China’s policy makers continue their balancing act. On the one hand, they want to revive economic activity at a time when it is slowing far more than previously anticipated. To do this, they have eased monetary policy with the goal of boosting credit-market activity. On the other hand, they are cognizant of the volume of potentially troubled assets held by banks and are taking action to protect the integrity and liquidity of bank balance sheets. This, however, means some stifling of credit activity.
The dilemma faced by the government is partly due to the negative impact of the crisis in Europe. The European Union is China’s largest export market and is now in a deeper recession than was expected. China’s exports to Europe were up only 3.2 percent in May, while exports to the United States were up 23 percent. Although overall export growth was strong, it was entirely due to the United States. Export growth would have been far stronger if not for the recession in Europe. The slowdown in exports to Europe has had a negative impact on industrial activity. For two months in a row, a purchasing manager’s index for manufacturing in China has declined and been below the critical 50.0 level, below which activity is declining.
Another factor slowing the Chinese economy is the lagged effect of last year’s monetary policy tightening, which had a negative impact on the growth of credit, including consumer- and housing-related credit. For example, the automotive industry is now facing difficulties as consumers stay home and dealer inventories pile up. The housing market has decelerated significantly as well—although house prices increased in May for the first time in 10 months—likely reflecting the impact of lower interest rates. The decline in housing investment has had a direct impact on industrial activity. Finally, Chinese company profits declined in May for the second month in a row, reflecting the pricing pressures of a stagnant market.
The result of all these events has been a continuing slowdown in growth, with real GDP growth declining for five consecutive quarters. For the past year, the government has taken action to offset the slowdown. This has mostly involved a loosening of monetary policy. First, there were reductions in the required reserve ratio for banks, with the goal of boosting the volume of lending. Lately, however, the central bank has become more aggressive, with two interest rate cuts in June and July of this year. The result has been accelerated growth of the money supply and bank credit. In addition, the government has engaged in a more (but not too) aggressive fiscal policy.
Consider the fact that, in 2008, following the near collapse of global financial markets, China implemented a massive monetary and fiscal stimulus in order to offset the negative impact of weak global demand. That stimulus was successful in offsetting the collapse of export demand. However, much of that stimulus money was loaned by state-run banks to local governments, which spent the money on infrastructure and other projects. Today, local governments are having difficulty servicing that debt, and there is a general recognition that the investment was excessive. The return on much of that investment was negative. Consequently, now that China is slowing again, the central government is reluctant to repeat such a policy, especially given the high level of local government debt. Instead, the central government is taking smaller steps to boost growth: gradual easing of credit conditions, targeted spending on some infrastructure projects, tax incentives for consumers to spend on automobiles and appliances, and more lending to small businesses. Bigger projects, however, are being avoided.
The decline in housing investment has had a direct impact on industrial activity.
Given the recent history of excessive investment in infrastructure and other fixed assets, the government is keen to avoid a further buildup of debt. Indeed, the volume of nonperforming loans held by Chinese banks increased in the most recent two quarters—the first time since 2005 that this measure had increased for two consecutive quarters. Consequently, while monetary policy has been aggressive, banking regulation has been equally aggressive in the opposite direction. Specifically, the China Banking Regulatory Commission plans to retain the maximum loan-to-deposit ratio at 75 percent and may take other actions aimed at constraining credit growth. In addition, the government has placed limits on bank lending to local governments lest their financial condition worsens. The purpose of these actions is to reduce liquidity and default risks. The regulators are concerned that, with lower interest rates and lower reserve requirements, the already large number of bad assets held by banks could increase if lending grows too quickly.
Another important action taken by the government has been to retard the appreciation of the currency. While other countries have complained, China has chosen to prevent further appreciation lest exports become less competitive at a time of weak export demand. This, of course, is only a temporary measure, and it will be in China’s long-term interest for the currency to rise further in value.
Finally, one interesting reason behind the government’s reluctance to engage in more aggressive measures to boost growth is that the big coastal cities of China continue to experience shortages of labor. Even though factory output has stalled, the factories still have trouble filling their labor requirements. This is because there has been a sharp decline in the volume of migration from China’s rural areas to the big coastal cities. This means that China’s authorities need not worry too much about social unrest rising from urban unemployment.