With a new regime just installed in China, it could take some time to implement essential reforms. In the interim, China faces risks from local government debt and the shadow banking system.
How fast can China grow? That is the question underlying much of the discussion about China’s economy these days. Clearly, double-digit growth is not in the cards and may even be a thing of the past. Growth of 7.7 percent in the first quarter was considered disappointing, and, until recently, many analysts were expecting growth to revert to the range of 8–9 percent. Yet now the government appears determined to reset expectations. The government has forecast that growth this year will be 7.5 percent, a good deal lower than many private analysts had forecast only recently. That is certainly slower than the 7.8 percent growth in 2012, which was the slowest rate of growth in 13 years.
Premier Li Keqiang, in a recent speech in Germany, said that growth for the remainder of the decade will average an even lower 7.0 percent per year. Although far slower than the growth experienced during the past two decades, Li indicated that China is “entering a range of reasonable growth.” Given that China has become a more mature economy with a declining labor force, Li is probably correct in setting more modest expectations. Moreover, growth of 7.0 percent is not bad: It doubles the GDP in 10 years. Li said that a combination of industrialization, urbanization, improvements in agricultural productivity, and investments in technology can contribute to healthy growth, and that this requires more market-oriented reforms. He also said that “for a very big economy, this is not easy.”
When and how such reforms will be implemented remains uncertain. While some reforms have been announced, many government statements have been relatively vague. With a new regime just installed, it could take some time to build the support necessary to implement much-needed reforms. In the interim, China faces some risks, including the ramifications of large local government debt, considerable leverage in the shadow banking system, and weaker-than-expected manufacturing activity. Manufacturing weakness stems from weakness in export markets. In addition, rising wages in China are having an adverse impact on export competitiveness, thereby leading to an exodus of manufacturing capacity. Thus, even growth in the range of 7–8 percent cannot be guaranteed.
Financial market reforms
One area of reform in which the government has begun to take action involves the financial system. Indeed, China appears to be on the verge of implementing significant reforms. A report from the central bank says that there is consensus that now is the time to introduce deposit insurance to the banking system. Analysts say that this bodes well for introducing liberalization of interest rates. Free movement of interest rates would eliminate the automatic nature of bank profitability that now exists under interest rate controls, which puts bank capital, and consequently deposits, at risk—hence the need for deposit insurance.
Freer interest-rate movement will be critical to eliminating some of the imbalances in the Chinese economy. Government-controlled interest rates mean that funds are not necessarily channeled to the most profitable uses. As such, currently there is often excessive and ineffective investment, not to mention incentives for excessive risk taking that puts the entire system at risk. Low interest rates have probably contributed to the property price bubble in China as well. Freer interest rates also would help reduce the demand for shadow banking services, which also create risks to the economy. Indeed, the central bank report called for greater supervision of such activities. Why is this so important?
Premier Li Keqiang, in a recent speech in Germany, said that growth for the remainder of the decade will average an even lower 7.0 percent per year.
China’s shadow banking system could pose a systemic risk to China’s financial system. In China, formal banks face interest rate regulations, both on deposits and loans. This restricts the supply of credit and channels most such credit to state-run companies. However, tens of thousands of non-bank entities have been established in order to operate outside interest rate controls. Some such entities, part of the shadow banking system, are operated off-balance-sheet by banks. They are funded not by deposits but by the wholesale market. They offer high-interest loans to businesses, households, and local governments. Their massive activity is unregulated, unsupervised, and not transparent. Part of the problem is that, although the formal banking system has a non-performing loan (NPL) ratio of only 1 percent, this number lacks meaning when an estimated 36 percent of credit is extended by non-banks—and their NPL ratio is unknown. The risk is that formal banks, which have provided wholesale funding for the shadow banking system, could face big losses. Already there have been some defaults. Ultimately, it would be more effective for interest rate controls to be abandoned. This would eliminate the need for shadow banks and lead to a more efficient system of financial intermediation.
Based on what many government officials have said, there is much to do on the financial front. Implementation of deposit insurance would certainly be an important first step.
Further global integration
Another area of change involves China’s economic relationship with the rest of the world. China’s government now says it will study the possibility of joining the Trans-Pacific Pact (TPP), an effort to create a free-trade area in the Pacific Basin. Currently there are 12 countries involved in this effort: the United States, Japan, Canada, Mexico, Peru, Chile, Vietnam, Malaysia, Singapore, Brunei, Australia, and New Zealand. If China joins the group, the TPP will collectively account for more than half of global GDP. Freer trade would entail not simply lowering tariffs and quotas, although this would be an important component. It would also involve freeing up domestic markets so that they would have to compete freely with foreign companies. From China’s perspective, this could be a positive development in that it would create pressure to privatize state-run companies, create a level playing field for the private sector, and allow free movement of prices of goods and credit. Still, agreement on the TPP is probably a long way off.