Should China deleverage?
Because China's debt consists overwhelmingly of loans by stateowned banks to state-owned enterprises, depositors and investors feel confident (rightly or wrongly) that their assets carry an implicit government guarantee.
China's mounting debt problem recently moved into the spotlight when Moody's downgraded the country's sovereign rating. But was the downgrade really warranted? Though China's overall debt-to-GDP ratio is not an outlier among emergingmarket economies, and its levels of household and government debt are moderate, its corporate debt-to-GDP ratio, at 170%, is the highest in the world, twice as large as that of the United States. China's corporate leverage (debt-to-equity) ratio is also very high, and rising.
A high and rising debt-to-GDP ratio, which goes hand in hand with a high and rising leverage ratio, can lead to financial crisis through three channels. The first is the deterioration of the quality of financial institutions' assets, and the decline in the price of those assets. With institutions forced by mark-to-market accounting to write off an equal amount of equity, the leverage ratio rises, leading to a further deterioration in asset quality and decline in asset prices.
The second channel is refusal by investors, concerned about the rising leverage ratio, to roll over short-term debt. This causes the money market to seize up, forcing banks and other financial institutions to tighten credit and raise interest rates, thereby further weakening borrowers' debt-service capacity. Defaults proliferate and the volume of nonperforming loans rises.
The third way a high debt-to-GDP ratio can lead to crisis is by driving banks and nonbank financial institutions, unable to secure sufficient capital, into bankruptcy. In this case, the public could panic and withdraw their cash, fuelling a run on deposits that could lead to the collapse of the entire financial system.
But none of these scenarios seems like a real risk for China, at least not in the foreseeable future. China is, after all, a highly frugal country, with gross savings totaling 48% of GDP. As a result, loanable funds are abundant, and funding costs can be kept low. Therefore, China has more scope than other countries to maintain a high debt-to-GDP ratio.
Moreover, because China's debt consists overwhelmingly of loans by state-owned banks to state-owned enterprises, depositors and investors feel confident (rightly or wrongly) that their assets carry an implicit government guarantee. And not only is the government's fiscal position relatively strong; it also has $3 trillion in foreign-exchange reserves – a sum that far exceeds China's overseas debts. China's government could, if it so chose, bail out banks in trouble, preventing contagious bankruptcies.
Mitigating the debt risk further, China's capital account remains largely closed, enabling the government to block capital flight and gain sufficient time to deal with unexpected financial events. It helps, too, that the People's Bank of China stands ready to inject liquidity into the money market whenever necessary.
None of this is to say that China's high level of corporate debt is not a cause for concern. But it does imply that deleveraging may not be as urgent as many seem to think, especially at a time when China has another, more pressing policy imperative to pursue – one that could be undermined by rapid deleveraging.
For years, China has been in the grips of overcapacity-driven deflation. The producer-price index (PPI) has declined in year-on-year terms for 54 consecutive months, while the annual rise in the consumer-price index (CPI) is hovering around 1.5%. In October 2016, PPI growth turned positive, suggesting that the debt-deflationary spiral may have been
broken. But, after a few good months, the sequential growth rate of PPI has turned negative again, suggesting that now is no time to test fate on deflation.
This is all the more true at a time when the government is clamping down on runaway real-estate prices – an effort that is likely to deter investment, thereby weakening economic growth in the next six months. In this context, a wrong move could tip China back into a debtdeflationary spiral – which would pose a more acute threat to China's economic stability than the risks stemming from the debt-to-GDP ratio.
Still, Moody's points out, China's debtto-GDP ratio is a serious problem. Moreover, to justify its downgrade, it argues that the government's efforts to maintain robust growth will result in sustained policy stimulus, which will contribute to even higher debt throughout the economy.
But this reading fails to distinguish between the long-term trend of the debtto-GDP ratio when the economy grows at its potential rate and the real-time debtto-GDP ratio when the economy grows at a below-potential rate. When an economy is growing at roughly its potential rate, as China's is today, it makes no sense to lower the growth target below that rate.
To be sure, China does have reason to implement economic stimulus. The overcapacity that, until recently, dominated the Chinese economy was rooted partly in a lack of aggregate demand (and partly in wasteful overinvestment).
In an ideal world, China's government could respond by stimulating household consumption. But, in the absence of further reforms in areas like social security, growth in consumer spending is bound to be slow. In the meantime, the government must rely on an expansionary fiscal policy to encourage infrastructure investment, even if it means raising the debt-to-GDP ratio.
Such an initiative should also entail improved financing opportunities – including lower borrowing costs – for small and medium-size enterprises. Meanwhile, the rise in the corporate debt-to-GDP ratio could be stemmed by efforts to improve capital efficiency, boost enterprise profitability, narrow the difference between credit flows and credit-financed investment, increase the share of equity finance, and align the real interest rate with the natural interest rate.
There is no doubt that China's debts – especially its corporate debts – are a serious problem, and must be curbed. But China must balance that imperative with the more urgent need to maintain a growth rate more or less in line with potential, and prevent the economy from being tipped back into a debt-deflationary spiral. So far, China has managed to juggle these two imperatives. One hopes that it has time to address the challenges before it drops a ball.
Yu Yongding, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People's Bank of China from 2004 to 2006. Copyright: Project Syndicate
show the amount of "fear" in the market. This year it has topped 15 just once – when the markets saw the prospect of U.S. President Donald Trump's impeachment as likely. (Low readings are bearish while high readings are bullish.) In contrast, during the past two years, the index spiked above 20 nine times, eclipsing 25 on four of those occasions.
Driving the rosier outlook, in part, has been the absence of traditional sources of worry. For instance, concerns that had been growing over the long slide of China's foreign exchange reserves ebbed when that trend reversed at the beginning of the year.
Another source of comfort for investors is the global reflation trend that manifested toward the end of 2016. Chinese producer prices, driven by oil price stabilization, had reversed their fall early last year, and, for the first time in years, China began exporting inflation, rather than deflation, to the world. That, compounded with the hope that surrounded the new U.S. president's campaign package of tax cuts and infrastructure spending, created a generally warm feeling that buoyed markets. That confidence carried into this year as the types of political worry that had previously traumatized markets, particularly anxieties over a eurozone breakup, evaporated with every electoral defeat of Euroskeptics. The accession of the more federalist Emmanuel Macron to the French presidency has accentuated this theme, while euro area growth has also picked up.
All of this positivity, however, risks obscuring the danger of some uncomfortable underlying truths. In reality, many of the aforementioned positive indicators have been falling away. Chinese producer prices reached an apex in February and have been falling ever since, dragging inflation in the developed world back down with them. Much of the early-year inflation came after oil prices bottomed out at the start of 2016. But the subsequent price recovery that drove the inflation is over, and oil prices are now where they were at the start of last year. With the energy market showing signs of oversupply, energy prices have softened. Oil production growth in the United States, Nigeria and Libya will cap energy prices and prevent them from contributing significantly to inflation.
Meanwhile, Trump appears to be backing away from the most ambitious of his tax and infrastructure proposals, and even then, the prospects of them being enacted look increasingly dim. In fact, the markets' understanding of the U.S. administration's focus is shifting toward trade policy, where potential lies more in the ability to depress markets than to buoy them. U.S. economic data have also been less positive in recent months, with gross domestic product growth slipping over the first quarter of the year.
Against this backdrop it would be easy to assume that central banks, which seem to see a global economy on the rise, have not yet caught up with the latest trends. Inflation across the developed world has tracked falling energy prices, and despite little expectation of a greater inflationary trend in the coming quarter, central banks have not drastically altered their outlooks. As the Fed announced the news of its latest rate hike, it implied that at least one more would follow this year. It also continued to lay out its plan to shrink its balance sheet, all part of an attempt to "normalize" after several years of extraordinarily low rates and bond-buying.
The European Central Bank's (ECB's) lending rate remained unchanged, but it did remove the possibility of dropping rates in the foreseeable future. The Bank of Japan also held steady, though behind the scenes it has allowed the pace of its monthly bond purchases to fall below its official target, a sign that it may be trying to quietly step back from that policy.
Meanwhile, the United Kingdom, suffering its own special circumstances after the Brexit vote of 2016, now faces a weaker pound and diminishing consumer spending. That combination, coupling rising inflation with a nascent slowdown, leaves the Bank of England in a bit of a pickle: If it raises rates to stave off inflation, it risks further throttling the economy. On June 15 its decision-making council decided to leave the rate unchanged, but its 5-3 vote made clear the extent of the bank's dilemma.
Nevertheless, any accusations of complacency leveled at the Fed, the ECB and the Bank of Japan probably aren't warranted, because there are other factors at play. In the wake of the 2008 crisis, each took unprecedented measures, allowing interest rates to drop to record lows while going on bond-buying sprees that ballooned its balance sheets in relative terms. That created a problem, because there are hard limits to how far monetary policy can go, particularly through interest rate manipulation. If rates drop far enough into negative territory, say around minus 2 percent, they will pass what is known as the zero lower bound – the point at which, considering administrative costs, it would be cheaper for depositors to withdraw their money from bank vaults and stuff it in their mattresses. This is still a theoretical threshold, but with eurozone and Japanese interest rates hovering around zero, it feels uncomfortably close.
While the extreme monetary policy enacted after 2008 was thought necessary at the time to stave off a 1930s-style depression, it has created conditions that are hard to escape. Just as a fighter pilot who puts his plane into a steep dive to win a dogfight must gain altitude before attempting a new manoeuvre, central banks are trying to give themselves room to react in case another crisis emerges. This is why the Fed is inclined to continue raising rates even if data show a less robust outlook, and the Bank of Japan is resisting a further loosening of its monetary policy, even though inflation remains at zero, far from the 2 percent target it has set.
Meanwhile, vague specks of attacking fighters have appeared on the radar. In the eurozone, Italy is working its way through an electoral law that will enable it to hold new elections. The biggest threat to the currency union would be a new government containing the radical Five Star Movement, but the surging influence of Silvio Berlusconi's Forza Italia and the separatist Northern League could also spell trouble. In the United States, alongside impeachment risks and slowing growth, there are signs of a bubble in the auto loan industry and in overheated technology stocks, both of which could present a sudden setback to the economy. And once China's upcoming National Party Congress concludes, Beijing would be free to launch a concerted effort to tackle massive debt levels, an action that could disrupt the global economy.
Far from showing complacency, then, the current hawkishness of the world's central banks might be displaying prudence in taking the opportunity provided by clear skies to gain as much altitude as they can, in case more drastic action is needed in the future.
“Central Bankers Regain Altitude While They Can” is republished with the permission of Stratfor, under content confederation between Financial Nigeria and Stratfor.
A view of the People’s Bank of China