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.

Financial Nigeria Magazine - - Contents - By Yu Yongding

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

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