected after the SARS incident: “On narrow paths, turning back is wise; all passersby are transient.” Within certain systems, individuals can feel like puppets—constrained not just by personal factors, but by systemic helplessness. This is institutional cost. Crises like epidemics act like contrast agents in a CT scan: they make hidden institutional costs suddenly visible. When internalized into economic models, this shocks the marginal product of capital (MPK), potentially triggering structural transitions that existing techniques may miss—but that we can perceive.
Thus, I emphasize: under the pandemic shock, what we see is aggregate demand collapsing; what we may not see—but is entirely possible—is potential growth collapsing in parallel.
This is plausible. So how should policy respond?
Over the past 3–5 years, it has become clear that China’s economic dynamics differ markedly from both the past and classical Keynesian economics. The Phillips Curve has broken down: as the economy slows, monetary purchasing power erodes faster, leading to pronounced inflation amid contraction.
Stimulus triggers runaway inflation across commodities, consumption, and services—cash depreciates rapidly. Withdraw stimulus, and debt-deflation pressures re-emerge and self-reinforce; once sentiment turns, containment becomes precarious. Frankly, statisticians at the National Bureau of Statistics have done considerable work stabilizing expectations in recent years.
This begs the question: Is the supply side still in a steady state?
My interpretation of this phenomenon is that inflation during downturns—and the breakdown of the Phillips Curve—originates on the supply side: persistent negative shocks erode long-term growth momentum, while demand remains propped up by entrenched rent-seeking structures. This widening gap creates stubborn inflation expectations—a systemic feature, not just a temporary price level.
No wonder sentiment is poor: money loses value while the economic pie grows slower or stops growing altogether.
Having identified China’s macroeconomic state, where should policy focus amid the pandemic—supply or demand? Focusing on demand is straightforward: deploy monetary, fiscal, and real estate tools. But what do we gain?
If policy focuses on demand and triggers a sharp rebound, a positive output gap would almost certainly lead to rapid inflation.
If it prioritizes the supply side (potential growth), it effectively recalibrates China’s macroeconomic coordinates. The pandemic acts like a contrast agent, suddenly revealing what was blurry. Which coordinates? Externally, China’s integration into the world—especially U.S.-China relations. Domestically, the relationships between government and market, central and local governments, officials and citizens, and people and capital—collectively termed “governance.” This is likely the focal point for academic research.
2. Concrete Perspective
Concretely, macroeconomics can be simplified through the Balassa-Samuelson model. China’s core issue reduces to the gap between the RMB’s nominal and real exchange rates. Over the past few years, this gap has widened. Simply put: the RMB is no longer worth ¥7. Under strict capital controls, the nominal rate is pegged near “7.” Since 2015, China’s balance of payments shows a striking “errors and omissions” item—trade surpluses haven’t fully translated into foreign exchange reserves. Why?
The gap between nominal and real exchange rates reflects economic rents from real estate and “perceived inflation.” Over time, it morphs into systemic risk—raising the probability of a Minsky moment.
From a policy standpoint, narrowing this gap requires a four-character approach: “devalue externally, appreciate internally.”
“External devaluation” depends on circumstances and is hard to achieve. Last year’s move beyond 7 was significant, reflecting political wisdom at the highest level. “Internal appreciation” means strengthening the RMB’s domestic purchasing power. Economists understand the implications.
Here is an emerging logical chain for consideration.
The pandemic’s massive livelihood shortfall squeezes real estate (seen in paralyzed public health resources and broader impacts on SMEs, employment, and incomes). Real estate squeezes local governments, which then pressure the central government. Logically, unless the central government can create space by “squeezing” the U.S.—allowing RMB depreciation—it cannot stimulate domestic demand without forcing real estate to bear the cost alone. But can we squeeze the U.S.? Adversaries are exploiting the situation to compress China’s strategic space. Given Anglo-Saxon pragmatism and a “dark forest” worldview, how plausible is this?
As the global industrial hub—a $14 trillion economy—China has been paralyzed for nearly two months, yet global financial markets have reacted minimally. Indices keep rising, seeming almost indifferent. The only coherent explanation is that the West may be conducting a long-desired stress test on the authenticity and resilience of China’s supply chain role: how replaceable is it? This echoes recent remarks by Mayor Huang Qifan: his greatest worry is that the pandemic could accelerate the shift to “backup suppliers,” meaning some factories may never return.
Colleagues note that Foxconn (Hon Hai), Apple’s contract manufacturer, is running at full capacity in India, Mexico, Thailand, and elsewhere. This may explain why U.S. equities have remained resilient.
The popular historical-political book The Nexus presented a grand narrative of globalization’s supply chain hubs and super-sized economies. Now, the authenticity and resilience of those concepts are being tested. This is our unavoidable reality. We must save ourselves—save the “world’s factory”—urgently. The direction is clear: reduce economic rents and lower institutional costs.
In summary, our current macro-policy may have only one viable direction—partly because we have no alternative.
3. Capital Markets
Short-term, equities have little else going for them besides liquidity. The PBOC’s ~¥3 trillion in reverse repos provided temporary relief, hence the swift recovery. Not because funds flowed directly into stocks, but because massive liquidity eased pressure across the debt network, lifting risk appetite and channeling deposits into equities.
What markets should really worry about are long-term issues: equity valuations ultimately reflect the quality of economic governance—not just economic performance. More broadly, they reflect the function of governance as a whole.
An analogy: China’s economy today resembles a heavily overloaded truck descending a steepening slope while braking continuously—its load accumulated from years of leverage. For years, everyone has accepted the economy is on a downward slope. This model has accumulated risks, and the solutions are widely known. Every equity trader carries a powerful “macro-universe” within, functioning as a capable macroeconomist. Everyone knows the systemic risks China has accumulated; they exist objectively. What the market truly fears is whether we can manage the risk-release process—whether the driver can steer this vehicle safely down the slope.
Since the Central Committee elevated the capital market’s status last year, equities have improved significantly. Society now places high expectations on the market—a sense of historical mission, political will, and national strategy. Today’s tech-stock boom and elevated risk appetite demonstrate this progress.
Can this risk appetite be sustained? It largely hinges on whether subsequent policy shows enough will and capacity to curb—or even reverse—the rising trend of institutional costs. The pandemic acts like a contrast agent—a “major test of governance,” in the Central Committee’s words. Once injected, the coordinates become visible. What comes next? Can we succeed? This is the true test for the equity market. Short-term recovery is a liquidity story—the PBOC’s temporary relief—but attention must also be paid to timely withdrawal, lest side effects become severe.
Whether this market can stand firm long-term—and truly fulfill the Central Committee’s mandate as a “systemic lever optimizing resource allocation”—depends crucially on our commitment to suppressing economic rents and lowering institutional costs.
The above reflects conceptual insights—not data-driven research—offered for your reference and discussion.