China wants to maintain adequate growth, but it also wants to restrain the growth of credit in the shadow banking system. As such, the government is taking steps to resolve imbalances.
The economic slowdown in China continues, raising questions about the appropriate direction of government policy. First, consider the numbers. In the first two months of 2014, industrial production was up 8.6 percent from a year earlier, the slowest rate of growth since the start of 2009 when the world was in the midst of the global financial crisis. In addition, retail sales for the first two months were up only 11.8 percent from a year earlier, a considerable slowdown compared with the past few years. Additionally, exports were actually down 1.7 percent in the first two months compared with a year earlier, which reflects the impact of weak demand in Europe as well as rising wages and an increased currency value in China. Finally, the growth of fixed asset investment, while still strong at 17.9 percent in the first two months of 2014, has decelerated considerably.
The economic slowdown has been brought about by weakness overseas as well as a tightening of credit market conditions by the Chinese authorities.
The economic slowdown has been brought about by weakness overseas as well as a tightening of credit market conditions by the Chinese authorities. In recent months, the government has indicated that it is more interested in addressing fundamental structural problems in the economy rather than focusing on growth. It has said that it is content with growth in the neighborhood of 7.5 percent, which is quite slow compared to recent years.1 And yet the continuing and perhaps unexpected deceleration in the economy has evidently caused concern. Consequently, Premier Li Keqiang said in March that the government will boost the growth of fixed asset investment in order to stabilize the economy.2
It is interesting that the government is focusing on investment rather than consumer demand. One serious criticism of the government is that it has allowed far too much investment, much of it wasted and much of it leading to excess capacity and, consequently, low or negative returns. The result is likely to be serious trouble for the financial industry, which has funded much of this investment. Consequently, the new emphasis on investment can be seen as a setback for the cause of reform. Or it can be seen as a compromise by the government, which is trying to balance a desire for reform with a desire to maintain growth. The problem with allowing a sharp slowdown in economic growth is that it could exacerbate excess capacity, suppress profit margins, and cause further stress in financial markets.
With credit growing faster than GDP, the economy is becoming more dependent on credit to drive growth, thus setting the stage for trouble down the road. China faces a tough balancing act. It can attempt to keep the economy growing by allowing more expansion of credit. Yet this risks trouble in the future when servicing debts becomes more problematic, especially if many debts go bad as expected. The other option is for the government to try to solve the credit dilemma by cracking down on credit creation. Yet doing so creates the risk of a slowdown in economic growth. By allowing a default in the domestic private sector recently, the government sent a message that there is risk in lending money foolishly. This may help to restrain excess credit growth as well as shift toward more realistic pricing of credit. Indeed, risk spreads have increased lately. On the other hand, the government’s indicated direction may lead to a sharp tightening of credit market conditions, slower economic growth, and more defaults.
The big question now is to what extent the government will continue efforts to slow the growth of credit through the shadow banking system. Doing so will be critical in reducing the risk of bad debts. There has indeed been a slowdown in the growth of nonbank credit in the so-called shadow banking system. Yet, at the same time, there has been a commensurate boost to traditional bank lending. It appears that the government has encouraged banks to bring assets back onto their balance sheets. As such, bank loans accounted for 64 percent of new credit in the first two months of 2014, compared with 55 percent of credit during all of 2013. Trust company lending fell from 11 percent of new credit in 2013 to 5 percent in early 2014. Evidently, the government has made it more difficult to shift money from the interbank lending market to off-balance-sheet lending vehicles. Yet while the government has slowed the growth of shadow banking, it has been averse to slowing the growth of overall credit lest this lead to a further slowdown in economic growth. Consequently, it apparently has allowed for accelerated formal bank lending.
A big part of the shadow banking system in China has involved trust products. Specifically, large banks have raised funds by selling trust products with high returns to wealthy individuals. The money raised is loaned to companies and individuals who lack access to cheap credit through the formal banking system. This, of course, resulted in a massive increase in credit and, it is feared, a massive increase in potentially bad debt. After all, many of the loans went to property speculators who built ghost towns and empty shopping centers. In March it was reported that some Chinese banks were curtailing their involvement in this market, although this could not be confirmed. Trust products in circulation increased 46 percent in 2013, reaching 10.9 trillion yuan (roughly $1.7 trillion). About half of the trust products will mature this year. If some banks have chosen not to sell more trust products, it could reflect fears that defaults on loans will force the banks to bail out the trust products. The result would be lower bank profitability.
Despite the slowdown in shadow banking, there has been a rush into Internet-based money market funds that offer depositors a high rate of return with the ability to withdraw at any time. Formal bank deposits offer a return capped by the government. Such funds are not regulated, nor are the deposits insured. As such, some analysts worry that they represent yet another risk to China’s financial health. China’s government has pledged to deregulate bank deposit rates. Once they do this, the allure of nonbank vehicles will diminish. As such, it was noteworthy that, recently, the governor of China’s central bank said that deposit rates will be freed within one to two years, a pace faster than many analysts had expected.3
If China is to grow through innovation and entrepreneurship, then capital markets will have to operate on a more market-oriented basis and channel funds to start-ups and small businesses.
In addition, the Chinese government has approved trial plans for the establishment of five privately owned banks. These banks would compete with the large state-run banks and would be the start of larger plans to create a more market-based system of financial intermediation. Also, Premier Li said recently that he intends to promote Internet banking in China. The head of China’s bank regulator said that “while private banks are subject to the same regulation as other banks, they should have also their own characteristics, especially focusing on serving small and medium-sized companies.”4 Interestingly, almost 90 percent of bank capital in China is now supplied by the government. One of the frequent complaints about China’s banking system is that, due to the overwhelming dominance of state-run banks, smaller businesses have often been starved of capital. If China is to grow through innovation and entrepreneurship, then capital markets will have to operate on a more market-oriented basis and channel funds to start-ups and small businesses.
The Chinese government has doubled the band around which the currency can move before government intervention takes place. This is part of a gradual move toward a more freely floating currency, which in turn is part of a larger effort at financial market liberalization. The move was expected. Until recently, most analysts would have expected this to mean more room for appreciation of the currency. Earlier there was substantial upward pressure because, with an external surplus, China was experiencing a large inflow of capital—which has only accelerated recently in anticipation of further appreciation. Yet the central bank recently allegedly engineered a drop in the currency, causing uncertainty on the part of currency traders. This action means that the currency could go in either direction—just as the government probably hopes.
Specifically, the move allows the currency to move up or down by as much as 2 percent against a basket of currencies. If the renminbi hits that limit, the government will intervene to prevent further movement. Yet it is a rare day when a floating currency moves that much. As such, the move effectively makes the Chinese currency a floating currency, except during periods of unusual stress. The US government, long a critic of Chinese currency policy, welcomed this action. However, investors now face a more uncertain environment, especially as there is now risk of depreciation. It is interesting that, while the action is meant to remove the government from currency valuation, the fact that the government may have pushed the currency down means that it effectively remains a player. The current downward pressure on the renminbi may no longer involve the government directly. Rather, it may simply reflect market fears of further intervention by the government. More will need to be done in order to create a more truly liberal financial system. The government will have to ease capital controls, free deposit interest rates, and become more transparent about monetary policy.
EndnotesView all endnotes
- Reuters, “Instant view: China aims for 7.5 percent economic growth in 2014,” March 4, 2014, http://www.reuters.com/article/2014/03/05/us-china-parliament-instantview-idUSBREA2404D20140305.
- Reuters, “WRAPUP 1-China says plans to speed up investment, stabilise demand,” March 20, 2014, http://www.reuters.com/article/2014/03/20/china-economy-idUSL3N0MH1CS20140320.
- Reuters, “China top leader reaffirms economic reforms,” March 22, 2014, http://www.reuters.com/article/2014/03/23/china-economy-idUSL4N0MK01K20140323.
- Sophie Song, “China banking reform: 10 private companies including Alibaba and Tencent allowed to set up private banks,” International Business Times, March 11, 2014, http://www.ibtimes.com/china-banking-reform-10-private-companies-including-alibaba-tencent-allowed-set-private-banks.