Friday, November 21, 2014

China’s Narrowing Policy Horizons

BEIJING – Back in the last quarter of 2011, when the decline in China’s investment growth accelerated, concerns about a hard economic landing intensified, particularly given the authorities’ reluctance to pursue new expansionary policies. By May 2012, however, the government had changed its mind, with the National Development and Reform Commission approving ¥7 trillion ($1.3 trillion) in new projects. That, together with two ensuing interest-rate cuts by the People’s Bank of China (PBOC), guaranteed an end to the economic slowdown in the third quarter of 2012.

The Chinese economy’s performance has thus maintained the cyclical pattern familiar from the past two decades: rapid investment growth, supported by expansionary policy, drives up the economic-growth rate. Inflation follows, so policy is tightened and growth slows. But inflation remains high or rising, so more tightening is imposed. Inflation falls at last, but growth slows more than desired, owing to the overcapacity that resulted from excessive investment in the earlier phase of the cycle. At this point, policy becomes expansionary again, and the cycle begins anew: led by investment growth, the economy rebounds.

Thus, the acceleration of economic growth since the third quarter of 2012 should come as no surprise. With the government still having room to wield expansionary monetary and/or fiscal policy, the economic revival was only a matter of time.

There is no reason to doubt that the Chinese economy in 2013 will follow the old growth pattern. But China’s decision-makers should bear two things in mind. First, in the past, short-term macroeconomic stability was often achieved at the expense of structural adjustment and rational allocation of resources. To achieve sustained growth, a balance between short-term and long-term objectives must be struck. Striking that balance is the biggest challenge facing China.

Second, some financial vulnerabilities are embedded in the economy. Unless they are defused in time, financial shocks may derail the economy from its normal growth path.

According to preliminary reports, annual investment growth in 2012 reached roughly 14% – significantly higher than the GDP growth rate, which accelerated in the fourth quarter as a result of a strong rebound in investment in real estate and infrastructure. In 2013, it can be expected that, barring major disruptions, strong investment growth will push China’s GDP more than 8% higher year on year.

The timing of the inevitable policy shift back to tightening depends on overall inflation, particularly house prices. The problem is that the investment share of China’s GDP is already about 50%, while double-digit investment growth in 2013 is expected to push that rate still higher. Such a growth path is simply not sustainable.

The money supply has grown significantly faster than output for decades. In 2012, the growth rate of M2 was about 14%, relatively low by historical standards, but still significantly higher than the nominal GDP growth rate. As a result of this chronically rapid growth in broad money, China’s M2/GDP ratio has surpassed 180%, the highest in the world. Though the full implications of this uniquely high ratio for macroeconomic stability need further investigation, it certainly implies financial fragility and a weakening of the PBOC’s ability to control overall liquidity in the economy.

Third, though China’s public debt/GDP ratio is officially still under 20%, since the onset of the global financial crisis in 2008, its fiscal position has deteriorated. If the government’s contingent liabilities are included, China’s debt/GDP ratio may be closer to 50%.

A worrying development in this regard is the rapid rise in enterprise debt, which, according to various studies, now surpasses 120% of GDP – much higher than the leveraging rates of nonfinancial enterprises in major developed countries. Even if this does not trigger a crisis, it sharply narrows the government’s scope for using expansionary fiscal policy to stimulate the economy.

In 2011 and early 2012, there was much talk of a crash in China’s housing market, and a chain-reaction of defaults in underground credit networks and local-government finance platforms. In 2013, the talk has changed to the danger of a resurgent housing bubble and the collapse of the shadow banking system, which consists mainly of wealth-management firms and trust companies.

According to market sources, total assets managed by the shadow banking system have risen exponentially since 2009, totaling ¥14 trillion, or one-third of GDP, in the third quarter of 2012. With relatively slow growth, corporate profitability, upon which the returns of the shadow banking system’s asset pools are based, is low and falling. Where, then, will the high returns of the financial products provided by the shadow banking system come from?

If the shadow banking system collapses, the consequences for the financial system will be much graver than the problems caused by underground credit networks and local-government finance platforms, which were much discussed in 2012. No wonder, then, that one influential banker regarded as a possible successor to PBOC Governor Zhou Xiaochuan has warned of the possibility of a “Chinese-style subprime crisis.”

For now, the Chinese economy, having received its cyclical dose of stimulus, should be okay. By the end of the year, however, the costs of the structural adjustment needed to shift China’s growth model away from investment demand could rise further.

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    1. CommentedJohn Haslett

      "decline in investment growth accelerated"
      Am I right that mathematicians would describe this is a fourth derivative?

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    3. CommentedProcyon Mukherjee

      It would be interesting to see what M2/ GDP ratio of 180%, which by any standard has no other parallel, has actually done to U.S. This surge has moved to fixed asset investment of a recurring 50% of GDP year after year; such an investment led growth had to move to the external sector for support thus creating a current account surplus with commensurate increase in foreign exchange reserves. While the Chinese economy did show a sustainable growth trajectory of plus 8% for almost a decade, this also led to a trade advantage to U.S. that helped hundreds of U.S. corporations to a better input sourcing that eventually led to a better bottom line. By any rough estimate 25% of the current cash pile of S&P 500 could be traced to this shift from external sourcing helped by Chinese surge in exports.

      The question is whether a shift to domestic consumption, which could stymie the external account, make China's progress be based on more stable and sustainable model of growth. But the deeper question is how the shrinking balance sheet strength of the corporate sector in China (as liabilities are growing at an alarming pace) could be revived as surely that needs urgent attention.