The Chinese economy appears to be stabilizing, at least for now. China’s government has provided modest stimulus aimed at stabilizing growth, including extra spending on infrastructure and easing of credit conditions, and there are indications it is working. China’s industrial production was up 10.4 percent in August versus a year ago—the fastest rate of growth in 17 months. This is consistent with other recent data pointing to a recovery in China’s growth, including exports.
In August, China’s exports were up 7.2 percent from a year earlier, which was better than expected. Exports to the United States and the European Union were up, and exports to Southeast Asia were up a staggering 30.8 percent. Exports to Japan, however, were down for the seventh consecutive month, reflecting political tension between Asia’s giants. On the other hand, Chinese imports were weak in August, rising only 7 percent (below market expectations), suggesting weakness in domestic demand. The result of these indicators was an increase in the trade surplus. However, evidence suggests that the boost to exports might, in part, be due to fake invoicing of exports by investors seeking to bring foreign money into China. If so, the acceleration in exports is not really as good as reported.
There were other positive indicators as well. First, Markit’s purchasing manager’s indices (PMIs) for both manufacturing and services improved in September.1 Of course, improved PMIs are not necessarily a sign of rising business confidence; they could reflect a decision by the authorities to boost investment by making credit available to state-run enterprises. Second, retail sales in August were up 13.4 percent from a year earlier. This was the fastest rate of growth this year. Third, credit growth took place after four months of decline. While this may be worrisome in the longer term, it boosts economic activity in the short term. Specifically, bank lending increased by 711 billion Chinese yuan in August, while total social financing, a measure that includes bank lending as well as nonbank credit creation, increased by 1.57 trillion yuan in August.
The fact that bank lending accounted for less than half the growth of credit is cause for longer-term concern. It means that the unregulated, unsupervised, and poorly measured part of the credit industry—including the issuance of wealth management products (WMPs) and other forms of shadow banking—is expanding once again, thereby possibly setting the stage for troubles down the road. It also means that the credit squeeze of June is clearly over, and that the government is now being accommodative in order to keep the economy growing. Indeed, the broad money supply accelerated in August as well.
The government is caught in a difficult spot. On the one hand, if it tightens credit conditions, growth will most likely falter. On the other hand, if it allows nonbank credit to continue growing rapidly, it could face future crises arising from the further creation of bad debt. The challenge for the leadership will be to reform the financial system in a way that avoids a financial crisis.
What about reform?
China has continued the gradual move toward interest rate liberalization.2 Back in July, China removed the floor on borrowing costs. Recently, it announced that banks will be permitted to trade certificates of deposit. The central bank said that this move will create the “conditions for steady and orderly promotion of deposit-rate liberalization.” Such liberalization will be critical to creating a more normal financial system.
Under the current system of interest rate controls, depositors obtain a small return on their savings and, consequently, have a strong incentive to look for alternative vehicles such as well-known WMPs. At the same time, banks have an incentive to go off their balance sheets to satisfy that demand. The result has been the huge expansion of the unsupervised and unregulated shadow banking system. This expansion has fueled excessive and often wasteful investment, a property price bubble, and the accumulation of debts that might not be repaid. The only way to prevent this from happening again is to liberalize and more fully privatize the financial system. When this happens, banks will be forced to compete for deposits, and they will no longer be able to provide cheap loans to state-run companies, which has fueled so much inefficient investment. As such, the recent move, while small, is a step toward a radically different and improved financial system for China.
Meanwhile, what should China do with its mountain of debt? The government has implemented an audit to determine the quantity of debt and will have this information in time for the party meeting in November. Of particular concern is the amount of local government debt, which has increased rapidly in the last few years, and many local governments are finding it difficult to service these debts. So far, the central government has compelled state-run banks to roll over these debts, but it could choose to allow some defaults to take place in order to improve market discipline. Interestingly, local governments in China are not actually permitted to issue debt. To get around this, they have set up over 10,000 off-balance-sheet local government financing vehicles to fund infrastructure investment. These vehicles may hold as much as 20 trillion yuan of debt, or more than $3 trillion. To service these debts, most local governments simply sell land.
The challenge for the leadership will be to reform the financial system in a way that avoids a financial crisis.
A new experiment
In early October, China began testing a free trade zone in Shanghai. Within a 29-square-kilometer (11-square-mile) area outside Shanghai, the government is permitting free movement of interest rates, currency convertibility, the relaxation of restrictions on foreign investment, and exemption of goods from tariffs and value-added tax. Anticipation of the free trade zone already has led to a surge in property prices in the area, as well as a big increase in the equity prices of companies that are expected to benefit from the zone. However, not many details are known about how the zone will function. Still, it is seen as an experiment by the Chinese government to understand the impact of full market liberalization. In some ways it is similar to what China did in the past. In 1979 China established a special economic zone in Shenzhen. This experiment in promoting foreign direct investment was later extended to other parts of China and partly formed the basis for the massive changes China experienced over the following 30 years. As such, the new zone near Shanghai, if successful, could be the basis for financial deregulation across China. Given that China’s early hopes for Shanghai to become a major financial center have not come to fruition, the creation of the free trade zone may be intended to revive such plans.
On the other hand, critics say that such zones actually stifle rather than promote reform. By walling off reform from the rest of the country, such zones prevent reform from becoming part of the economic landscape. Moreover, only two foreign banks have chosen to locate in the zone, suggesting a lack of confidence that there will be a level playing field for foreign operators. It is too early to say whose argument is correct.
- Bloomberg News, “China to allow interbank trading of certificates of deposit,” September 26, 2013, http://www.bloomberg.com/news/2013-09-26/china-set-to-allow-interbank-trading-of-certificates-of-deposit.html.