China: A turning point?

China: A turning point?

China: A turning point?

Global Economic Outlook Q3 2013

While the global economy is modestly accelerating, China appears to be faltering. But for now, the country’s new leadership will focus on economic fundamentals instead of resorting to stimulus.

Dr. Ira Kalish is director of global economics, Deloitte Research, Deloitte Services LP.The Chinese economy appears to be faltering. At a time when the global economy is showing signs of very modest acceleration, China is shifting in the opposite direction. In the process, it is taking other countries such as Taiwan and South Korea in a negative direction as well. In June, a purchasing managers’ index (PMI) for manufacturing, published by Markit, shifted into further negative territory, indicating that the critical industrial side of the Chinese economy is actually in decline.1 A separate PMI for the services sector showed, at best, anemic growth.2 While domestic demand continues to grow, it has benefitted from relatively loose credit market conditions that now face reversal. Indeed China’s banking system is at a crossroads. It is going through a traumatic shift brought on by a government determined to alleviate financial imbalances, even at the temporary cost of slower growth. The new leadership has indicated that stimulus is not in the offing. Instead, fundamental issues will be addressed.

Slowdown in manufacturing, slow growth in services

First, the industrial side of the economy is faltering. A PMI for the manufacturing sector published by Markit declined from 49.2 in May to 48.2 in June.3 A reading below 50.0 means a decline in activity. The lower the number, the faster the decline taking place. Hence, the June reading suggests deterioration in the manufacturing sector. This was the second consecutive month in which the PMI fell. There was a decline in new orders and an especially deep drop in export orders.

In addition, Markit published a PMI for the services sector.4 This indicator increased modestly from 51.2 in May to 51.3 in June. Still, it remains low compared to recent months. New orders remained above 50.0, but were at the lowest level in 4.5 years. A sub-index for construction activity remained strong, but it declined nonetheless.

The weakness in economic activity reflects weak overseas demand—especially in Europe—and a slowdown in domestic spending on infrastructure and other forms of investment.

Out from under the shadows

Interestingly, the economy is slowing despite the fact that credit is growing rapidly. Indeed Chinese authorities are concerned that credit growth is not translating into economic growth and that credit growth is creating risks to the economy. In the first quarter, credit was up 58 percent, but real GDP growth was a very modest 7.7 percent. The authorities are worried that too much credit is flowing into things that contribute nothing to growth, including considerable speculative activity. As such, the central bank has taken steps to cool down credit markets. This includes cracking down on illegal capital inflows, tightening conditions in the mortgage market, and providing closer scrutiny of the shadow banking system.

It is the shadow banking system that has been at the center of attention. It has developed largely because of restrictions on commercial banks. They remain state-owned and face interest rate regulation. That is, the rate they pay depositors is capped, and the rate they charge borrowers is capped as well, providing the banks with a predictable and favorable profit margin. Their borrowers are mainly state-owned enterprises (SOEs) and local governments that get cheap credit and, as a consequence, invest excessively. Everyone else—including private sector businesses and households— lacks substantial access to bank credit.

The weakness in economic activity reflects weak overseas demand—especially in Europe—and a slowdown in domestic spending on infrastructure and other forms of investment.

In order to profit from the excess demand for credit, banks have bundled loans into Wealth Management Products (WMPs) that are essentially securitized assets. They sell these WMPs in order to shift assets off the books and raise funds that can be loaned at higher interest rates through off-balance-sheet vehicles known as trust companies. The result has been an explosion of credit outside normal banking channels and outside the purview of regulators. Moreover, this has enabled the banks to maintain a very low non-performing loan ratio even if many of the loans they have made (especially to local governments) have actually gone bad.

The WMPs are like bonds in the sense that they have a maturity date, usually in less than three years, sometimes as little as six months. When they come due, banks must pay back the investors. If the loans behind the WMP have failed, the banks must somehow raise funds to service the WMPs. This has generally meant issuing new WMPs, often at even higher interest rates. To grease this market, much interbank lending has been taking place. WMPs are not the only part of the unsupervised shadow banking system, but they are the most noteworthy. The WMPs tend to be bought by wealthy individuals who want a better return than can be obtained through banks. In any event, the whole system exists because of interest rate regulation. Absent this, there would be little need for a system outside normal banking channels.

Default on a WMP would mean that individual investors would lose their money. Yet this is hardly desirable. As such, the banks continue to fund the WMPs, often borrowing from one another to raise short-term funds needed to pay owners of WMPs.

How did we get to this point?

One of the things that recently enabled a dramatic increase in credit has been continued growth of the money supply. This was partly due to the need to monetize inflows of capital. Such inflows were fueled, in part, by the illegal practice of faking export invoices. Exporters would do this in order to borrow overseas and bring money into China to invest, all the while falsely treating these inflows as export revenue. This “carry trade,” if not monetized, would have put upward pressure on the currency. To avoid currency appreciation, the People’s Bank of China (PBOC), China’s central bank, purchased foreign currency, thus maintaining the exchange rate and boosting the money supply. When the government recently cracked down on fake invoicing, capital inflows slowed dramatically. This, in turn, meant that the central bank was no longer providing as much liquidity, but the demand for interbank lending continued apace. Without support from the PBOC, interbank lending rates started to rise. When the PBOC initially failed to intervene to suppress rates, investors panicked, thereby driving rates up to unusually high levels.

Ultimately, the PBOC intervened lest any banks fail. Yet the episode offered a glimpse at government thinking. The new leadership has spoken publicly about getting the shadow banking system under control. Clearly the recent events suggest that they are trying to find a way out of the current situation. However, unless they allow free movement of interest rates, the situation could worsen. Moreover, the lack of transparency in the system means that potential risks may be hidden and could explode at any time. While a Lehman type event is unlikely given that the government owns the banks, a serious credit crunch is possible, which would have negative ramifications for economic growth.

Most analysts expect that the government will bail out banks and absorb losses, should the need arise. They would probably place restrictions on credit growth, but not too much lest they dramatically slow the economy. The result could be continued growth of credit, fueling the continuation of economic growth through investment in infrastructure. This means an increasingly distorted economy with huge financial imbalances, rising investment, and declining GDP growth. It would be better, of course, to liberalize financial services and create a more efficient system. The problem is that the transition to a market-driven system will involve a transition that would be challenging to implement. A market system would mean less credit growth, higher returns on bank deposits, higher costs of borrowing from banks, less investment by SOEs, and a gradual shift toward a consumer- driven economy.

For now, it appears likely that the economy will grow slowly, that credit growth will slow down, and that the authorities will seek ways to gradually shift the financial system away from dependence on non-traditional forms of financial intermediation.


View all endnotes
  1. Markit Economics, “Press releases,”, accessed July 17, 2013.
  2. Ibid.
  3. Ibid.
  4. Ibid.


Dr. Ira Kalish

Dr. Ira Kalish is chief global economist of Deloitte Touch Tohmatsu Limited.

Global Economic Outlook, Q3 2013: China
Cover Image by Jessica McCourt