Debt deflation and revitalization of existing assets are now the two challenges confronting China. As there is a necessary intrinsic logic between the two, they offer a point of breakthrough for the next-step reforms.
In June, Chinese PPI had a year-on-year decrease of 2.7%, negative for the 16th consecutive month. Demands from the real economy continued to shrink, indicating that traditional sectors with excess production capacity and high asset-liability ratio may well run into repayment risks as the Chinese financial sector de-leverages. To a large extent, the policy sequel of the post-financial crisis’ stimulus package and large-scale credit expansion will gradually surface.
In response to the worsening international financial crisis and greater downward economic pressure at home, China introduced a series of economic stimulus programs in 2008. The economy rebounded robustly with credit expansion in the banking sector and with accelerated investment. But the consequent corporate leverage ratio (liability ratio) has also risen continuously. Since 2011, the economy has been on a downward curve, profit growth has slowed down and more businesses have suffered losses, leading to serious debt arrears and increased chain debts. As a result of money stranded at debt repayment, the real economy was the first to feel the impact of money shortage.
While the real economy goes downward, the phenomenon of money circulation within the financial sector has only intensified. Shadow banking and off-balance-sheet financing such as wealth management products offered by banks, trust plans and entrusted loans continue flooding. Local governments keep investment and debt expansion by way of off-balance-sheet loans, corporate bonds and inter-bank debt financing. Both have contributed to inflated total social financing.
Since the beginning of this year in particular, the increasing imbalance between GDP growth rate and credit expansion speed has caused market attention. With higher leverage ratio, worries about default caused by debt accumulation have been on the rise. At this critical moment, the US Federal Reserve talked explicitly about a quantitative easing exit and the Chinese Central Bank started to tighten money supply, a shift from the previous easy-money policy. The de-leverage effect has driven the money multiplier lower by a large margin, leading to the sudden arrival of the Minsky Moment for the Chinese market.
So the money shortage in China is not just a money problem. Its nature lies with the unsustainability of the debt-dependent Chinese economy. The money shortage has sounded an alarm for China. To avoid greater impact on the economy in the future, China has to “scrape the poison off the bone” and cut off the chain of high risks.
Admittedly, an overly strong and austere policy or one mishandled may well trigger new economic and financial risks in the near term. The Chinese monetary policy must be balanced between short and long terms and designed in a way to avoid new harms to the real economy by excessively fierce de-leveraging efforts. The money shortage on the inter-bank market has now affected the real economy, with huge financing pressure for businesses.
Furthermore, as they are concerned about continued illiquidity, the banking and financial institutions tend to hoard cash, which will lead to not only fewer mid- and long-term loans to the real economy and SMEs, but also slower money circulation and lower money multiplier.
The monetary policy was intended to force liquidity back to the real economy and therefore “revitalize existing money.” However, changed policy expectations may well make the banks more reluctant to lend, squeezing the credit available to the real economy. As such, once the economic growth and corporate income growth cannot cover the rising debt scale and financing cost, not only the real economy will suffer another impact but also the liquidity risk may well turn into a repayment risk.
Being aware of this, the Central Bank’s monetary policy position has somehow softened. However, it should give even clearer policy signals to stabilize market confidence by maintaining overall market stability and liquidity support to the real economy while pushing ahead with the de-leveraging process. By injecting liquidity to banks and money markets by reverse repo and other market tools and using various policy tools to restore Shibor to normal level, the Central Bank will be able to effectively lower financing costs, boost market confidence, circulate money faster and liquidize existing money.
The recent guidelines for the financial sector made it clear that ten measures would be taken to “revitalize existing assets” and “use the best forging steel for knife blade.” This suggests that the Chinese leadership is determined to revert resource misallocation and reform existing systems. The next step should focus on speeding up interest rate liberalization, improving the framework for macro-prudential regulation and local government debt management, and reducing burden over the real economy so as to eliminate the systemic and institutional causes of capital arbitrage or internal money circulation and truly restore balance between the virtual and the real economies. Only by doing so can the existing assets be revitalized.
Zhang Monan is Deputy Director of the World Economic Research Office at the Economic Forecast Department in the State Information Center.