A big risk to China’s economy is that troubles associated with the financial system will become more onerous before the government can fully implement the reforms it has announced.
There is continuing evidence of weakness in the Chinese economy. The Chinese government’s own purchasing managers’ index (PMI) for the services sector declined in December, falling from 56.0 in November to 54.6 in December, a five-month low. This follows recent news that PMIs for the manufacturing sector in China also declined in December. Evidently the Chinese economy is decelerating but continues to grow—proving challenging for the leadership as it intends to implement difficult reforms. A strong economy would be a helpful backdrop for reforms as it would offset the negative consequences of structural changes in the economy.
One of the biggest challenges for the government is to rein in the rapid growth of debt, especially debt accumulated by local governments within the shadow banking system. Until now, there was not much transparency about the volume of such debt, only a general idea that it had grown too quickly. However, an audit conducted by China’s national government has determined that local government debt is now 17.9 trillion renminbi ($2.95 trillion), and it has increased 13 percent in the last six months alone and 48 percent in the last two-and-a-half years.1 This verifies the longstanding view that local government debt has soared rapidly.
The audit office said, “China’s government-debt risks are under control in general, but there are potential risks at some places.”2 The main risk is that many of the projects in which local governments invested failed to generate positive returns. Moreover, local governments do not generate much tax revenue, often relying on the sale of land to service their debts. While there have been no defaults, this is largely due to the central government requesting that banks roll over local government debts. Eventually, something has to give. The central government could be forced to resolve the issue by taking over some local government debt. This would have the effect of increasing central government debt and reducing central government fiscal flexibility.
A day after China’s audit office issued the report on the stunning growth of local government debt, the central government pledged to rein in the growth of such debt. The National Development and Reform Commission (NDRC) said it will cut the “disorderly growth” of local government debt by allowing local governments to issue long-term debt in exchange for short-term bank loans. This will be part of a larger effort to develop a municipal bond market. In addition, the NDRC will encourage private investment in infrastructure projects at the local level. Finally, the NDRC intends to more effectively monitor the finances of local governments.3
Separately, the People’s Bank of China said that it will continue to encourage financial reform and innovation. Specifically, it said it will allow banks to issue certificates of deposit.4 This is seen as a first step in allowing free movement of deposit interest rates, which in turn will help discourage the growth of the shadow banking system and force banks to improve the quality of their assets. For now, the cap on deposit rates has two negative consequences. First, by limiting the return that investors get, it encourages some to save excessively or seek alternative investments. As such, many affluent Chinese invest in property, fueling a potential bubble and contributing to excess construction. Second, if banks paid market deposit rates, they would have to charge higher interest rates for loans. This would reduce excessive lending and force banks to boost the quality of their loans. Essentially, freer interest rates would boost the efficiency of the financial system and ultimately lead to less and better investment and faster economic growth.
The government reports that in four key cities house prices increased rapidly in November.
Meanwhile, China’s housing bubble shows no sign of being contained. The government reports that in four key cities house prices increased rapidly in November. Specifically, prices were up 21 percent in Shenzhen and Guangzhou, 18 percent in Shanghai, and 16 percent in Beijing. Prices were up in 69 of 70 cities surveyed. There are several problems associated with rising house prices. First, housing continues to be less affordable for a large number of Chinese. Second, the price rise reflects continued speculative activity in which individuals are taking on mortgage debts that might not be serviceable if prices reverse. Third, prices are rising despite a variety of policy measures designed to cool the market, and thus more blunt policy instruments might be needed.
Financial market reforms offer the promise of a shift away from property investment, yet it could take time before such reforms are implemented. For now, one of the big risks to China’s economy is that troubles associated with the financial system will become more onerous before the government can fully implement the reforms it has discussed.
EndnotesView all endnotes
- Bloomberg News, “China’s local debt swells to 17.9 trillion yuan in audit,” December 31, 2013, http://www.bloomberg.com/news/2013-12-30/china-s-local-debt-swells-to-17-9-trillion-yuan-in-audit.html.
- Reuters, “China says to rein in local debt, push financial reform,” December 31, 2013, http://www.reuters.com/article/2013/12/31/us-china-economy-policy-idUSBRE9BU06P20131231.