These days, everybody cares about economic growth in China—as they should. Depending on how you measure it, China’s economy is either the largest or the second largest in the world. When it comes to global commodity markets, it is the dominant player—viewed through this lens, everyone has skin in the China growth game. A disappointing year for the Chinese economy can have far-ranging domestic and international consequences.
Last week, Chinese leadership treated us to a surprisingly clear statement of its economic goals. Premier Li Qiang announced a 2025 annual real GDP growth target of 5% and an annual inflation target of 2%. This implies that China’s nominal GDP growth target for 2025 is 7% per year. What should we make of this ambitious target?
When it comes to national income determination, we keep our eyes on the money supply. In other words, we think about national income determination, or the course of nominal GDP, through the framework of the quantity theory of money (QTM). As Milton Friedman put it in his 1987 New Palgrave Dictionary of Economics entry, the conclusion the QTM is that “substantial changes in prices or nominal income are almost always the result of changes in nominal supply of money.”
Testing the target
The income form of the QTM states: MV=Py, where M is the money supply, V is the velocity of money, P is the price level, and y is real GDP (national income). The velocity of money is the number of times, per unit of time, that money is used to purchase goods or services in an economy—the “turnover rate” of money. It is important to remember that the quantity theory of money is an identity: The left-hand side of the equation, MV, is the total amount of money spent in an economy, while the right-hand side, Py, is the total income received in an economy. By definition, they must be equal. So that we can analyze short-term percentage changes, we convert the quantity equation into the following differential equation: %ΔM + %ΔV = %ΔP + %Δy.
Since the growth of the money supply is (either directly or indirectly) under the control of the central bank, a country can stimulate or depress nominal GDP growth (%ΔP + %Δy) by changing the growth rate of the money supply (%ΔM) for a given rate of change in velocity (%ΔV). The standard caveat to the QTM is that there are long and variable lags between changes in the supply of money and changes in economic activity and the price level. If the growth rate of the money supply changes today, it can take anywhere from six to 24 months to affect nominal GDP growth.
By rearranging the QTM identity to solve for M, we can gauge whether China’s growth target is realistic. Given a historical (2019-2023) annual change in velocity of -3%, the money supply growth rate required to achieve a real GDP growth target of 5% and an inflation target of 2% must be:
%ΔM = 2% + 5% – (-3%) = 10%
So, in order for China to hit its targets, the People’s Bank of China (PBoC) needs to engineer an annual money supply growth rate of 10%.
We can look at the last 24 months of China’s annual M2 growth rates (the broadest measure of money in China) to surmise whether China will hit its targets in 2025. As it turns out, China’s money supply is not growing quickly enough: Since December 2023, its annual M2 growth rate has averaged 7.44%, with a high of 9.7% in December 2023 and a low of 6.17% in June 2024. Today, the M2 growth rate stands at 7.02% per year.
Deflation problem
The current picture we have of the Chinese economy comports with China’s inadequate money supply growth. A surprise late surge in Chinese real GDP growth in the fourth quarter of 2024 managed to push the annual growth figure just enough to meet the government’s target of 5%, while the price level (measured by the Consumer Price Index—CPI) did not grow at all in 2024, ending the year well below the government’s previous annual inflation target of 3%. Ominously, China just released its February CPI. It entered deflationary territory at a stunning -0.7% per year. If that is not bad enough, in the first two months of 2025, Chinese imports of crude oil, refined oil products, and iron ore dropped by 5%, 16%, and 8% year-over-year, respectively. While some of these developments sent shock waves through financial and commodity markets, they were no surprise to practitioners of the QTM.
Unfortunately for the Chinese, their top leadership, the 24-person Politburo, doesn’t have money on its radar. It seems to only be focusing on fiscal “stimulus” and interest rate reductions. Although it has pledged to adopt a “moderately loose” monetary policy stance, it clearly doesn’t realize, like most central banks today, that monetary policy is not about interest rates or fiscal stimulus, it is only about changes in the stock of money.
Indeed, China’s relatively lackluster performance last year flew in the face of its various fiscal stimulus packages, programs it thought would increase growth and inflation. Just last week, the Politburo unlocked even more fiscal stimulus. Now, the PBoC is banging the interest-rate drum, claiming in January that it will “pay more attention to the role of interest rate control,” specifically the seven-day reverse repo rate, and reducing its emphasis on quantitative, money-based measures like credit growth. The failure of these fiscal and interest-rate programs to stimulate growth must be a real head-scratcher for the Politburo. For monetarists like us, there is no mystery: China’s “stimulus” packages were never really stimulative, because they failed to bring the broad money supply growth rate to a level consistent with its desired growth and inflation targets.
Based on the QTM, it is clear that unless China rapidly gooses its money supply growth rate in the first few months of 2025, a nominal GDP growth target of 7% will turn out to be little more than wishful thinking. Put simply, China will be attempting to drive a car 10 miles with only 7.44 miles worth of gas in its tank.
Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and the author, with Leland Yeager, of Capital, Interest, and Waiting. Caleb Hofmann is a research scholar at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise.
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