Zhiguo He is a Chinese economist and James Irvin Miller Professor of Finance at the Stanford Graduate School of Business. Before joining the Stanford faculty, he was a professor at the Chicago Booth School of Business. Aside from teaching, He also serves as a faculty research associate at the National Bureau of Economic Research and the executive editor of the Review of Asset Pricing Studies.

This transcript has been edited for length and clarity.

Sarah Jeddy: Thank you for taking the time to speak with me. I was wondering if we could start with a brief introduction?

Zhiguo He: I am an economist from China, and I came to the United States in 2001. At that time, China was definitely a developing country, although the economy started opening up a little bit, everybody would agree that China was still lagging behind the US or other countries quite a bit. And when I arrived in 2001, 9/11 happened, and to a lot of people, that’s a game changer. Another event happened at the end of 2001, was the WTO. So China got accessed, entered the WTO in December of that year, and that was definitely a game changer for China’s economy, just that the entire labor force found a way to fuel the economy. It’s also that I wanted to mention a lot is that just Chinese are fundamentally, at least for two generations, they want to work. They work very hard. They are extremely diligent. And they just feel like, if they are working to earn money, it’s part of their consumption. That’s very, very weird. Weird kind of attitudes towards usual people, and hard to understand, to be honest, from outside, but that’s how hard working. And also, you know, just save for the future family to feel the growth of China, I guess, in the past 20 years, in the first part of the 20 years, which is 2001 to 2020 basically.

Sarah Jeddy: Yeah that makes sense. So then what do you think is, like, the cause of, or the relevant history, of the financial relationships between the United States and China?

Zhiguo He: The United States saw bigger investment opportunities in China in the beginning of 2000 when the WTO started opening up China. VCPs got into China in the early 2000. This is where the kind of textbook kind of financial connection started to be established. Before it was like DFI, most direct foreign investment, right? Those examples, including, let’s say, GM invests in Shanghai automobiles. Basically, foreign companies have both the technology as well as intellectual property. They know how to do stuff. China knows nothing. Only have labor, and then they start to collaborate. Beijing, from the very beginning, very clear that, you know, it’s okay, we give you the market, but you need to teach us. How do you do these things? This is now the debate—whether China is stealing technology or not. I just feel like this crazy debate, even this is from the very beginning, very clear. If you can come here, we will learn from you, you know, and oftentimes, we will say that this so-called technology transfer is a premise for you to open up, and it’s all agreed at that time. China is learning super fast. That’s a problem.

One interesting example—when GM started to open up in Shanghai to produce cars, they chose the cars to be made. It was basically in the 70s, already out, and nobody doing this anymore in the U.S. That was a response to this. They knew it. That’s the important part of this, direct foreign investment. Then, finance—true finance investment. Think about jd.com, think about these early internet-based companies. You see very big foreign venture capital names everywhere. Another layer is mutual funds—foreign investors like professional funds start to invest in China, in stocks. That’s the secondary market. The VC is the primary market. FDI is kind of zero level. The third party is also big, through so-called stock connect—where, say, Fidelity or Vanguard can use access in Hong Kong to directly invest in A-shares. Starting from 2016 that was a big exposure. When COVID happened and China’s growth slowed down, a lot of foreign money stayed at first, thinking maybe they’ll have to come back. Eventually, they decided to get out because after two or three years, they kept losing money. I think the lowest point is 2024—most of them are completely out. Now Beijing is doing something to convince them to go back, and that is gonna take a long time. I think they should come back, but it’s beyond my pay grade to really change anything.

Sarah Jeddy: So then, what role do you think that the tariffs imposed by President Trump play in these relations?

Zhiguo He: It will hit the Chinese export industry. I would guess that the GDP will be affected by at least 1%. I’m more on the optimist side. It’s only 1% if Trump indeed launched a blanket tariff. What happened in the past was there’s a lot of exemptions that you can apply for. So a lot of impact can be shielded in the median one. What we already saw last time was that there’s a lot of shifts in the supply chain from China to other countries, and the impact won’t be that large. So in short, tariffs hurt China’s GDP growth. Will that completely change the way people think about China? No, because China is not doing well, just from the very beginning.

Sarah Jeddy: That makes sense. So then I guess, kind of in the same vein we’ve seen efforts from like, both China and the US to decouple financially. So how do you think that would affect global financial stability, if at all?

Zhiguo He: I think decoupling is really happening at the heart of technology. There’s another area where decoupling is heavy—science. I worry about it. I don’t think there’s any solution to that. A lot of researchers would like to travel to both sides, but both governments are influenced by certain interest groups. In China, there are groups that try to convince Beijing that we need to prepare for the worst—potential U.S. military actions. I can imagine the other side does too. So all the sensitive exchanges, including financial, will be cautioned to an extreme extent. On that side, I am pessimistic. I think in the time of Trump, as well as Xi, it’s harder to get any progress. One thing I do see is that Singapore benefits. Most of these kinds of meetings happen in Singapore now.

Sarah Jeddy: So do you think that Singapore is going to play an increasingly large role?

Zhiguo He: They already play a role. They enjoy their position very, very well.

Sarah Jeddy: Do you think they would try to leverage that for more? Do you think they will succeed?

Zhiguo He: They already succeeded. It’s an extremely small country. For a while, there were a lot of Hong Kong businessmen going to Singapore because they were worried that Hong Kong is not politically stable. I always went to Hong Kong, and there’s always a group of very lefty people versus extremely right. People who want a Hong Kong with no attachment to Beijing. Others believe Hong Kong can survive only because of Beijing and are very grateful. I wouldn’t say that I agree with everything, but Beijing just wants political stability. It’s not trying to discourage economic diversity. For instance, cryptocurrencies—in the mainland it’s all banned, but in Hong Kong, it flourished. Hong Kong even tried to compete against Singapore as another center for cryptocurrencies. And Beijing is very happy about this outcome.

Sarah Jeddy: Okay, so kind of pivoting, I guess. What role do you think China will play in shaping global financial markets in the coming years?

Zhiguo He: Little.

Sarah Jeddy: Little? Do you think it’s going to shift towards Singapore then?

Zhiguo He: In the old times, China got people’s attention not because of its financial market—it was booming. People went there to make money. But the power you felt was from the real business: jd.com, Alibaba, Tencent, Ant Financial. Now Deep Seek. Financially? It’s little. What people might sense is that because of its economic growth, because its trade was growing so fast, its currency became popular. The RMB, Chinese yuan, became a hard currency in Pakistan, East Asia. Beijing is excited about seeing that. They want to make the currency more influential. Replacing the dollar? Almost impossible. But becoming important locally—Southeast Asia—yes. That’s standard.

Hong Kong helped foreign investors get access to the onshore market where they can do hedging and other instruments. In that sense, it affects global financial markets. But China has closed capital accounts, which means money cannot move freely. So the impact China has on the world is through the real economy—not through financial markets.

Sarah Jeddy: So then, what do you think the real impacts will be in the coming years?

Zhiguo He: Manufacturing. China has impacted the world through this extremely complete, sophisticated value chain. Everything—China can produce. They’re moving away from extremely low-end work. Some things are moving to Vietnam or India. But when it comes to iPhone-level production—high-end parts—other countries cannot do it. Think about where chips reside—not the chips themselves, but the circuit boards. You need sophisticated manufacturing to do those things.

Sarah Jeddy: So those were all my questions. If you have any more comments.

Zhiguo He: I actually wanted to say something about what Neil was talking about this morning—entrepreneurs and private business in Beijing. Also related to industrial policy. I’m very neutral, slightly positive, towards industrial policy—China trying to promote hardcore technology over, say, food delivery apps. Beijing thinks that kind of thing is less useful than chips, for example. I think that’s fine. They’re slowly figuring out the best way is not to pick winners themselves. What’s good about the recent EV car industry is they subsidized consumers. First, they built out charging stations—only the government can do that. Second, they subsidized purchases. Not always 100% useful, but the best any government can do. The U.S. does it too. The issue is when governments subsidize the firms directly. The better way is to subsidize the consumers—let the market pick the winners. Customers still want the best product. Whoever wins the market gets the money. That explains the fast growth of EV cars in China in the past three years.

Sarah Jeddy: Yeah, that makes sense. Perfect, thank you so much for taking the time to talk to me. I really enjoyed this!

Zhiguo He: Thank you!

Image courtesy of Zhiguo He

This transcript is from an interview conducted on March 9, 2025, in partnership with the Brown China Summit (BCS). Founded in 2014, the Brown China Summit is Brown University’s student-led hub for all things China. Their mission is to promote and facilitate constructive dialogues about China’s global role on all fronts. This year’s annual conference, BCS 2025: Silk Roads and Cyber Paths, featured panels on China’s Artificial Intelligence Strategy, China’s financial markets, US-China Relations and their impact on Southeast Asia, Religion in China, and the Chinese real estate crisis. Keynote speakers included Xiao Geng, seasoned financial regulator and Chairman of the Hong Kong Institution of International Finance, as well as Susan Thornton, former US Diplomat to China and Assistant Secretary of State for East Asian and Pacific Affairs. Besides their annual conference, BCS hosts regular Chinese movie screenings, talks with Chinese entrepreneurs/industry leaders, and other discussion events throughout the year. See their website for more information: https://www.brownchinasummit.org/

This interview was conducted with Liqian Ren, Director of Modern Alpha at WisdomTree Investments. She came to the United States almost 30 years ago after receiving her bachelor’s degree in computer science from Peking University in Beijing, China. Liqian Ren later received her master’s degree in economics from Indiana University–Purdue University Indianapolis and then her MBA and Ph.D. in economics from the University of Chicago. 

This interview has been edited for length and clarity. 

Niemiec: Can you share your thoughts about the current state of China’s economy and finances? 

Ren: I think because China’s equity has had a lot of volatility in the last couple of years, it is investable–but it has a lot of risks. Clients are reminded that for [investing in] China, you need to know not only how much risk you can take, but also how much risk you are willing to take. China can endure for two or three years, but before the recent run, there was lots of very negative sentiment on China equity. It makes people wonder: did they make the right investment? There are a lot of opportunities in China to make money, but it’s also very risky. 

The US and China are in competition, and the US does have a lot of tools that it could use. Some of those tools are not yet used. If the relationship deteriorates further, I assume that the US will use a lot of those tools, like limiting investment, for example. The US currently limits private equity investment in certain Chinese industries. It could be broader. It is possible that the US may also limit public market investment. China is still very vibrant in terms of entrepreneurship, so that is a positive.

Rivas: How do you think the current geopolitical tensions between the US and China are influencing investment strategies and opportunities? 

Ren: The US-China relationship directly impacts China’s equity. If you look at tax sanctions and the trade war, these are generally negative for China and Chinese companies. Companies will not be able to make as much money as before. Tax sanctions are going to be the number one factor. On the other hand, China’s equity is also very driven by local factors. For example, of the two biggest rallies in the last six months, one was in September, which was driven by Chinese policy, and the second one was DeepSeek, which was driven by China’s AI development. It is true that the US-China relationship is a factor; but I will say, if I have to put it in a quantitative form, that China’s equity is 60 percent driven by domestic and local factors and 40 percent driven by the US-China relationship. 

Rivas: Can you elaborate on DeepSeek? 

Ren: DeepSeek itself and its technology are still not as good as ChatGPT. What really changed is people’s perception of Chinese AI development. The US in the last couple of years has been using mostly two tools to limit Chinese AI research. One is tax sanctions and not allowing China to acquire any chips. The second tool is limiting Chinese access to US research capability. Chinese students and researchers do have a hard time coming to the US to study. 

DeepSeek is a little bit of a counter to these limits. The US was successful but not as successful as they thought they could be because DeepSeek, first, was able to develop China’s generative AI, using software investment in improvements, instead of chips, which is hardware, which the US is putting sanctions on. Secondly, a lot of DeepSeek’s researchers came from top Chinese universities like Zhejiang University. That is also kind of a signal that the US limiting the Chinese from coming and studying in the US is not working. A lot of people here thought, hey, if we don’t allow them to have chips, we don’t allow them to study, then China is not going to be able to develop AI in the near term. But it turns out, within about two years, you have a player that comes and delivers a good enough technology, again, not as good as the US, but good enough. But good enough is good enough for China. 

Niemiec: Do you think DeepSeek could get as good or even better than what we have now? 

Ren: Right now, I think the US is still the tech leader. China, in AI, will be a little bit behind until it’s the same as the US. However, in a few selective strap areas, like batteries, China’s technology probably is now very close to the US. With DeepSeek, I think what China demonstrated is that it was close enough. If China didn’t develop AI in the next five years, then it would indicate it’s really behind. DeepSeek was able to be developed within two or three years. That suggests to people that if the US has sanctions, if there’s a lead, the lead time is probably closer to three years instead of ten years, as many people originally thought it was. 

Rivas: How will the tariffs recently imposed by Donald Trump on China impact the Chinese economy? 

Ren: It’s definitely negative, because China does rely on exports. On the other hand, if you remember, during the first trade war, China was able to continue to export to counter some of those negative impacts. So yes, it is negative; on the other hand, because China is a producer, and it does have a skill economy and a lot of things like clothing, where even though some of it has been moved outside, China still retains much of it. I personally love fashion, but if you go into stores and you check some of the clothes that are usually made in China, these clothes are slightly on the higher price end. The reason is that China’s supply chain is still very resilient and if stores want a piece of really complex construction to be done, they prefer it be done in China, considering the quality. So yes, it has a negative impact. But China also has some resiliency in these trade tariffs. 

Niemiec: In terms of resilience, there have been a couple news sources reporting retaliatory tariffs that could be imposed on the US. What is your opinion on those? Do you think that was a good move? 

Ren: A lot of these retaliations are mostly for the media. The Chinese government also has local public pressure, right? If it doesn’t do anything, it will be perceived as weak. They do have pressure to come up with something. But if you actually look at what China came out with, the retaliatory measures, it’s very low-skill, very targeted. The impact is nothing like a counter. So I will say those are mostly for China to do something to show that it is willing to fight back a little. But it’s not yet completely a trade war. China still hopes to navigate this to come up with some understanding with the US while also trying to open up a market for Chinese goods outside the US. Chinese exports to the US are still a huge part of its economy, but China is also trying to sell to other countries. I think there it goes back to the US being the ultimate buyer. The US has a lot of leverage, but I think the main purpose of China’s retaliations is about doing something, about communicating to the local public that we are going to do something, but the actual retaliation is very limited. 

Rivas: What sectors of the economic market in China do you believe have the most promise for long-term growth and why? 

Ren: So a lot of times investment is different from extra growth. I will say in China, high-end manufacturing will continue to grow, because it is now not just for economic growth, it’s also a government countermeasure against the US. But that does not necessarily mean that if you just buy stocks in high end manufacturing, you need to be able to sell to expand the market outside. I would say the areas that will see more growth are more manufacturing-related, more technology-related. This is mainly because they are also going to get more government-oriented money. The other area of growth is probably Chinese domestic brands. For many Chinese locals, luxury brands used to be very dominated by Western businesses like Louis Vuitton. Because China’s economy is not in a good condition, not as positive as before, a lot of Chinese consumers want high quality products but also cheaper prices. Chinese brands are trying to develop a lot within the higher luxury space. Chinese luxury brands don’t have the name recognition of other top brand names, but they domestically are able to offer good value and high quality clothing. A lot of these domestic brands and branded goods are likely to grow in popularity. Before, you didn’t hear about Chinese brands because manufacturers usually sell for American brands, but now, because the US wants to decouple, these Chinese manufacturers need to find something and they found having a brand actually helps the profitability. I think we will see a rise of these Chinese brand activities. 

Rivas: Billionaires and people of wealth are having an increasing impact on politics. Do you think such individuals will affect relations between the US and other countries, including China? 

Ren: That’s very interesting. We are in uncharted history here. I tried to go back and read history, but honestly, I wasn’t able to find anything. During the Cold War, there were American entrepreneurs who also had business interests in the Soviet Union, but the Soviet economy was never as tapped globally as China’s is now. It really is an uncharted history. That’s the way I’m seeing it. China right now doesn’t need the foreign direct investment, but I don’t think they will go against these entrepreneurs. Actually, China is very welcoming of companies like Tesla. Sometimes they do a little bit of limiting, for example preventing Tesla cars from going into government compounds. Even that comes and goes, and now they say they don’t do that anymore. Tesla’s self-driving software is now being tested in China. The US is not allowing Chinese workers to come to prevent a “sphere of spying”. yet China is still allowing Tesla to be a self-driving system. I think on these issues, China probably will use them as a way to show that China doesn’t want to decouple as much. I think the pressure will be coming more from the US side. If the US public feels that Elon Musk’s business is impacting his judgment, the public opinion in the US will probably shift first. I think generally China is courting these entrepreneurs instead of doing negative things to them. They prefer American firms to come and invest. 

Niemiec: For clarification, would you say that foreign investment in China is mostly private investors or international investors that invest in Chinese equities? 

Ren: If it’s a strategy listed in the US, then it’s still mostly US investors, even though people have been—before the recent run—much more negative on those. One of the panelists mentioned China as uninvestable. I personally think it’s investable. It’s just that it has a lot of risks. If it’s a strategy outside, it’s still the US public and the US institutions. I think pension funds are now going to leave China due to the political pressure. The state pension fund, especially in the more conservative states, is probably going to be the first mover. But if the relationship deteriorates, any investor or pension funds can be subject to scrutiny. I think we have not gone to that end yet. In direct investment, it’s definitely American firms. I think American firms, if you see banks and pharmaceutical firms, have reduced their investment significantly. Foreign direct investment in China has really gone down significantly, but companies like Tesla are still investing in China.

Image courtesy of WisdomTree

Signage hangs at the International Monetary Fund (IMF) headquarters in Washington, D.C., U.S., on Tuesday, April 14, 2020. In its first World Economic Outlook report since the spread of the coronavirus and subsequent freezing of major economies, the IMF estimated today that global gross domestic product will shrink 3% this year. Photographer: Andrew Harrer/Bloomberg via Getty Images

The lingering effects of the COVID-19 virus remain to be seen in full as the world grapples with the third wave of infection.^[1] A little more than a year after COVID-19 was declared a pandemic by the World Health Organization, however, Sub-Saharan African countries have developed a level of expertise in not only protective health measures, but also in fiscal policies that allow them to curb and recover from the hard-hitting economic depression they experienced at the start of 2020.

While individual nations have experienced their unique successes and challenges, a recent World Bank report stated that overall, Sub-Saharan Africa is projected to experience an economic gross domestic product growth of 2.3% to 3.4% in 2021, sharply contrasting to its 2% decline in 2020.^[2] The significance of this feat can be found in the fact that such growth is attributed to economies heavily reliant on tourism and trade; by contrast, global economic powerhouses like Germany and France are predicted to grow on a similar scale of 3.6% and 4.2%.^[3]

In a virtual briefing with Albert Zeufak, the World Bank’s Chief Economist for Africa, multiple reasons were cited to explain the successful recovery, the first being stronger agricultural growth and a recovery in commodity and consumer prices that was faster than expected. In splitting Sub-Saharan African economies into three – the largest (i.e. Nigeria, South Africa, and Angola), diversified (i.e. Kenya), and mining economies (i.e. Botswana) – an analysis of the International Monetary Fund’s (IMF) Regional Economic Outlook for Sub-Saharan Africa can lend insight into Zeufak’s claim.The average consumer price percent change in South Africa dropped from 4.1 to 3.3 in 2020 and quickly recovered to 3.9; in Kenya, from 5.2 to 5.3 in 2020 and a return to 5.0; and in Botswana, from 2.8 to 1.6 and a return to 3.0.^[4]

Zeufak further attributes the success of Sub-Saharan African economies in the face of COVID-19 to a “clear rebound in consumption and investment confidence returning to countries that have managed to contain the virus.”^[5] Although it is true that the third and current viral wave has boiled down to infection numbers 41% as high as the previous wave, weighing on the World Bank and IMF’s growth projections, steadily increasing vaccination coverage rates spearheaded by donations and supranational alliances such as GAVI, a supranational health partnership for vaccine distribution, have served as a plus-point for these nations.^[6]  The unique commodity outputs of different Sub-Saharan African nations have also been attracting investors around the world; diversified economies and rising mining economies are looking more appealing as the rest of the world also suffers from the economic stress due to the virus. Diversified economies like the Ivory Coast and Zambia (whose exports number around 700) have enjoyed a total investment increase of 1% and 0.6% respectively, and mining economies like Guinea have experienced an increase of 3%.^[4] While the numbers may not seem incredibly set apart from the trends in previous years, the mere fact that these countries experienced an increase and not a decrease in investment during a pandemic is impressive.

Debt suspensions and loans also happen to be at the forefront of the predicted 3.4% GDP growth for Sub-Saharan Africa. Several African countries have signed up to be a part of a debt relief plan announced near the end of 2020. Led by the world’s top 20 economies, the task force called Group of 20 (G20), officiated a debt suspension plan that entailed the freezing of all debts until mid-2021.^[7] In addition, G20 called upon private creditors to take part in implementing a comparable initiative, their goal being to defer $12 billion in extra liquidity. While they experienced little to no luck on that end, the G20 Initiative still managed to assist more than half of the countries on their list, generating around $5.7 in debt payments. Additionally, supranational organizations like the IMF have been coming to provisional agreements on programs and packages that could support the COVID-19-induced crises.^[3] Considering that debts have only been temporarily suspended, it is plausible that come mid-2021, some indebted countries may return back to their initial position with the loaner state. It is also reasonable, however, to assume that with many SubSaharan African states finding success in their economies, the financial pressure they face may wane slightly.

The economic rebound of Sub-Saharan Africa portrays an economic triumph for the continent in global fiscal context. The World Bank projects a 4% GDP growth rate by 2022; this means that from 2020 to 2022, the years the COVID-19 virus was and is most active, the Sub-Saharan African region will have experienced a percent change of 2%.^[3] The world’s largest economies pale in comparison: the United States will have experienced a 0% change and the Eurozone, a negative 2.8% change in those two years.^[11],[12] It certainly is a strange twist in the typical order of affairs, where the ex-imperial developed nations of the West dominated the global economy and free trade markets in every way possible; the irony of it all exists in the fact that within a pandemic, Sub-Saharan Africa experienced the greatest increase in real GDP growth in the past two decades while the Eurozone and United States experienced one of the lowest changes in real GDP growth in that same time period. Perhaps the potential for a future in which the developing, ex-colonial countries of Sub-Saharan Africa match the economic prowess of the developed nations of the West exists. And perhaps, then, the return of these countries to their pre-colonial glory is feasible after all.

References

^[1]The Guardian. “Covid Third Wave May Overrun Africa’s Healthcare, Warns WHO,” March 26, 2021. http://www.theguardian.com/global-development/2021/mar/26/covid-third-wave-threatens-african-healthcare-who.

^[2]Reuters. “Sub-Saharan Africa Economies to Grow 2.3%-3.4% This Year – World Bank,” March 31, 2021. https://www.reuters.com/world/middle-east/sub-saharan-africa-economies-grow-23-34-this-year-world-bank-2021-03-31/.

^[3]IMF. “World Economic Outlook, April 2021: Managing Divergent Recoveries.” Accessed April 25, 2021. https://www.imf.org/en/Publications/WEO/Issues/2021/03/23/world-economic-outlook-april-2021.

^[4]IMF. “Regional Economic Outlook for Sub-Saharan Africa.” Accessed April 25, 2021. https://www.imf.org/en/Publications/REO/SSA/Issues/2020/10/22/regional-economic-outlook-sub-saharan-africa.

^[5]“Bloomberg – Sub-Saharan Africa Set for Uneven Rebound, World Bank Says” Accessed April 25, 2021.https://www.bloomberg.com/tosv2.html?vid=&uuid=2 f8277f0-a60c-11eb-87c7-8f0662665b7e&url=L25ld3MvYXJ0aWNsZXMvMjAyMS0wMy0zMS9zdWItc2FoYXJhbi1hZnJpY2Etc2V0LWZvci11bmV2ZW4tcmVib3VuZC13b3JsZC1iYW5rLXNheXM=.

^[6] “Covid-19 Africa: Who Is Getting the Vaccine?” BBC News, March 19, 2021, sec. Reality Check. https://www.bbc.com/news/56100076.

^[7]Shalal, Davide Barbuscia, Andrea. “G20 to Extend Debt Relief to Mid-2021, Pushes Private Sector to Help.” Reuters, November 22, 2020. https://www.reuters.com/article/us-g20-saudi-debt-idUSKBN2820NJ.

^[8]IMF. “IMF Loan to Support Economic Recovery in Kenya.” Accessed April 25, 2021. https://www.imf.org/en/News/Articles/2021/03/17/na031721-imf-loan-to-support-economic-recovery-in-kenya.

^[9]Fairless, Tom. “As Covid-19 Vaccines Lag, Europe Keeps Cheap Money Flowing.” Wall Street Journal, April 22, 2021, sec. Economy. https://www.wsj.com/articles/ecb-expected-to-keep-policy-unchanged-split-on-what-to-do-next-11619066162.

Written by Jake Kochanowsky (Wesleyan University)

While all eyes are fixated on the chaotic Brexit negotiations, another major political story is unfolding in Italy. After emerging victorious from a contentious parliamentary election earlier this year, the Italian Five Star Movement (MS5), a far-right populist party, has formed a coalition government with the League, another conservative party. Together, they have attempted to follow through on campaign promises by proposing a radically modified government budget that will increase government spending for the Italian welfare system. Internationally, the budget has been deemed as illogical as a result of Italy’s history of economic struggles and growing debt. The EU’s concerns about the budget are legitimate and even necessary to prevent severe political and economic repercussions, yet the Italian government is resistant to EU conformity and any reduction of its sovereignty over domestic policies. It is a tenuous situation, and Italy’s major role in the Eurozone as its third largest economy lends it additional urgency. In this paper, I will consider why the Five Star Movement insists on its impractical budget and what the economic and political consequences of this budget are as it stands. Despite its commitment to its campaign promises, MS5 and its ministers must consider alternatives to its budget; otherwise, the country will face an economic recession that will harm the world economy. 

Capitalizing on rural frustration with establishment politics and Italy’s large influx of immigrants, the MS5 successfully won control of the Italian Parliament in the 2018 general election. The party promoted itself on the promises that it would deport illegal immigrants and focus its internal policies on creating jobs and lowering the national tax rate.[1]The hope these policies engendered in supporters generated enough momentum to carry the party to power in the Italian government via a coalition with a similar right-wing party, the League. Compelled to follow through on campaign promises, Luigi Di Maio, Matteo Salvini and many MS5 leaders adjusted the Italian budget to cover higher government expenditures. Motivated by the welfare of their constituents, the MS5-led parliament has proposed a new budget that includes allowing retirement as early as the age of 62, instead of 67 years old, and introducing a “citizenship income” or basic welfare level of €780 a month for the poor and unemployed.[2] Most importantly, they plan to cut the income tax which will be split into two brackets, with citizens paying 15% or 20% of their annual income.[3]

The proposed budgetary modifications are unpalatable to the EU since the new budget will raise Italian deficits on its GDP to 2.4%, an increase from 0.8% in the original budget.[4] While this deficit isn’t above the EU’s hard cap of 3%, Italy’s economic woes over the past two decades and stagnant growth have many in the EU Commission worried about the consequences this budget will have on the Italian economy and the EU’s economy as a whole. Furthermore, the EU wants member states to avoid breaching a public debt ceiling of 60% of GDP. Italy, with the second highest debt in the EU, already sits at 131% of its GDP.[5] This staggering debt figure has rattled investor confidence and decreased bank loans, interest rates and the strength of the euro, compelling the EU to intervene.

Accordingly, the EU has responded to this “serious non-compliance” to existing economic regulations by condemning the Italian budget and threatening disciplinary action.[6] Moving forward, the EU Commission has started a process which will create a timetable for the Italians to modify their budget; if they do not comply, they will face fines up to 0.5% of their GDP (roughly €9 billion).[7] It is in both parties’ best interests to avoid this scenario, but the Italian government has not been receptive to EU feedback. Italian Prime Minister Matteo Salvini reflected the opinion of the Italian people when he responded, “the EU should respect the Italian people considering Italy pays the EU €5 billion more than it receives.”[8] This statement is reflective of the Italian attitude towards the EU as 52% of Italian citizens are anti-EU. This sentiment has been driven in recent years by the recent dependence in the EU on its larger nations, such as Italy, to pay a higher portion in taxes while receiving less money back in subsidies and investment. Additionally, the EU’s immigration policies run contrary to the MS5’s platform and has added to the tensions between the current government and their EU counterparts. However, despite the majority Euroscepticism in Italy, don’t expect the Italians to leave the EU just yet. The Italians may remain adamant about their budget and cynical of the EU Commission’s suggestions, yet it is important that the Italians at least consider the feedback in order to maintain their position in the EU and prevent their economy from weakening further.

It is evident Italy is attempting to veil its euro-skeptic attitude, and instead is demonstrating specious optimism regarding the budget by proffering an argument that lacks data and statistical evidence.  EU criticism of the budget has noted that in a situation of extremely high debt, Italy is planning significant additional borrowing rather than fiscal prudence. Commission VP Valdis Dombrovskis stated, “the uncertainty and the rising interest rates are taking their toll on the Italian economy. Also, it hinders the ability of Italian banks to lend to Italian companies and households at affordable cost.”[9] The Italians disagree with this analysis; instead, they suggest that their borrow-and-spend policy would boost economic growth, reduce the debt ratio, and decrease unemployment rates, which currently sits at 10.5% (and is a grotesquely high 32.5% for young professionals).[10] However, the EU Commission’s economic analyses suggest that this strategy will fail to produce the economic returns the Italian government expects and leave Italy with an even larger debt burden.[11] This would lead to further market turbulence, credit downgrades, and will severely restrict credit lines for Italian companies. Consequently, a failure to address these issues would have a widespread economic impact.

The Commission’s concerns are well-founded – decades of economic strain and inefficiency serve as proof that Italy is in poor financial health and ill-prepared to increase government spending. Italy’s €2.3 trillion in national debt is extremely risky, and budgetary issues have contributed in bringing its economy to the brink of recession.[12] The Commission says Italy’s budget plan would increase the structural debt-to-GDP deficit by around 1.2% of GDP, or about €22 billion, and is demanding a deficit reduction instead.[13] That would imply spending cuts far in excess of the roughly €8 billion of savings that Italy’s government currently plans.[14] With its outstanding debt obligations, Italy has many worried that it could default on its debt, triggering a recession and greatly weakening the Eurozone.

As of recent, the European Central Bank and other foreign creditors have ceased purchasing Italian government bonds and debt, because they question Italy’s ability to pay off its debt obligations, especially with concerns that the proposed budget will continue to raise interest rates and lead to the government defaulting on its debt.[15] There is fear that these government bonds, whose yield rates have reached record highs, will become worthless.[16] At the moment, Italian banks, who are the primary holders of these bonds, would also incur tremendous losses on these sunk assets. Devoid of billions of euros in assets, the banks would be forced to open new lines of credit that would make them susceptible to defaulting on their own debt obligations. In this potential scenario, the banks would be dependent on its bankrupt government to bail them out, likely forcing extensive stimulus packages and loans from the EU and thereby weakening the Eurozone. Furthermore, even these last resort stimulus packages are not guaranteed. If the European Central Bank (ECB) and other international creditor refused to lend to Italy’s government to keep its public services running, the political and economic consequences would be incalculable.

The fiscal tension resulting from MS5’s policies has also greatly impacted interest rates, bank loans and growth in the Italian private sector, creating a trickle-down effect of negative repercussions. Interest rates sit at all-time lows; however, the Italian banks are skeptical of a financial downturn and an increase in loan defaults, and have greatly reduced the number of loans available to the public.[17] In Italy, 90% of small and medium sized businesses are dependent on bank loans, but even the safest borrowers have suffered a reduction in the availability of these loans.[18] As a result, Italy’s business activities and entrepreneurial ventures have all been curtailed. The IMF estimates that the credit tightening triggered by Italy’s budget plan has already slowed economic growth and that this decline cannot be reversed by Italian stimulus spending.[19] In addition, an economic tool, the Purchasing Managers Index (PMI), indicates that Italian business activity contracted in November, raising the likelihood that Italy is moving towards recession. Italy’s GDP fell by 0.5% in the third quarter, which many attribute to a steep decline in business investments, compounded by hesitant consumer spending.[20] Finally, the PMI predicts that Italy’s economy will contract once more in fourth quarter, meaning the country will enter a technical recession for the first time since 2013.[21] Italy’s GDP has consistently grown at rates lower than the whole of the EU since 2012, but its decline in the last quarter has made it apparent that fears over the new budget are well-founded. The resulting contractionary financial spending by Italian banks has already hurt Italian businesses and under the proposed budget, these issues will only be exacerbated in the private sector.

The growing risk of recession is putting pressure on Italy’s new government to yield to the EU Commission and comply with EU fiscal rules, despite MS5 and the League’s previous protests. As of December 2018, Italian Economic Minister Giovanni Tria has suggested that he is willing to start a dialogue with the Commission to adjust MS5’s proposed budget, yet he also maintains that any such changes should not impede economic growth. If economic growth is Italy’s key priority, then MS5’s course of action is obvious – it must fully comply with the EU Commission. The confidence shock to bond markets, Italian banks and the country’s business sector illustrates the constraints facing financially fragile nations like Italy in the Eurozone. The current economic troubles are felt by everyone from the government to the banks to the Italian workers. In the long-run, to ensure the strength of its currency and access to ECB funds, the Italians are best-served by remaining in the EU. In the interim, to revitalize its economy, its businesses, and create job growth, Italy must cooperate with the EU to prevent the country from encountering the same economic conundrum that Greece currently faces. While it might not serve their political interests, the Italian government must accept EU demands to keep itself from pushing its own economy into a recession.

The uphill battle to fix the Italian economy will require greater political compliance by its ruling government, who may have to sacrifice its campaign promises for the betterment of its country’s financial health. Although it is unrealistic to expect that the Italian economy will recover in the immediate future, heavy changes to MS5’s proposed budget are necessary to keep the economy from sliding into a recession with Eurozone-wide consequences. In any case, it is certain that economists, international investors, and Italian citizens will be closely watching the ongoing dialogue between Italy and the EU Commission. With Italy on the verge of a recession, it is imperative that they heed the EU’s concerns and adjust their budget to prevent the collapse of their economy.  

Endnotes

[1] James Politi, “Populist Beliefs: Where Italy’s League and Five Star Stand,” Financial Times, May 10, 2018, https://www.ft.com/content/8ca9a840-543e-11e8-b3ee-41e0209208ec.

[2] The Associated Press, “Italy’s New Populist Leaders Vow to Deliver on Campaign Promises,” The New York Times, June 08, 2018, https://www.nytimes.com/2018/06/03/world/europe/italy-government.html.

[3] The Associated Press, “Italy’s New Populist Leaders Vow to Deliver on Campaign Promises.”

[4] Bjarke Smith-Meyer and Silvia Sciorilli Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans,” POLITICO, November 24, 2018, https://www.politico.eu/pro/commission-calls-for-disciplinary-action-against-italy-over-budget-plans/.

[5] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[6] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[7] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[8] Smith-Meyer and Borrelli, “Commission Calls for Disciplinary Action against Italy over Budget Plans.”

[9] Jan Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant,” Reuters, November 21, 2018, https://www.reuters.com/article/us-italy-budget-eu/eu-moves-to-discipline-italy-over-budget-rome-remains-defiant-idUSKCN1NP2MX.

[10] Eric Sylvers, “Italy’s Big Budget, Designed to Help Business, Is Hurting It,” The Wall Street Journal, November 21, 2018, https://www.wsj.com/articles/italys-big-budget-designed-to-help-business-is-hurting-it-1542796201.

[11] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[12] Giovanni Legorano and Paul Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession,” The Wall Street Journal, December 05, 2018, https://www.wsj.com/articles/italy-tries-to-end-budget-fight-with-eu-as-economy-teeters-on-recession-1544017194.

[13] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[14] Strupczewski, “EU Moves to Discipline Italy over Budget, Rome Remains Defiant.”

[15] Sean O’Grady, “Italy Is Pushing Europe to the Brink of Another Economic Crisis,” The Independent, October 03, 2018, https://www.independent.co.uk/voices/europe-italy-eurozone-debt-crisis-salvini-on-the-brink-economic-crisis-not-new-a8566416.html.

[16] O’Grady, “Italy Is Pushing Europe to the Brink of Another Economic Crisis.”

[17] Jason Horowitz and Steven Erlanger, “E.U. Rejects Italy’s Budget, and Populists Dig In,” The New York Times, October 23, 2018, https://www.nytimes.com/2018/10/23/world/europe/italy-budget-eu.html.

[18] Horowitz and Erlanger, “E.U. Rejects Italy’s Budget, and Populists Dig In.”

[19] Legorano and Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession.”

[20] Joseph Hayes, “PMI Suggests Italy to Enter Technical Recession in Fourth Quarter,” IHS Markit, December 07, 2018, https://ihsmarkit.com/research-analysis/pmi-suggests-italy-to-enter-technical-recession-in-Q4-071218.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed: MarkitPMIsAndEconomicData.

[21] Hayes, “PMI Suggests Italy to Enter Technical Recession in Fourth Quarter.”

[22] Legorano and Hannon, “Italy Tries to End Budget Fight With EU as Economy Teeters on Recession.”